Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target

Japanese Finance Minister Naoto Kan has recently exerted pressure

on the Bank of Japan (BOJ) to act more quickly to defeat deflation,

saying he wants the falling price trend to end this year. “Two or

three years is too long. If possible, I hope that the consumer price

index turns positive by the end of this year” Kan told a parliamentary

session.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. The finance minister also said that the BOJ may have to set an

inflation target aimed at dragging the economy out of grinding

deflation … a policy where a central bank declares a target for

inflation and guides actual price levels toward that goal through

monetary policy such as interest rate changes.

BOJ Governor Masaaki Shirakawa made it clear he had no intention

of taking such a step, and explained in detail why he considers it

inappropriate. “There is a mood to reconsider the use of the

framework of inflation targeting following the recent financial

crisis," Mr. Shirakawa said at a recent news conference.

“If a central bank concentrates only on achieving a short-term

price goal, that could have an adverse effect on sustainable economic

growth, which is the final goal of monetary policy”, Shirakawa said.

Moreover, “such a mechanism would reduce the BOJ’s flexibility

on policy”.

Inflation targeting has become a favoured policy among many

central banks worldwide, but since the start of Japan’s deflationary

era in 1999, the BOJ has stoutly resisted calls to set an inflation

target against which it can be judged, and by which it can be

embarrassed if it misses it.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. Instead it has relied on softer price guidance in determining policy.

Its inflation objective is defined in the loosest terms, as a rate

between zero and 2% for the core consumer price index, as one

that meets its “understanding of medium- to long-term price

stability”, with no time-frame to achieve it and no penalty for

failure.

Still, core consumer price index, which excludes volatile fresh food

prices, fell 1.3% on year in December, dropping for the 10th straight

month.

Shirakawa’s comments suggest the central bank will not embark

on any further easing for now to put a stop to deflation. However

the BOJ might be forced to loosen policy toward the middle of the

year if the domestic economy loses momentum from its recent

strong performance … recent data showed the economy grew at a

4.6% annualized pace in the final quarter of 2009.

And with a key upper house election coming up in the summer, at

which the ruling Democratic Party of Japan hopes to win a majority

in the chamber, political pressure on the BOJ to do more to improve

the economic picture could rise.

Can the introduction of inflation targeting under deflation and

zero interest rates contribute to the Japanese economic recovery?

Generally, inflation targeting has been increasingly viewed as a

good monetary policy framework and widely applauded by

economists and policymakers.

In the literature, there are benefits of inflation targeting for both

inflation and output behaviour.

Inflation targeting should stabilise the level of inflation, reduce its

variability and persistence, and also decrease the variability of

output.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. A recent study by Daniel Leigh, an economist at the IMF, shows

that had Japan introduced an inflation target in the 90’s its

economy’s performance would have substantially improved and

the BOJ would have avoided the zero lower bound on nominal

interest rates.

But the essence of the question is to what extent the introduction

of inflation targeting will enhance credibility of the BOJ’s reflation

policy in a deflationary phase and help economic recovery.

More importantly, whether or not the BOJ monetary policy is

credible enough for inflation expectations to be anchored to an

inflation target.

Takehiro Sato of Morgan Stanley says that, unlike the Federal

Reserve, which has won a high degree of respect for its handling

of monetary policy, Japan’s central bank is not yet trusted by

markets because of its past moves. “The BOJ’s policy track record

is bad.

A target for inflation helps to anchor future expectations of

monetary policy, but BOJ lacks credibility.

The mere announcement of an inflation target would not change

expectations”, he said.

Indeed, the introduction of inflation targets among advanced

countries tends to be accompanied by an institutional framework

that makes inflation targeting credible and accountable.

In several countries, including New Zealand and Australia, inflation

targeting is an agreement between the government and the central

bank, and both are committed to policy that is consistent with the

inflation target.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. In several countries, including New Zealand and the UK, when

inflation exceeds the target by a wide margin, the Governor is

required to provide an explanation to the parliament. With

accountability and commitment, inflation targeting does become

credible.

A central bank in a deflationary environment

is subject to a time-inconsistency problem: it

cannot credibly commit to “being

irresponsible” and so continue to shoot for

high inflation.

