Fukui’s itchy trigger finger

It seems that while Prime Minister Abe is busy fending off opposition attacks in the Diet on nuclear weapons, Fukui Toshihiko, the president of the Bank of Japan, has been signaling that the BoJ will be raising interest rates again soon, this despite ambiguous signs about the strength of Japan’s recovery.

There are serious questions whether the time is right for Japan to rise its interest rates again, as this interview in the FT with Finance Minister Omi Koji by David Pilling and Martin Wolf indicates. This bit is of particular interest:

Paul Sheard, global chief economist at Lehman Brothers, said he was concerned that Japan’s economic authorities were applying the brakes at the wrong time. “The big picture in Japan is that deflation continues and monetary and fiscal policy are both being tightened,” he said. “I challenge you to find any textbook where that is described as an optimal policy mix.”

Of course, economics textbooks are far from infallible. Nevertheless, the point is a good one.

This remark is interesting in light of the Abe Cabinet’s latest push to trim the budget. Reducing Japan’s colossal deficit — in part the product of pump priming in the depths of Japan’s “lost decade” — is a necessary and long-term task for Japan’s government (previously discussed here). Because the government is committed to contractionary fiscal policy for the indefinite future, however, the BoJ must exercise extreme caution in its monetary policy decisions in the coming year. Anything more than a light tap on the brakes could bring the Japanese recovery to a screeching halt.

One impact of an interest-rate hike that overshoots the mark could be an unwinding of the carry trade — moves by global investors to take advantage of Japan’s low interest rates to buy cheap yen and then turn around and sell it for currencies with better returns (i.e., higher interest rates). As this article in the FT suggests, interest rate hikes designed to preempt inflation could have the perverse consequence of leading yen to flow back into Japan, raising the exchange rate, which would likely have severe consequences for Japan’s economic recovery. But then, I am probably the wrong member of my family to ask about the carry trade.

The data on the course of Japan’s recovery is probably too mixed at the moment to make a firm judgment as to its sustainability, and the BoJ may be acting a bit too hasty to be assuming that the next two years will see growth continue unhindered.

Politically speaking, I wonder whether Japan’s new air of confidence could survive a serious economic downturn. At the same time, though, a downturn could obviate the need to consider a consumption tax hike, about which Mr. Abe has determined no decision will be made until autumn 2007, after the Upper House elections.

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