March 9, 2006
Full Text of the Bank of Japan Statement
This morning's announcement by the BOJ has been misinterpreted by the market. The news stories are all talking about the BOJ abandoning its deflation policy (an event which, by itself, would have driven the markets down.) The real story is the BOJ did not tighten policy as they had threatened to do earlier in the week. This is good for the market. More to come on this.
JR
TOKYO (AFX) - Following is the full text of a Bank of Japan statement on its change in monetary policy guidelines:
Change in the Guideline for Money Market Operations
At the Monetary Policy Meeting held today, the Bank of Japan decided to change the operating target of money market operations from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call rate, and to set the following guideline for money market operations for the intermeeting period (see Attachment).
The Bank of Japan will encourage the uncollateralized overnight call rate to remain at effectively zero percent.
Measures concerning Money Market Operations
The outstanding balance of current accounts at the Bank of Japan will be reduced towards a level in line with required reserves. Given that financial institutions have managed liquidity against the backdrop of large amounts of current account balances and extensive funds-supplying operations by the Bank for a prolonged period since the adoption of the quantitative easing policy, the reduction in current account balance is expected to be carried out over a period of a few months, taking full account of conditions in the short-term money market. The process will be managed through short-term money market operations. With respect to the outright purchases of long-term interest-bearing Japanese government bonds, purchases will continue at the current amounts and frequency for some time, with due regard for future conditions of the balance sheet of the Bank. With respect to the complementary lending facility, the loan rate will remain at the current level. The temporary waiver of add-on rates for frequent users of the facility, in effect since March 2003, will also be maintained.
The Bank's View on Economic Activity and Prices
Since March 2001, in view of preventing sustained decline in prices and preparing the basis for sustainable growth, the Bank of Japan has supplied extremely ample liquidity with current account balance at the Bank as the main operating target. The Bank also made a clear commitment to maintain the policy until the consumer price index (excluding fresh food, on a nationwide basis) registers stably zero pct or an increase year on year. The Bank has since maintained the quantitative easing policy according to this commitment.
Currently, Japan's economy continues to recover steadily. Exports have continued to increase reflecting the expansion of overseas economies. With respect to domestic private demand, business fixed investment has also continued to increase against the backdrop of high corporate profits. Robust corporate activity is positively influencing households, and private consumption has become solid. Looking ahead, the Bank expects a sustained recovery.
Concerning prices, year-on-year changes in the consumer price index turned positive. Meanwhile, the output gap is gradually narrowing. Unit labor costs generally face weakening downward pressures as wages began to rise amid productivity gains. Furthermore, firms and households are shifting up their expectations for inflation. In this environment, year-on-year changes in the consumer price index are expected to remain positive. The Bank, therefore, judged that the conditions laid out in the commitment are fulfilled.
Current View on Monetary Policy
Given that the effects of the quantitative easing policy on economic activity and prices now mainly result from short-term interest rates being zero, there will be no abrupt change as a result of today's policy decision.
Looking ahead, in considering the central scenario for economic activity and prices, there is a high probability of realizing sustainable growth under price stability. In the meantime, it should be noted that, over the medium- to long-term, there is a risk of swings in economic activity, as the stimulus from monetary policy is amplified against the backdrop of improving corporate profitability and a positive turn in price developments.
On the future path of monetary policy, there will be a period in which the overnight call rate is at effectively zero pct, followed by a gradual adjustment in the light of developments in economic activity and prices. In this process, if the risk mentioned above remains muted, in other words, if it is judged that inflationary pressures are restrained as the economy follows a balanced and sustainable growth path, an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time.
March 9, 2006 Bank of Japan
At the Monetary Policy Meeting held today, the Bank of Japan decided, by 7-1 majority vote, to set the following guideline for money market operations for the intermeeting period:
The Bank of Japan will encourage the uncollateralized overnight call rate to remain at effectively zero pct.
Posted by John Rutledge at 11:16 AM
March 8, 2006
Japan Real Interest Rates
Bond market analysts are holding their breath waiting to see whether the Bank of Japan will raise interest rates tomorrow for the first time since the Meiji Restoration. My bet is they will leave rates unchanged, which could be a big boost for our bond and markets. But then I am wrong a lot.