Furthermore, there is a concern that once the Japanese economy

has emerged from a deflationary spiral and starts to recover, the

central bank will be tempted to renege on its commitment to a

high inflation target, because it would like the economy to return

to an inflation rate consistent with price stability.

Thus a central bank in a deflationary environment is subject to a

time-inconsistency problem: it cannot credibly commit to “being

irresponsible” and so continue to shoot for high inflation.

The result of the time-inconsistency problem is that the markets

would not be convinced that inflation would remain high, and

inflation expectations would not be high enough to lower real rates

sufficiently to stimulate the economy out of the deflation trap.

To overcome deflation and restore economic activity Japanese

policymakers may not need to adopt an inflation target.

They could simply use unconventional instruments, such as

purchases of riskier assets and foreign assets, more aggressively

so to persuade the markets and the public that there will be higher

inflation.

Salamat Shaw Capital Management Korea: Portfolio Recommendations

We have made no changes in our portfolios this month.

The latest developments in the government debt

markets have increased the uncertainties about

prospects for both the bond and financial markets.

However, although the pace of the global economic

recovery may be affected, there appears to be enough

momentum to enable it to continue.

We have therefore maintained the level of our exposure

to the equity markets; and we have left 10% of the funds

in the portfolio in cash deposits as a contingency

measure. Bond exposure is zero.

Shaw Capital Management Korea: Portfolio

Recommendations - The UK Hung Parliament

The bond markets are totally calm about the hung

Parliament, as they are about both UK and US bond

prospects, with yields still below 4%, in spite of the

huge deficits both countries are running.

What is going on?

The first point is that both countries are recovering,

and seem set for growth rates in the 2–3% range.

Such growth is not ‘V-shaped’ but a V was unlikely

given the shortage of oil and raw materials, which

continues to limit world recovery potential. It does

give a prospect of improving tax revenues and falling

benefit expenditures.

As growth goes forward it will be possible to work out

more accurately how much of the current deficit is

‘structural’ — i.e. will not disappear with returning

growth.

For the UK the current estimate is that about 8% of

GDP is structural: still requiring a huge programme of

retrenchment.

The second point is that neither the UK nor the US has

ever formally defaulted in modern times.

Indeed for the UK, they can date this from the end of

the Napoleonic Wars when public debt reached around

300% of GDP.

The third point is the new unwillingness to use higher

inflation to bring down the debt in real value. Inflation

(implying an ‘inflation tax’ on government monetary

liabilities which thereby lose their value) is now

proscribed after the poor experiences of developed

countries during the ‘great inflation’ of the 1970s.

Electorates have rejoiced at the new inflation targeting

policies that have formally ended governments’

experiments with this form of taxation.

The electorates hated the messy and unintended

redistributions of wealth this tax implied — often from

the weak such as pensioners to the wealthy and the

unionized.

In this context bond markets have treated Mr. Obama’s

delays and the UK’s election result as simply policy

deferred.

In that they are likely to be right.

Shaw Capital Management Korea: Portfolio

Recommendations - The state of the eurozone

By contrast the situation in the euro-zone looks

increasingly difficult.

The problem is that Greece and Portugal — the two

main current problem cases — joined the euro in the

expectation that low interest rates would keep their

public finances under control.

Internally these countries have difficulty in raising

taxes and curbing expenditure but joining the EU and

then the euro gave them the authority to insist on fiscal

discipline as the ‘price’ of joining.

Now the discipline is becoming harsh and yet interest

rate premia are rising, as the risk of default increases.

Germany and the other euro-zone countries are

unwilling to transfer resources to them — and even to

provide loans on terms below these market rates.

Germany’s position in particular has hardened

massively under hostile home reactions to perceived

‘bail-out’.

Germany is simply unwilling to make transfers after

the huge costs of its integration policies for East

Germany.

There will come a point where the advantages of being

in the euro are outweighed by the disadvantages for a

country like Greece.

Once interest rate premia get high enough inside the

euro, the attraction of floating the currency down

outside it and still paying similar interest rates will

become overwhelming to governments faced with

public hostility to further sacrifice.

