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Japan's weak consumption and rising pressure for interest rate hikes


japan economy analysis

Japan's weak consumption may intensify, rather than alleviate, the already mounting political pressure on the central bank to increase interest rates to curb the yen's decline, which is blamed for harming households through higher import costs. The depreciation of the yen has led to an increase in the cost of imported goods, making everyday items more expensive for Japanese consumers. This has strained household budgets, particularly for those on fixed incomes or with limited financial flexibility. The central bank, therefore, faces growing calls from various political and economic stakeholders to take decisive action to stabilize the currency and ease the financial burden on citizens.


This pressure is expected to prompt Bank of Japan Governor Kazuo Ueda to continue signaling a hawkish outlook on monetary policy. However, he is likely to include numerous caveats to account for the possibility that consumption might take longer than anticipated to recover, according to analysts. Ueda's cautious approach would likely involve careful communication to manage market expectations while leaving room for policy adjustments. Analysts believe that while Ueda might indicate a potential tightening of monetary policy, he will also highlight uncertainties in economic recovery, particularly regarding consumer spending patterns.



Despite the Bank of Japan's decision in March to end eight years of negative interest rates, the yen has depreciated by approximately 10% against the dollar this year. This depreciation is attributed to the significant divergence between U.S. and Japanese interest rates, which has remained a focal point for markets. The U.S. Federal Reserve has been raising rates aggressively to combat inflation, while Japan has maintained relatively low rates to support its economy. This interest rate differential makes the yen less attractive to investors, leading to its decline against the dollar.


Data released on Thursday revealed that Japan's economy contracted more than expected in the first quarter. This contraction was partly due to rising living costs, exacerbated by the weak yen, which negatively impacted consumption. Additionally, exports declined, indicating that the benefits to manufacturers from the weaker currency are diminishing. The decline in exports suggests that while a weaker yen usually helps boost competitiveness abroad, other factors, such as global demand and supply chain issues, might be undermining this advantage. The contraction in the economy underscores the fragility of Japan's recovery and the challenges posed by external economic conditions.



Analysts suggest that these weak economic indicators alone are unlikely to compel the BOJ to revise its steady rate hike plan, established in April. Policymakers are more concerned with whether consumption will rebound later this year, as projected. However, these indicators will underscore the importance of forthcoming data on consumption, wages, and service inflation in determining the timing of the next rate hike. Policymakers will closely monitor these data points to assess whether the anticipated recovery in consumer spending and wage growth materializes, which are critical for sustaining economic momentum and justifying further monetary tightening.


"The BOJ likely maintains the view that rising wages will boost consumption. But it will probably wait for second-quarter gross domestic product (GDP) data, due out in August, to verify if that's indeed the case," stated Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities. Muguruma's comment reflects a cautious optimism among some economists that wage increases could lead to higher consumer spending, thereby supporting economic growth. However, she also highlights the importance of upcoming GDP data in validating this expectation, indicating that policymakers will need concrete evidence of improvement before committing to further rate hikes.


The weak yen has become a significant challenge for Prime Minister Fumio Kishida, as it has dampened consumption. The renewed price pressures from higher import costs cast doubt on Kishida's ability to fulfill his pledge to turn inflation-adjusted wages positive in the coming months, especially as he already faces low approval ratings. Kishida's administration is under pressure to deliver economic relief and improve living standards amidst rising costs, making the yen's weakness a politically sensitive issue. The government’s credibility is at stake, particularly with voters who are feeling the pinch of higher prices for everyday goods.



Although the BOJ has dismissed the idea of using monetary policy to influence currency movements, increasing concerns about the drawbacks of a weak yen have led some government and business leaders to call on the central bank to raise interest rates from near-zero levels. These leaders argue that higher interest rates could help stabilize the yen and mitigate inflationary pressures caused by expensive imports. This growing clamor for action reflects broader worries about the economic and social impacts of prolonged yen weakness, which are becoming harder for policymakers to ignore.


For inflation to remain moderate, firms must be able to generate sufficient earnings to continue raising wages, stated Masakazu Tokura, head of the business lobby Keidanren, at a meeting of the government's top economic council on May 10. Tokura's comments highlight a key dilemma: while inflation can erode purchasing power, it is also necessary to some extent for economic growth and wage increases. Achieving a balance where inflation remains at a moderate level that supports wage growth without overwhelming consumers with high prices is a complex task for policymakers.


"Given the risk of the weak yen causing excessive price increases, I hope the government and the BOJ aim to achieve appropriate levels of inflation around 2%," Tokura said at the meeting, which Ueda also attended. Tokura's remarks underscore the importance of maintaining a target inflation rate that supports economic stability while avoiding the pitfalls of hyperinflation. The 2% target is seen as a sweet spot that can encourage spending and investment while keeping living costs in check. However, achieving and maintaining this balance in the current economic climate is challenging.