Thought you would like to see a piece I wrote on the subject on April 9, 2002 where I argued the recent change in Japanese monetary policy would pull them out of deflation and lead to a rising stock market. I'd like you to pay special attention to the material on real interest rates.
Economists talk about real rates a lot without thinking about why they matter or how to properly measure them. This piece describes the way I do it. It is completely compatible with the more recent work I have done using thermodynamics principles. It is also compatible with the work done by the REAL dynamic economists a hundred years ago. Hope you enjoy it.
Rutledge Investment Strategies
TRACKING ASSET MARKET SHIFTS TO BUILD WEALTH
April 9, 2002
Buy Japan Again
Thirteen years ago today, the Dow Jones Industrial Average closed at 2304; today it is over 10,000, for a return of more than four times your money. Over the same period, the Nikkei Index lost two-thirds of its value, from more than 40,000 in late 1989 to 11,000 today. Altogether, this un-leveraged long US short Japan position made 16.8 times your money in those thirteen years, a return of roughly 25% per year. Not bad for one trade.
It’s going to be a tough act to follow.
We didn’t think it was such a tough call to make. The disinflation and tax cuts of the Reagan years had dramatically lowered the cost of capital for US companies. US manufacturers had restructured their brains out during the 1980’s by selling low return assets and reducing costs. We were due for a boom.
Regulations on Japanese capital flows had just been eased, which exposed their overpriced assets to global arbitrageurs. Falling asset values would undermine the economy. Investors were counting the days until Japan owned the world. We thought Japan would shrink as it faced world capital markets. It was a great time to sell Japanese assets.
Lazy investors like me are grateful for both the massive size and the 13-year duration of this long-lasting source of deflationary energy. Both can be traced to the hardheaded and misguided policies of the Bank of Japan. The Keynesian-trained macroeconomists at the BOJ, who mistakenly equate low nominal interest rates with monetary stimulus, followed their textbooks word for word right into the black hole of deflation, as shown in Chart 1, which plots the price per square meter of Tokyo residential land. From its peak at more than 500,000 yen per square meter in 1990, land prices have declined every year for the past eleven years.
As I wrote last week, textbook Keynesian macroeconomic analysis denies a role for the full set of asset markets in determining economic activity. Keynesians restrict the transmission mechanism of monetary policy’s influence on the production economy to the effect of interest rates on investment spending decisions. This was the essence of James Tobin’s Presidential address to the American Economic Association thirty years ago and has been perceived wisdom among macroeconomists and macro modelers ever since.
This analysis leaves out the most powerful channel of monetary policy, real asset prices. Real, tangible assets—such as land, commodities, and existing stockpiles of produced goods—make up the bulk of people’s net worth, represent almost the entire stock of collateral for the banking system, and exert a powerful influence on both credit markets and economic activity. Monetary policy, by directly influencing real asset values, exerts huge influences on the economy.
Economics is the study of how people make choices—between goods and services, between work and leisure, and between consumption now and consumption later—using the information embodied in relative prices to help them make decisions. Likewise, when analyzing macroeconomics and asset markets, we should focus on relative returns, which are, after all, nothing more than the relative prices of different claims on a dollar of future purchasing power.
Ironically, the most lucid statement of how to do this right was written by John Maynard Keynes in Chapter 17 of The General Theory. (His discussion of an asset’s own rate of interest is the single most perceptive statement of the capital market choice problem ever written.) Keynes understood that all assets are simply devices for carrying over purchasing power into the future and that there are as many ways to do this, as there are non-perishable goods. And, he understood that people make choices among assets based upon their relative ability to accomplish this based on the assets’ relative returns, not absolute returns or nominal interest rates.
Keynes knew that in order for an asset market to be in equilibrium, total expected returns on all assets, measured in any numeraire, had to be equal. This is the thermodynamic equilibrium I wrote about last week. His examples included a calculation of the own rate of interest for a bushel of corn, which shows that his definition of an asset was not restricted to bonds, bills, or other paper assets.
I have always been fascinated by the way a creative master’s mind works. You can’t learn that from textbooks; you have to read the original writings and do your best to understand the historical context in which they wrote. In doing so, I have found there is more in common among Irving Fisher, Knut Wicksell, Bohm-Bawerk, and John Maynard Keynes than their various disciples like to admit. Read the masters, not the students, if you really want to understand their ideas.