A large devaluation is a way of allowing the economy

to recover and produce extra revenue.

Furthermore reintroducing the local currency will

allow the government to re-denominate the debt in

that new sovereign currency … so effecting a de facto

partial default.

These exits would not spell the end of the euro. But

they will remind markets that the euro is bound

together by political convenience only and not by some

deep commitment to European integration.

Up to now there has been a general belief in such a

commitment; however, Germany’s recent actions have

destroyed this belief.

It was this belief that kept interest rate premia down

on sovereign debt of euro-zone countries; rather like

the debt of UK local authorities — formally underwritten

by the UK government, it was felt that these countries’

debt was being implicitly underwritten by other eurozone

members. No longer.

But of course what can happen to Greece could happen

to any other country. If so its risk premia too would

rise and it too would face the same trade-off between

staying in or exiting with the freedom to float at similar

interest rates outside.

Hence the chances of more break-up would get larger

and the system would become gradually closer to a

system of ‘fixed but adjustable’ exchange rates like the

old European Monetary System.

Shaw Capital Management Korea: Financial Markets

For most of the past month sentiment in the financial

markets continued to improve.

There was further evidence that the global economic

recovery was still on track, and short-term interest

rates remained very low.

But towards month-end the mood changed after the

decision to downgrade Greek debt to “junk” status, and

to reduce the credit ratings of both Portugal and Spain.

There was a fear that the contagion would spread still

further, and that the bond market pressures resulting

from the massive fiscal deficits around the world would

have serious financial consequences.

There was always the risk that some of the measures

that were introduced to counter the recession might

have adverse consequences, and this is now proving

to be the case.

Shaw Capital Management Korea: Major Equity Markets

After moving ahead for most of the month, most of the

major equity markets are ending the period unchanged

or slightly higher, and there have been sharp falls in

many of the minor markets.

Wall Street has been the exception, and is ending

higher, encouraged by some favourable corporate

results.

But markets in Europe, including the UK, are lower,

and there have been falls in the Chinese market, and

other Asian markets, after the measures by the

authorities to reduce the risk of over-heating in the

Chinese economy.

However views about longer-term prospect are still

fairly positive, and the markets seem to be simply

pausing until some of the uncertainties have been

resolved.

Bond markets; have produced a mixed performance,

with the major markets holdings fairly steady, despite

the worsening background situation, but with the minor

markets, especially in Europe, suffering very sharp

falls, and yield spreads between the stronger and weaker

markets opening up to record levels.

The threat of sovereign debt defaults has increased

and urgent action is needed, especially in Europe, if

they are to be avoided.

However there are also warnings that similar conditions

could develop in the UK and in Japan if there are no

early moves to reduce the level of fiscal deficits.

It is still expected that an aid package will be agreed

to avoid a default on Greek debt; but this may only

provide temporary relief.

Shaw Capital Management Korea: Currencies

Movements amongst the major currencies have been

relatively small over the past month.

However the weakness of the euro has enabled both

the dollar and sterling to improve as investors have

rushed to reduce their exposure to the European

currency.

There is a fear that the debt problems affecting Greece

and other countries in the euro-zone will make it

extremely difficult to restore the credibility of the euro,

and that it might make it necessary for some countries

to leave the single currency system, at least on a

temporary basis.

Shaw Capital Management Korea: Short-Term Interest Rates

There have been no changes in short-term interest

rates in the major financial centres over the month.

The Bank of Canada though has indicated that it is

considering pushing rates higher, and this has

encouraged speculation that other central banks may

be planning similar moves.

Shaw Capital Management Korea: Commodity Markets

Moved higher over the past month as sentiment in the

financial markets improved.

Shaw Capital Management Korea: Competitive tax system in UK

Now consider UK taxation. Already under this current UK

government tax, and stealth taxation in particular, has become the

soft default option. By the mid-2000s the top marginal rate of tax

including all imposts, whether on wages or consumption, had

reached 60%, the average tax rate was 40% and the marginal tax

rate on the average person 43%.

Now that the explicit top rate of income tax has gone over 50%,

the top rate has gone up to around 67%. So far for the average

worker not much has changed since the mid-2000s. However,

further rises in tax rates from these levels are not an option and

indeed they must be cut, for two reasons.

