Japan: Why We Think A December Rate Hike Would Be Hasty
On Tuesday, the release of a strong Q3 GDP report weighed heavily on bond prices as Tokyo traders increased the probability of a December rate hike. Prior to this week, several indicators had suggested that Q3 economic performance had been on the wane, and that GDP would only expand by 0.2% on the quarter (+0.8% annualized) and 2.0% on the year. However, the actual figures were +0.5% (+2.0% annualized) and +2.7%, respectively, which made bond traders think the economy still had some life in it and that the Bank of Japan (BoJ) would feel more secure about raising rates again by December (almost nobody expects a rate hike after tomorrow’s conclusion of the current BoJ meeting). We, however, have changed our forecast and now think that the BoJ will (or at least that it should) hold rates well into Q1 2007.
As we explained in an earlier commentary (see Daily Global Commentary, November 13, 2006, “Japan: Does Another Weak Indicator Imply Soft Q3 GDP?”), we expected to see some strength in the Q3 GDP report, but it was the result of strong leading indicators earlier in the year rather than some unexpected strength in current conditions – as Tokyo markets seemed to think. Now, bond markets are using the GDP as a basis for the prospects of a December rate hike, however, the central bank seems to be studying some of the leading indicators that predicted the rise in GDP. And some of those leading indicators that were so strong earlier in the year are now on the decline.
When the BoJ started winding back its ultra-loose monetary policy at the beginning of this year, GDP showed a sustained acceleration of year-over-year growth. This expansion continued up to and into the Q1 2006 report, which was the most recent data available when the central bank engineered a 25 basis point increase in the overnight rate on July 22nd as the first step in its gradual normalization of monetary policy. From what the Bank was saying, the next rate hike looked set for December. However, some leading indicators were already moderating. Real M2 growth, a good leader of economic activity, had slowed during the first half of 2006. At the time the overnight rate was first increased, May real M2 growth had decelerated to an eight-year low of 1.2% on the year. As the following chart indicates, this indicator has only gotten worse.
With real M2 growth having dipped into negative territory for the first time since 1993, the outlook for the overall economy is hardly as strong as the Q3 GDP report would suggest. Rather than a picture of strength, it seems like Japan will end the year on a low note. And, assuming no unexpected declines in other leading indicators, GDP growth in Q1 2007 does not get much better. On a quarter-on-quarter basis Q4 GDP could actually contract by a small margin before rebounding slightly in Q1 2007, all which would leave year-on-year GDP growth hovering at just above 1% during the period – not the kind of figure that would reassure the BoJ.
At the conclusion of Thursday’s monetary policy meeting, market attention will turn toward BoJ Governor Toshihiko Fukui’s commentary about the outlook for interest rates. If the emphasis leans more the “normalization of monetary policy”, it should be interpreted as a December rate hike, which the central bank may very well regret in six months’ time. If, however, the discussion focuses more on “moderating economic forces” and a “slowdown in domestic demand patterns”, it means that Fukui & Co. have looked at the leading indicators and decided that higher interest rates can wait until 2007.