The economists at the Bank of Japan must have skipped Chapter 17. They believe monetary stimulus means low nominal interest rates—period. They are shocked that their expansionary policy has not produced results. They don’t know what to do next to end the deflation.
In fact, Japanese monetary policy has been extraordinarily tight for the past decade. Japanese interest rates—the way they would measure real interest rates if they had read Chapter 17—have been the highest rates in the world for the past decade and quite possibly the highest for such an extended period in recorded history. Until they get this right, there is no hope for a turnaround in Japan.
Most economists measure real interest rates as a nominal interest rate minus a CPI inflation rate. This is easy to calculate and may tell us something about consumers, but it tells us nothing about the capital market. Most of the goods and services that make up the CPI basket are too short-lived, i.e., their physical depreciation rates are too high, for an investor to use them to carry over value from one period to the next. In the US, for example, services that are not storable at all make up 55% of the CPI basket. Keynes would have been appalled.
What investors do care about are relative returns on different assets they can use to carry over purchasing power to the future. An asset is, by definition, an economic good that lasts for more than one period. Such assets can either be in the form of security claims on future income, such as notes, bills, bonds or equities, or they can be real goods, i.e., physical stockpiles of future purchasing power, such as bushels of corn, houses, machines, cars, or other durable goods.
The reason we care about real interest rates—the differential return, or spread, between securities and real asset returns—is twofold. First, whether people choose to store wealth as real goods or as securities makes a big difference for interest rates, prices, and growth. Second, tax and monetary policies have important effects on relative returns and therefore on their decisions.
We should measure real interest rates as a simple spread—the difference between the total after-tax return on a financial asset, such as a bond, and a tangible asset, such as a house. We should include everything the investor cares about in our analysis—interest payments on the bond, the service (rental) value of the house, storage and maintenance costs, liquidity value, the prospect for capital gains, and all the complexities caused by taxes. And, we should account for risk.
Asset market equilibrium requires the total returns on financial and real assets to be equal. If they are not, investors rebalance their holdings in such a way that capital flows from the low return to the high return asset until equilibrium is again established. Everything else flows from that simple statement.
This is the fundamental logic behind the Fisher Equation linking interest rates, the real interest rate, and expected inflation. Using our terminology, the nominal rate of interest must equal the expected rate of TPI inflation—the inflation rate of the stock of tangible (storable) goods plus a term that represents the sum of all the other factors that matter when comparing the risk adjusted after-tax returns on financial and real assets such as tax rates, depreciation rates, service value, liquidity value, etc. It is this latter term that we can use as a measure of the real interest rate.
TPI inflation rates in Japan, using government data for Tokyo residential land prices as a proxy for the TPI, have been consistently negative for the past decade, as shown in Chart 2, reflecting massive deflation. Land is both long-lived and the
largest asset class in Japan, as it is in every other country, industrialized or otherwise. Land deflation is the heart of the Japanese deflation problem.
TPI real interest rates in Japan, shown in Chart 3, as the difference between the long term prime lending rate and the annual price inflation of a square meter of Tokyo residential land, have averaged 9.74% since the deflation began in 1989. This is extraordinarily high compared with normal (1-3%) levels, and compared with the negative real rates in the 1980’s that drove land prices to high levels. The real rate in 2001 was still very high, at 6.41%, which explains why Japanese prices are continuing to deflate.
High TPI real rates caused by land deflation are a huge drag on real growth. I know of no example in history where an economy grows while land prices deflate. Deflation is especially hard on manufacturing companies, whose balance sheets are typically made up of tangible assets and financial liabilities. A company must offset its TPI real rate—the carrying cost of its balance sheets—with operating profits from its P&L in order to remain solvent. High TPI real rates make this almost impossible.
A simple regression of Japanese TPI real interest rates against real growth over the past decade shows that TPI real rates have a significant negative effect on growth. Each 100 basis point reduction in the TPI real rate adds about 20 basis points to real growth. Based on these estimates, the end of deflation would add at least two full percentage points to Japanese growth. Interestingly, the estimates
show that Japan would grow at 4% per year with a zero TPI real rate, roughly the level they ran in the 1980’s.
