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Monday, May 1, 2006

JAPANESE PERSPECTIVES

Global inflation changing economic fundamentals


Ajoint statement released April 21 by finance minis- ters and central bankers of the Group of Seven major economies in Washington noted that the global trend in economic expansion has entered its fourth year, with inflationary pressures relatively contained despite the surge in crude oil prices.

At the same time, however, the G7 warned against the negative impact of high oil prices and cited the risk — as this author pointed out in this space on March 13 — that worldwide imbalances could lead to greater protectionism.

The global economy has so far witnessed a mixture of deflationary and inflationary pressures.

On one hand, globalization has combined technology and capital from advanced industrialized economies with cheap labor and land in developing countries, increasing the supply of low-cost products and services and thereby adding deflationary pressures on a global scale.

On the other hand, this combination has resulted in new demand in developing economies, led by emerging major powers like China and India, resulting in sharply rising prices of energy and food.

Recently, however, the inflationary pressures have begun outpacing the deflationary ones. Crude oil prices just touched $75 per barrel, while prices of nonferrous metals are on the rise — with zinc quoted 130 percent higher and copper 80 percent higher compared with their mid-2005 levels.

Agricultural futures are also rising sharply, with sugar up 75 percent. Food that can be produced with low-cost labor is continuing to experience deflationary pressure. But prices of natural resources are expected to stay high, because the measures called for in the G7 statement — higher investment in oil production facilities, more dialogue between oil-producing and -consuming countries to prevent speculative trading, and more efficient use of energy — will not produce immediate results.

Even in Japan, where policy interest rates remain near zero, the Nikkei index of international commodities prices has climbed 18.5 percent from the end of last year. This will be reflected in consumer prices sooner or later.

The recent decision of the Bank of Japan to end its ultra-easy monetary policy amid such global trends has prompted long-term interest rates in major economies to rise nearly 0.5 percent. This, of course, will have an impact on bonds, stocks and currency-exchange markets around the world. When we consider the impact on the bond and stock markets, we need to remember that while short-term interest rates are determined by the central bank, long-term rates are determined by the markets.

There is a consensus that the surge in prices of natural resources will sooner or later push up yen interest rates, and the markets' attention is now focused on how soon the BOJ will lift the "zero-interest-rate" policy.

Japan's long-term rates are already rising on the assumption the policy will be lifted, and the market rates in other major economies are rising in a synchronized manner as well. Private-sector fund demand is on an uptrend, and long-term government bonds are expected to get fewer buyers. Bond prices will decline and yield will go up, thus putting downward pressure on share prices.

The effects on the foreign-exchange markets are more complicated, because exchange rates are determined by the relative economic performance of the countries involved.

The G7 members reaffirmed in the April 21 statement their belief that exchange rates should reflect countries' economic fundamentals — GDP growth, inflation, the current account balance and unemployment. Given that the $800 billion current account deficit of the United States accounts for over 7 percent of its GDP, the decline of the U.S. dollar does in fact reflect economic fundamentals.

What has so far kept the dollar strong is the currency's convenience — backed by high interest rates that attracted funds from countries with surpluses and made up for America's deficits. Since mid-2004, the Federal Reserve has raised its policy rates 0.25 percent on 15 separate occasions — partly to tame inflation, but also to keep foreign capital flowing into the U.S.

However, monetary tightening policy is nearing its limits — considering the impact on the U.S. economy. The interest rates on the yen and euro, on the other hand, are just beginning to rise. The gap with the dollar's interest rate will narrow and make the United States less attractive to foreign investors.

The closer market participants believe a new development is at hand, the more likely it is that a more widespread consensus will emerge on the course of long-term bonds, stocks and currency markets, thereby sending market trends in one direction. These markets are already factoring in future developments that correspond to economic fundamentals.

Teruhiko Mano is a professor at Seigakuin University Graduate School.


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