Mana Nakazora, a private-sector member of the council, also urged the BOJ to use monetary policy to help "moderate downward pressure on the yen," according to the minutes of the meeting. Nakazora's call for action reflects a broader consensus among some economic advisors that the central bank should take a more proactive stance in managing the yen's value. By moderating the yen's decline, the BOJ could help stabilize import prices and provide relief to consumers and businesses alike, who are struggling with rising costs.


These discussions followed escalating government pressure that had already led the BOJ to adjust its dovish policy communication in April, which was blamed for further sharp declines in the yen. The central bank's previous stance was perceived as too lenient, contributing to the yen's weakness. This perception prompted the government to exert pressure on the BOJ to adopt a more balanced approach that considers the broader economic implications of its policies, including the impact on currency stability.


After a meeting with Kishida on May 7, Ueda stated that the BOJ would be "vigilant" regarding yen movements when setting monetary policy. The following day, he mentioned that the BOJ might raise rates if the yen's decline significantly impacted prices. These statements marked a notable shift in the central bank's tone, signaling a greater willingness to intervene if currency depreciation continues to exacerbate inflationary pressures. Ueda's remarks were likely aimed at reassuring markets and stakeholders that the BOJ is closely monitoring the situation and is prepared to act if necessary.



These comments contrasted with those made on April 26, when he said recent yen falls would not immediately affect inflation—a remark that pushed the yen below 160 to the dollar and led to suspected yen-buying intervention by the government. The stark difference in Ueda's tone over a short period reflects the dynamic nature of currency markets and the need for central banks to remain flexible in their communication strategies. The initial comment had triggered a sharp market reaction, highlighting the sensitivity of currency traders to BOJ signals.


Although the yen has since recovered some losses to hover around 155, government dissatisfaction continues. Despite the partial recovery, the yen's value remains a point of contention, with various stakeholders expressing ongoing concerns about its impact on the economy. The government's dissatisfaction indicates that the issue is far from resolved, and further actions may be required to stabilize the situation fully.



Finance Minister Shunichi Suzuki told reporters on Tuesday that the government and the BOJ must "avoid causing friction" with any policy divergence. Administration aides described these remarks as a reminder for the central bank to consider government concerns over the weak yen. Suzuki's comments emphasize the need for coordinated policy efforts to ensure that monetary and fiscal measures align and support each other in addressing economic challenges. This coordination is crucial to avoid sending mixed signals to the market and to ensure a cohesive strategy for economic stability.


"In reality, current yen levels have a significant negative impact on people's livelihoods," a source close to Kishida's administration told Reuters. This statement underscores the tangible effects of currency movements on everyday life, highlighting the importance of addressing the yen's weakness not just from a macroeconomic perspective but also from the standpoint of individual welfare. The administration's recognition of these impacts suggests a growing urgency to find solutions that can alleviate the financial strain on households.


In theory, raising interest rates when the economy is weak seems counterintuitive. However, the situation in Japan is somewhat different, as short-term rates remain close to zero despite inflation exceeding the BOJ's 2% target for two years. This unique context means that even a modest increase in interest rates could help stabilize the currency without severely constraining economic activity. Japan's prolonged period of ultra-low interest rates has created conditions where traditional economic principles might not fully apply, necessitating a nuanced approach to policy-making.



A modest increase in nominal interest rates would still keep inflation-adjusted, real borrowing costs deeply negative. This means that while nominal rates might rise, the actual cost of borrowing, when adjusted for inflation, would remain low, potentially minimizing the negative impact on economic growth. This approach could provide a middle ground, helping to support the yen and control inflation without stifling economic activity.


Former BOJ executive Eiji Maeda stated that the BOJ is unlikely to raise rates solely to slow the yen's decline. However, he noted that the impact of yen movements on prices might be more significant now than when Japan was experiencing deflation. Maeda's insights suggest that while currency stabilization is important, the central bank must also consider broader economic conditions and the interplay between exchange rates and inflation. This perspective highlights the complexity of monetary policy decisions in the current economic environment.


"From this perspective, the impact of a weak yen on inflation is important in guiding monetary policy," said Maeda, who expects the BOJ to raise rates as early as July. Maeda's expectation of a rate hike indicates that the central bank may be preparing to act sooner rather than later, reflecting a growing recognition of the need to address inflationary pressures. His comments underscore the importance of a responsive and adaptive monetary policy framework that can address evolving economic challenges effectively. Source: Reuters


17.05.2024



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