O.K., let's admit it: Tracking monetary trends is sometimes as exciting as reading a how-to manual on refrigerator repair. But maybe not this time around. Anyone interested in the 2006 global economic outlook should be paying attention to the Bank of Japan, the European Central Bank, and the U.S. Federal Reserve right now.
All three are navigating very tricky shifts in interest-rate polices during the coming months. Central bankers in Tokyo, Frankfurt, and Washington are going to be confronting some big policy dilemmas.
Let's start with Japan, a $4.5 trillion economy that clocked 5.5% annualized growth in the fourth quarter and has a good shot at outperforming the U.S. in 2006 (see BW Online, 2/17/06, "Japan's Rapid Growth Spurt"). On March 8, the Bank of Japan (BOJ) will kick off a two-day policy board meeting in which the central bank could start to wean the world's second-biggest economy off a five-year run of ultra-easy money.
JAPAN'S DEEP DIVE. Since 2001, Japan has flooded its money market with cash. And since 1998, the BOJ has kept interest rates at pretty much near-zero levels (with the exception of one ill-timed rate hike in 2000 that helped push the economy into recession). Why? In 1998, Japan became the first economy since the Depression Era to experience price deflation -- that is, consumer prices started to decline. Coming on top of a blowout in stock prices and real estate that started in the early '90s, deflation hit consumer spending and corporate earnings hard.
The other problem, which started in the early '90s as well, is that the balance sheets of both corporate Japan and the banking sector took a huge hit. Japanese companies, big owners of real estate, borrowed heavily during the late '80s to fund their purchases. When that bubble burst, companies faced huge debt loads and started to devote the bulk of their resources to paying down those loans (see BW Online, 3/3/06, "How Japan Fell into the Hole").
Now the problem for BOJ Governor Toshihiko Fukui is how quickly to tighten credit. There's no denying that the economy has returned to fast-track mode. That means inflation -- not deflation -- is finally back on the radar screen. Core consumer prices jumped by 0.5% in January year-on-year, the biggest increase in eight years. Japan Inc. is also flush with cash. Corporate borrowing as a percentage of gross domestic product (GDP) is about 52%, a level not seen since 1956. As a first step, the BOJ is expected, perhaps this week, to start pulling back the excess cash that has flooded into the banks.
EUROPEAN IMPROVEMENT. The more important decision by the BOJ is when to actually start raising interest rates. Plenty of central-bank insiders fear a spike in inflation if the BOJ doesn't act swiftly. Fukui is under enormous political pressure from Prime Minister Junichiro Koizumi's government, however, to move slowly. Koizumi's economic planners have to manage a debt load that's the highest in the industrialized world, about 1.5 times annual GDP. Lower rates mean the government can issue fresh bonds cheaply to fund its operations and pay pensions.
Some economists think Japan is still a long way from declaring victory over deflation. Macquarie Research analyst Richard Jerram figures that if you strip out seasonal factors that pushed up consumer prices in January, the data only show a 0.1% year-on-year increase. He thinks the BOJ could make the mistake of raising key short-term rates later in the year, which would unnecessarily restrain Japan's economy. "That might have an impact on asset prices," such as stocks and real estate, he warns.
After years of drift, there is solid evidence that the 12-nation euro zone is back on track. The countries together generate about $9 trillion in annual GDP, and growth this year may hit 2.1%, vs. 1.5% in 2005, investment bank UBS predicts. That may seem pretty modest, but it would be Europe's best showing since 2000.
INCREASES ON TAP. There's just one problem: The ECB, led by President Jean-Claude Trichet, has an inflation ceiling target of just under 2% -- and consumer price growth has been running above that level for about a year. In February, that figure rose to 2.3%. So on Mar. 2, the ECB raised a key interest rate by a quarter of a percentage point, to 2.5%. That followed an increase last December, which ended two years of no rate changes.
Trichet made clear that more increases could be in the pipeline. "Risks to price stability prevail," he told reporters after the latest hike was announced. As a result, European bond yields on two-year issues rose to nearly 3%, their highest level since late 2002, suggesting that the market believes one or two more moves by the central bank could be in the cards.
As things stand now, most economists say the ECB's credit tightening isn't enough to derail the recovery. By historical standards, key interest rates remain low, points out Ralph Wiechers, chief economist for the German Engineering Assn., an industry group representing machine-tool makers. And bank loans are still reasonably priced and plentiful for credit-worthy companies.
HIGHER U.S. INFLATION? Wiechers does concede that inflation is a worry, and that the ECB is likely to follow up with future rate hikes. If the central bank overshoots with monetary tightening, it could cause an unwelcome and rapid appreciation of the euro vs. the yen and the dollar. "If rates rise too much, it will start to affect exchange rates," he frets. That would hit export earnings and depress growth.
After the latest ECB move, the euro touched a one-month high against the dollar, and the region-wide Dow Jones Stoxx 600 slipped 1.2% on Mar. 3, the first decline in six weeks. But what really has Wiechers and other economists in Europe and Asia anxious is the prospect of higher inflation in the U.S., a critical export destination for the world's manufacturers.
Right now, Fed watchers generally expect the central bank to raise interest rates two more times. (After cutting rates to historic lows in 2004, the Fed has raised rates 14 consecutive times in 0.25% increments.) That would take the benchmark Fed funds rate up to 5% in early May, a scenario that has been pretty much priced into U.S. stock and bond prices.
COOLING HOUSING MARKET. There's a small chance that the Fed might feel compelled to do more. Why? There are some worrisome signs of inflation. Core consumer prices grew by 2.1% year-on-year in January -- slightly above new Chairman Benjamin S. Bernanke's preferred range of 1% to 2%. Also, the U.S. jobless rate stands at just 4.7%, which could mean wage pressures down the road. Macroeconomic Advisers, a U.S. forecasting firm, believes GDP will grow at a brisk 5% annualized rate in the first quarter, but will likely slow to 3.8% in the April-to-June period.
Optimists argue the Fed may well be able to exit gracefully from its rate-hiking crusade in May, as expected. Others think signs of a cooling housing market in some regions of the U.S. will dampen consumer spending -- and by extension, ease inflationary pressure.
Some say that the global economy, which has kept the price of all manner of goods in check, will largely do the Fed's work for it. "Because of competitive pressures, it is difficult to raise prices," says Ed Yardeni, chief investment strategist at Oak Associates in Akron, Ohio. "Companies have to raise their productivity, which keeps inflation down."
REAL-LIFE CONSEQUENCES. Much will depend on the economic data released during the next two months. If there are any inflationary shocks in those numbers, the Fed might have to take interest rates beyond 5%, which would almost certainly constrain the U.S. economy and global growth. The other choice -- doing nothing and letting inflation get out of hand -- would be a disastrous start to the Bernanke era, and is quite unlikely. "We're at a juncture for crucial issues in assessing the economy," figures Mickey Levy, chief economist at Bank of America.
Bernanke, Fukui, and Trichet face a tough year. While they can rely on some of the best economists on the planet for advice, don't believe anyone who suggests that setting monetary policy is an exact science. And while what they do for a living may seem arcane, remember this: If these three central bankers make any missteps, there will be real-life consequences for plenty of workers, homeowners, and investors in 2006.
Bremner is BusinessWeek's Asia regional editor, based in Hong Kong
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