Real interest rate calculations based upon CPI and WPI data miss all this. The average CPI real rate for the same period was -2.21% using the short term prime lending rate and +0.96% using the long term prime lending rate. WPI real rates average -3.62% and -0.45% on the same basis. All four measures were negative for 2001, reinforcing the Bank of Japan’s misguided claim that they have been pursuing stimulative monetary policy.
Land prices and other real asset prices are still falling. And they will continue to fall until TPI real rates move sharply lower. Deflation cannot end in Japan until the Bank of Japan makes it safe to hold tangible assets again. This will require a whole new attitude about printing money compared to anything we have seen before. That appears to be happening.
The Japanese monetary base has increased by 32.6% during the past twelve months and at an incredible 52% annual rate for the past six months, as shown in Chart 4. Yes, there is a credit crunch and, yes, there are tons of bad loans so don’t expect to see a return to growth tomorrow. But rapid monetary base growth for an extended period would eventually re-liquefy the Japanese economy and end TPI deflation.
Loans are bad loans because the underlying assets do not have the ability to produce the free cash flow to service them. The most direct way to address the Japanese bad loan problem is to turn bad loans into good loans by monetizing asset values.
The recent acceleration of the Japanese Monetary Base could reflect a new religion at the Bank of Japan, but I doubt it. BOJ staff economists still have their noses in their textbooks and are still whining about liquidity traps. More likely, it reflects the growing pressure from Prime Minister Koizumi and the White House to end deflation. Most likely, it reflects the fact that the currency markets have decided to take over the reins of Japanese monetary policy and end the deflation themselves by depreciating the yen.
After a decade of public works projects, Japan is nearly covered in asphalt and government debt has reached crisis levels at more than 18 months GDP. Recent downgrades by rating agencies have made it clear the government cannot continue to borrow and spend money forever. Declining credit quality has produced a declining yen.
On top of these market forces, there has been a shift of attitude within the Japanese government in favor of pushing the yen lower to counteract deflation. The Bank of Japan has been actively buying dollars (with newly printed yen) in recent months to push the yen lower. This has been their first un-sterilized intervention since WWII. These purchases have flowed straight into an increase in the Japanese monetary base.
It is too early to tell yet whether the switch to stimulus is real, but it is worth keeping a close eye on in the coming weeks. If it is, this will be a huge opportunity to buy Japanese assets. I am inclined to make a small bet today and increase the size of the bet as we see more proof. The Japanese government has cried wolf many times before. This time, I think they mean it.
Posted by John Rutledge at 8:22 PM | Comments (1)
March 7, 2006
Factoids from the China Budget
China watchers should take a look at the following CCTV article reporting on economic performance in 2005 and the new budget for 2006.
A few of the more interesting points. In 2005, the country's fiscal revenue exceeded 3 trillion yuan, and the GDP grew at a rate of nearly 10 percent.
In 2005, tax revenues exceeded 3 trillion yuan, or 375-billion US dollars. That's an increase of 19.8 percent, or more than 62 billion US dollars, from 2004. The budget deficit accounts for 1.6 percent of China's total GDP.
In the past year, the central government spent nearly 300 billion yuan, or 37.5 billion US dollars in promoting agricultural development and helping increase farmers' income, an increase of over 13 percent over 2004.
More than 360 billion yuan, or 43 billion US dollars, was spent on providing reemployment and social security guarantees, an over 17 percent increase compared to 2004.
The central government also continued furthering fiscal and tax reforms in 2005. It conducted a trial plan for value-added-tax reform and adjusted the individual income tax.
The budget for 2006 will raise the revenues to nearly 2 trillion yuan, or 11.7 percent, to over 250 billion US dollars. The revenue will be used to provide compulsory education in rural areas. In 2006, a trial reform will be carried out in 12 provinces, autonomous regions and municipalities to set up a free compulsory education funding guarantee system. In 2007, rural areas across country will enjoy free compulsory education.
China's GDP has exceeded 18 trillion yuan, or more than 2.2 trillion US dollars, a 9.9 percent increase over 2004.
Total import and export volume exceeded 1.4 trillion US dollars, a of over 23 percent increase over 2004.