The first reason concerns the ‘Laffer Curve’; which computes the

extra revenue raised for every rise in the marginal tax rate.

This curve reaches a peak at some fairly moderate marginal tax

rate because of the effect on effort and tax evasion.

All informed observers, including the Institute of Fiscal Studies

which is generally in favour of higher taxes and redistribution,

agree that the 50% new top tax rate will not increase revenue and

will probably lower it for this reason.

The second reason concerns growth. Growth comes from the

innovative activities of entrepreneurs, who are extremely sensitive

to marginal tax rates because their activities are risky and any

gains uncertain; the more these are taxed the less the expected

return and if this drops below some threshold they will not bother

at all.

The UK needs both to make the fiscal

adjustment on the spending side by reviving

old-style Treasury control and then quickly

bring their tax system back into the land of

reasonable incentives, following that up with

reforms ‘flattening’ the marginal tax rates

across the economy and income groups.

Estimates of the effects on growth of marginal tax rates are for

obvious reasons uncertain; but the sort of effect that comes out of

empirical studies is an elasticity of one third, i.e. for every 10%

reduction in tax growth would rise by 3% (e.g. a reduction of the

marginal tax rate from 40% to 36% would raise growth from 2.5%

to 2.58%).

This effect seems small but it accumulates into something large.

So in short the UK needs both to make the fiscal adjustment on the

spending side by reviving old-style Treasury control and then

quickly bring their tax system back into the land of reasonable

incentives, following that up with reforms ‘flattening’ the marginal

tax rates across the economy and income groups.

The supporting role of monetary policy

This fiscal adjustment, however gradually brought about, is going

to be a fairly grim process and it will dampen growth further.

It will require the efforts of the monetary authorities to support

the economy through it, without pushing inflation over the target.

At present the bank credit is not expanding, whereas a growing

economy requires bank credit growth usually of twice or more

times the GDP growth rate.

The Bank of England is keeping interest rates low but has suspended

the printing of money (‘quantitative easing’), even though bank

credit growth has not responded.

But it may well need to restart it. This is something the UK will

need to watch and if, as seems likely, inflation falls back to well

below the target and the economy falters under fiscal retrenchment,

the Bank of England will need to take steps to get the broad money

supply growing again.

As we have noted before, other channels for money appear to be

working in substitution … UK equity and corporate bonds issues

have been substantial recently. So liquidity may turn out adequate

even without credit growth revival.

Our forecast for the UK

Though the UK Budget was predictably vacuous, being a pre-election

affair, our forecast assumes that action pretty much along the

above lines will be taken after the election by whatever government

is in power … hung Parliament or not.

The reason is that there is little room for manoeuvre and privately

in fact the parties do not materially disagree, except to some degree

on what modest room there could be for tax rises instead of spending

cuts.

So in short we think there will be fiscal retrenchment, monetary

policy will provide support, and so the UK recovery will slowly

continue.

Shaw Capital Management Investment Deadlock for Japan

The Democratic Party of Japan’s (DPJ) landslide victory in the Lower House election a year ago ushered in euphoric predictions of bold new policies, and even a transformation of the Japanese political system. There were widespread hopes that the DPJ would end the run of short-lived leaders. Instead, Prime Minister Yukio Hatoyama’s tenure proved to be a slow-motion train wreck. Indeed, the DPJ quickly showed itself to be no more competent in governing Japan than its much-derided opponent, the Liberal Democratic Party (LDP).

After shedding its two albatrosses of Hatoyama and general secretary Ichiro Ozawa, and many of its earlier campaign pledges, the DPJ hoped for a respectable showing in the last Upper House election. Instead, the ruling DPJ suffered a stunning defeat, when voters had the opportunity to show whether they were confident in Prime Minister Naoto Kan’s just over 1-month-old administration. The party ended with only 106 seats, far short of the 122 needed for an outright majority. The gap is too large to be filled by creating a coalition, because the most likely potential partners also lost seats.

