No. 20 — May 19, 2000


Weekly Review

--- by Douglas Ostrom

Almost unnoticed, the yen has been sinking. As recently as April, Tokyo, fretting that the currency's strength would undermine the fragile recovery of the world's second-largest economy, apparently bought billions of dollars in an effort to stem the yen's run-up in value. Now, however, the movement is in the opposite direction. From a daily high of ¥102.8=$1.00 in April, the yen has lost ground, briefly sinking below ¥110=$1.00 in mid-May before settling around ¥109=$1.00.

Most analysts see the yen's slide as a reflection of the Federal Reserve Board's recalibration of U.S. monetary policy. With signs of inflation starting to appear, the Fed has moved more aggressively to stem the growth of aggregate demand. The prospect of higher U.S. interest rates made fixed-income investments in this country more attractive, lifting demand for the dollar. As a consequence, the American currency had risen against both the yen and the euro by mid-May.

The Fed's May 16 decision to increase the federal funds target rate on overnight loans among banks by half a percentage point to 6.5 percent, followed quickly by a similar move by Canada's central bank, was far more dramatic than the five straight quarter-of-a-point boosts engineered by the Fed since June 1999. As expectations that the Fed would lift rates by a bigger-than-normal margin rose in advance of the latest meeting of its Federal Open Market Committee, the yen went into a nosedive against the dollar. However, since the rate hike matched predictions, the action itself had little effect on currency markets.

The yen also has been adversely affected by the Japanese economy's shifting prospects. Despite reports that Tokyo is on the verge of declaring the recession over, analysts have detected indications of continued weakness in, for example, consumer spending. Moreover, plant and equipment expenditures show signs of petering out before achieving a real recovery from the downturn. Private-sector machinery orders other than for ships or from the electric power industry sank 4.9 percent in March on an seasonally adjusted, annualized basis, the third straight month of decline. Nonetheless, on a quarter-to-quarter basis, orders in the January-March period managed a 4.9 percent gain, significantly better than the Economic Planning Agency's prediction of a 1.6 percent falloff (see JEI Report No. 19B, May 12, 2000). In any event, the latest monthly figures — as well as EPA's forecast of a 1 percent drop in machinery orders in the April-June period — are hardly bullish for business investment, suggesting that the capital goods market may remain weak.

Weak investment demand — and the more sluggish economic growth that could result — may be part of the explanation for the mid-April to mid-May downturn of the Nikkei average of 225 stocks listed on the first section of the Tokyo Stock Exchange. The gyrations of American equity markets and changes in the composition of the Nikkei index also played a role (see JEI Report No. 17B, April 28, 2000), but the Japanese stock market continued to fall in May even after the impact of those factors would appear to have been spent.

After ending April at 17,973.70, the Nikkei closed trading May 11 at 16,882.46, its lowest finish in more than seven months and a marked contrast to this year's high of 20,833.21, set April 21. The Nikkei, unlike American markets, even fell slightly following the Fed's rate-hiking announcement.

All these factors render the Bank of Japan's policymaking process more difficult. The Fed's decision to raise U.S. interest rates by half a point meant that BOJ could have followed suit without sending the yen soaring. Japan's central bank has been clearly signaling for months that it regards the current policy of near-zero interest rates undesirable over the medium term (see JEI Report No. 16B, April 21, 2000). Certainly, a boost in Japanese rates would seem logical in light of central bank discount rates that, following the Fed's May 16 move, stood at 6 percent in the United States and at 0.5 percent in Japan.

But BOJ chose to stand pat at the monthly Policy Board meeting held May 17, continuing its de facto policy of zero interest rates, partly because the bank had to contend with the homegrown factors that have contributed to the yen's weakness. The last thing BOJ wants to do at a time when investment demand may be weakening is to make capital spending more expensive by raising rates.

BOJ will not publish the minutes of the May Policy Board meeting until July 3. As a result, analysts can only speculate about how much the Fed's actions less than 24 hours earlier influenced the thinking of one or more of the nine Policy Board members present. To the extent that their concerns echoed those of many Japanese analysts, they might have worried that the Fed's six recent rate hikes, which have been widely interpreted as attempts to cool speculative fever in U.S. equity markets, bore an uncanny resemblance to BOJ's own actions a decade or so ago.

At that time, the central bank lifted interest rates in part because it felt that run-ups in the prices of both real estate and equities had gotten out of hand. One consequence was a collapse of asset prices. Even before the Nikkei's mid-May plunge, the index stood at little over half its peak value, which was reached shortly after BOJ began tightening the screws in 1989.

Such a history may be one more reason for the central bank's current reluctance to push interest rates out of the cellar. Should the Fed's policy have an impact even approaching that of BOJ's strategy a decade or more ago, Japan's central bank would need to move quickly to provide liquidity in the economy's current low interest-rate environment. Maintaining its stance of zero interest rates is consistent with such contingency planning.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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