In the budget plan for 2006, GDP growth is 8 percent and 9 million jobs must be created to keep the unemployment rate below 4.6 percent. Inflation is less than 3 percent. Overseas trade volumed increases by 15 percent. And disposable income of urban and rural residents should increases by 5 percent.
That's the competition, folks. We need to quit whining and get back to work.
JR
Posted by John Rutledge at 6:56 PM
GM Pension Cuts
GM has apparently decided to face at least some of the music. No way they can compete in the global auto market carrying what analysts are politely calling pension and health care "legacy costs".
For a deja vu, dig out an old dusty copy of "Rust to Riches", the book that Deborah Allen and I wrote in 1989 about the role of the US and Japan in the emerging global economy. Hint: the title of the first chapter is "General Who?"
I will scan the chapter and post it on our site when I can get to a copy.
Legacy costs are essentially balance sheet issues. They are the "memory" of the economic system. Each line item on a balance sheet represents a decision made by grown-ups at a certain time based on all the information they had at their disposal then. Think of it as a bottle of wine with a vintage date. The balance sheet is the wine cellar.
Both the promises and the historical cost of the line items on the balance sheet represent a specific, vintage, information set. You can actually "read" the information set in the composition of the balance sheets.
As time moves on, however, information sets change. Sometimes these changes are radical. New information is quickly priced into the asset markets and reflected in secondary market prices. When those diverge substantially from cost--when the change in the information set is big enough--it undermines collateral and trips wires in credit agreements. That's when companies die.
There are two reasons this is all happening faster today. First, there have been big changes is in global capital markets. The cost of moving capital, from anywhere to anywhere in the world, has effectively gone to zero. Capital is now free to go anywhere it can earn a return. It is leaving the US and Europe (where it is plentiful), and moving to China and India (where it is not). That capital redeployment makes a worker in China or India employable and more productive but has the opposite impact on a tool-using worker in the US.
The second big change is the increased bandwidth of global arbitrage. Once upon a time, price and wage differentials across countries were driven together gradually by international trade by transporting good on ships. But ships have limited capacity, which slowed the resulting price changes. Today we are connected with optical fiber, which allows an enormous volume of commerce to be tramsmitted at the speed of light. Price and wage changes are more abrupt as a result.
We are going to see a lot more changes like this in the coming months. Global markets take no prisoners.
JR
Posted by John Rutledge at 2:32 PM | Comments (1)
CNBC Kudlow & Co. tonight
I will be on Larry Kudlow's show tonight from 5:00-5:30PM EST. Be there or be square.
Larry and I have known each other since 1976. We will have a great time talking about the econoimy and markets. Tonight we will talk about interest rates (the Fed is trying its best to kill the economy), the OPEC meeting (a bunch or really nice guys) , microchips (commodity), telecom (hysteria of the week), and airlines (never own an airline; they are already owned--by their employees).
JR
Posted by John Rutledge at 2:12 PM | Comments (1)
Bret Swanson on Ma Bell in Today's WSJ
My friend Bret Swanson from the Discovery Institute wrote a great op-ed piece in today's Wall Street Journal on the telecom merger titled Let There Be Bandwidth. Bret and I have spent more time together lately than those 2 guys from Brokeback Mountain. We both spoke to the Indiana legislature on telecom and technology issues in the Fall. Bret visited Bob Mundell and me in Beijing in December. Then last week we both talked to the US Chamber of Commerce Foundation's annual meeting in Florida. Bret's a great guy and has a good understanding of technology issues. I am sure you will like his article.
JR
Posted by John Rutledge at 12:47 AM
March 6, 2006
Qatar Market
The real downdraft in the Gulf region is Qatar, where the Doha market is down 22.6% year to date. Same story. Huge increase (500% since January 2000), bubble signs recently, free fall in recent days/weeks.
Investors in America need to pay attention to the local markets in the oil patch. Best way to do so? You can get free daily price quotes from my friends at Global House in Kuwait. And you can get a weekly summary of the business and economic stories from the region's press from MENAFN.
JR
Posted by John Rutledge at 6:21 PM | Comments (1)
Manufacturers New Orders for January
The numbers: New orders for manufactured goods in January decreased $18.9 billion or 4.5 percent to $398.2 billion. Shipments increased 0.3 percent to $410.0 billion, the highest level since 1992. Unfilled orders decreased $4.5 billion or 0.7 percent to $633.7 billion. Inventories, increased $2.3 billion or 0.5 percent to $472.8 billion.
