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Monday, July 3, 2006

JAPANESE PERSPECTIVES

Inflation, Japanese monetary policy and global imbalances


Here are three questions to ponder over in the summer season: Is inflation back? When will Japanese interest rates start rising? Do global imbalances matter?

These questions will determine whether we will have a nice and quiet second half of the year or become embroiled in turmoil of major proportions.

As for the first question, one answer is that inflation is and has already been back with us for quite some time. As far as the upper end of the production stream is concerned, that is.

China's development demand has been pushing up the price of raw materials and basic production components for quite a while now. Meanwhile, the same China factor has been working to hold down prices at the lower end of that production stream. Whatever you make, the Chinese can make it cheaper.

China-driven cost pressures and China-driven price competition. The combination of the two recently brought about a strange situation in which inflation and deflation were existing side by side with equally persistent force.

But now the landscape seems to be gradually shifting. Two factors are involved.

One is that there are limits to which people can hold down prices in the face of ever rising costs. Manufacturers are beginning to put up their end-product prices to reflect pent-up cost pressures.

The other factor is that Chinese wages appear to be on the rise. "Whatever you make, the Chinese can make it cheaper" may no longer be quite the hard and fast rule it was. Already production is being moved to Vietnam and elsewhere in search of lower labor costs.

These developments suggest inflation may just possibly be about to start spiraling upwards. The offsetting effect of price competition will certainly not disappear altogether. Nonetheless, if more and more people feel they can get away with it, both prices and wages are obviously going to start rising. Or at least stop falling, anyway.

This brings us to the next question of when Japanese interest rates are likely to go up. Very soon, would be the logical answer.

Revelations concerning BOJ Gov. Toshihiko Fukui's flutter in the markets should not distract the central bank's mind from its task of normalizing interest rates. Mr. Fukui should indeed consider his position seriously, but meanwhile monetary policy should not be held hostage by the fortunes of the governor as an individual.

When Japanese interest rates go up is the moment when global imbalances start seriously to matter. To the extent that Japanese money had nowhere to go but the United States, global imbalances were not a problem.

Indeed they were actually a solution, without which money would find it difficult to get around the world. The American deficit and Japanese surplus canceled each other out beautifully.

Once Japanese money starts finding investment opportunities in the domestic market, however, things are going to look considerably different. America will either have to fund itself or to downsize its economy to reflect the shrinkage in incoming foreign investments.

It follows that as Ben Bernanke, the FRB's new chairman, considers his next interest rate move, it is really neither U.S. inflation nor the U.S. economy's ability to withstand further interest rate hikes that should be his primary concern, but Japanese interest rates and their moment of return to normality, and there is no doubt that is what's on his mind.

Thus, to paraphrase John B. Connally, U.S. Treasury Secretary under the Nixon administration who famously remarked that the dollar was "our currency, your problem," Ben Bernanke would now say that Japanese interest rates are "your interest rates, my problem."

Noriko Hama is an economist and a professor at Doshisha University Graduate School of Business.


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