As a result, the DPJ coalition can no longer ensure approval of its legislative initiatives. A twisted parliament portends even greater legislative stalemate and political gridlock. Gerald Curtis, a professor at Columbia University in New York and a long-time expert on Japanese politics, said the election had returned Japan to the paralysis and gridlock of the past few years. “You cannot pass a budget now in this political environment. You’ll have weak and unstable government. While the world changes fast, the Japanese government will change very slowly”. Trying to put a good face on the results, Kan said he viewed the election as a “starting point” for his push for a more responsible government ... The policy implications of the election outcome do not suggest an aggressive approach to monetary, fiscal or structural policy over the next few months.

Indeed, the attention of the large parties will most likely be focused on internal matters, leaving less time for focus on the economy. Gridlock is bad for the economy and for investor sentiment if policy drift continues for a prolonged period. According to Alan Feldman, managing director at Morgan Stanley in Tokyo, there are so many pressing problems in the Japanese economy that the costs of gridlock could be very high. In particular, pressure on the Bank of Japan for more aggressive monetary policy will likely be minimal, at least until political disarray ends. Without strong political leadership little progress is likely on budget priorities. The same goes for tax decisions.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.

Shaw Capital Management Investment Equity Markets 2010 Part 2

For the moment attention is focused on the strength of the German economy, and the beneficial effects that will be felt elsewhere in the zone; and there has also been a relaxation of tension about debt defaults, after the rescue package agreed by the member countries, and the intervention by the ECB to support the weaker bond markets. The German export performance depends of the maintenance of strong growth in the global economy that may not be sustained; and the odds still suggest that one or more of the weaker countries will at least be forced to defer interest payments on its sovereign debt, and may even default. The latest improvement in the markets therefore seems likely to need further support from Wall Street if it is to be sustained. The best performance amongst the major markets over the past month had occurred in the UK market. The measures announced by the new Coalition government to reduce the size of the fiscal deficit have been well received by the market, despite the fact that they will slow down the pace of the economic recovery over the coming months; and the latest estimate of a 1.1% growth rate in the second quarter of the year suggests that the effects of the fiscal retrenchment might even be less than had been expected, and has removed most of the fears about the possibility of a move into a “double- dip” recession.

The improvement in sentiment amongst investors is therefore easy to understand. Even before the announcement of the estimate of growth in the second quarter of the year, there had been further evidence of an improving economic situation. The unemployment rate fell; retail sales volumes rose by 1%, the strongest monthly increase in almost a year; and the latest quarterly survey from the CBI reported that manufacturing output increased at its strongest rate since 1995.

The 1.1% estimated rate was well above most forecasts. It was the result of expansion in both the manufacturing and services sectors of the economy. But the most surprising figure was the estimated 6.6% rate of growth in the construction sector that accounted for around one third of the overall growth in the period. It has also produced considerable interest regarding the reaction of the Bank of England to these figures. The bank has previously been mainly concerned about the risk of slower growth, and had even considered at the last meeting of its Monetary Policy Committee “arguments in favour of a modest easing in monetary policy” because “prospects for gross domestic product growth had probably deteriorated a little over the month”.

The mood will have changed now; but the governor, Mervyn King, has recently indicated that there will be no early changes in policy as a result of one set of figures. The background factors affecting the market therefore remain. Short-term interest rates will remain low, and the economy is performing better than expected; but the austerity measures that are to be introduced, and especially the increase in VAT in January, will depress demand over the coming months. It therefore seems likely that the UK market, like the markets in mainland Europe, will need further support from Wall Street if the recent strength is to be sustained.

The Japanese market is lower over the past month. There has been further evidence that the pace of the recovery in the Japanese economy is weakening; andthe poor performance by the ruling Democratic Party in the recent election seems likely to lead to a period of political uncertainty that will make it difficult for action to be taken to reverse the trend.

The earlier decision to introduce measures to reduce the massive fiscal deficit was a major reason for the government’s poor election performance in the election, and may well be reversed; and the Bank of Japan’s action to try to increase the rate of bank lending, especially to smaller companies, also seems unlikely to have much of an effect on the economic situation. The background situation in Japan is therefore very disappointing, and this is reflected in the performance of the equity market. It seems unlikely that there will be any early improvement in the situation, and so the Japanese market weakness looks set to continue.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.