New orders for manufactured durable goods in January decreased $22.9 billion or 9.9 percent to $207.8 billion, revised from the previously published 10.2 percent decrease. New orders for manufactured nondurable goods increased $4.0 billion or 2.2 percent to $190.5 billion.
What the numbers mean: The decline was all airplanes and cars. Boeing had a huge December and a lousy January. And autos were down 2.9%. Ex-transportation orders increased +1.6%. Business investment spending was strong; industrial equipment orders rose 55%. On net, the report shows growth steaming along just fine.
JR
Posted by John Rutledge at 5:32 PM
Saudi Market Rolling Over
Take a look at the Saudi stock market, where prices fell by 10.37% last week. The worst damage was in the electricity sector, which lost a quarter of market value in one week.
Market cap fell SR 314 billion ($1=3.75 SR) in the SR 3 trillion market.
The market has been on a tear for 3 years. Company performance is terrific but prices have gotten too high. It is not a coincidence, however, that the decline in the Gulf markets began when the lynch mob in the US Congress made the Dubai deal a front page story.
Keep an eye on the emerging markets. They are the canary in the coal mine for shrinking global capital markets.
JR
Posted by John Rutledge at 5:12 PM
Telecom Mergers
Everyone is a telecom expert on the TV today, talking about the AT&T, BellSouth merger. They are evenly divided between economists doing a Pee Wee Herman scream to scare people over size and monopoly issues, and those looking for "synergies."
Where were they on Thursday, before the deal was announced?
The real story is not the false spectre of monopoly. (Both technology and deregulation are pushing prices for telecom services down.) It is telecom reform, technology, and global competition.
I have never been any good at figuring these deals out before they are announced. I don't think anyone else is either. So how do we make money out of it? By identifying situations where policy changes have given rise to growing tectonic pressures on relative returns. Then pitch your tent and wait for the eruption. The announcement this weekend was part of the eruption I have been anticipating. There is lots more to go.
I have had a telecom theme as one of the Storm Systems on the Weather Map page of the www.rutledgecapital.com website for some time. The policy change last June, when the White House was forced to choose between deregulation and protecting the CLECS, was the trigger that set up all the mergers since then.
Then there is the telecom reform story echoing through the halls in Congress. The pressures to do so are enormous. Asia is building new telecom networks. We need massive capital spending in the US to regain recapture our competitive position. (5 years ago the US produced 40% of all telecom equipment in the world--last year 20%). Deregulating telecom assets if the only way to get that done.
Telecom reform is going to happen, but it is currently being held up in Congress to allow the members to squeeze every drop of political juice out of the issue. Universal Service is a massive political cash cow, as is video franchising.
Communications is a global industry; networks know no municipal, state, or national boundaries. Telecom is the central nervous system of the entire economy and the source of our productivity gains. Capital goes wherever it can earn a higher return. We need to keep communications assets here at home. All point to pressing hard on deregulation and reducing franchise barriers to new capital investment.
JR
Posted by John Rutledge at 3:09 PM
Protectionism is the Biggest Risk Today
I am getting worried about the markets. The company fundamentals are fine but the things I see in the news are making my nose twitch.
Pat Buchanan and Barbara Boxer ganging up on free capital flows is an ominous sign. They are not the story. They are just astute politicians with a good nose for public emotions, leading the lynch mob from behind, as usual.
It is the fact that the people/voters are getting so frightened and are pressing for protectionism in all its forms that is the ominous sign for the market.
The Dubai ports issue has been the big story here, but there are similar things happening in France Spain, and Italy.
Smoot and Hawley did not create the Smoot-Hawley tariffs. They were merely surfing the wave of public sentiment at the time; exactly like Buchanan and Boxer.
Markets are information networks that use prices to transmit information. When they are open for business the economy and markets do fine. But kneejerk policies (capital controls, tariffs, currency bashing) can temporarily disrupt the information flows. That's when information networks short-circuit and blackouts (recessions, credit crunches, trade wars, market downturns) can happen.
Check out the stock markets in the Gulf region; they are rolling over big time. Stay tuned.
JR
Posted by John Rutledge at 2:54 PM | Comments (3)