Monday, November 01, 2004

Off of a discussion in Brad Setser's Web Log, the General took a little time this weekend to cozy up with a New York Fed research paper titled "Reserve Accumulation: Implications for Global Capital Flows and Financial Markets". Now if that title alone doesn't make you want to download the paper right away, I don't know what's wrong with you.

OK, so you don't want to download the paper. Let me hit the highlights as far as my interests go.

First, I learned that Japan is doing almost no sterilization. "Sterilization" is a process in which a central bank soaks up money from its economy which it injected into it by buying foreign currency reserves. By sopping up money via sterilization, the money supply goes down and interest rates go up, pushing prices down as well.

It only makes sense that Japan, battling deflation for almost a century now (or so it seems), wants its purchases of US treasury securities unsterilized. China, on the other hand, is sterilizing about half of its purchases, trying to limit the growth of its money supply and thus keep inflation in check. The anti-Japan in this sterilization story is Taiwan, which sterilizes every foreign reserve it touches. Best to wear the lead apron in Taipei.

This matters because on October 19 I argued that Japanese deflation is the permissive condition behind the infinite Japanese appetite for the US dollar. If/when inflation returns to Japan, they won't be so keen to allow their massive purchases of dollars -- enabled by their massive sales of yen -- to balloon the domestic money supply and thus provoke even more inflation. That said, I didn't consider sterilization. Japan could continue buying dollars even after its deflation ends -- but it would have to begin sterilization.

No problem, you say? Here's the second interesting thing I learned from this New York Fed paper. To retire from circulation the yen created to buy dollars, Japan will have to "soak it up" by buying it, aka issuing debt. The more sterilization, the larger government debt grows.

In early 2004 Japan spent some �15 trillion to support the dollar. Japanese government debt hit an all-time record earlier this year at �729 trillion, with the country carrying by far the largest debt load in the OECD. Can Japan commit itself to a vigorous sterilization campaign when faced with these kinds of debt loads? Perhaps the Bank of Japan has an infinite appetite for US dollars, but private capital markets do not have an infinite appetite for Japanese government debt.

So the end of deflation might really be the end of vigorous Japanese intervention in currency markets, because Japan quite literally cannot afford to sterilize indefinitely. But will Japanese deflation end any time soon? Just last week the Bank of Japan boldly forecast the upcoming demise of deflation -- sort of. It now estimates an inflation rate in 2005/06 of +0.1%.

So once again, three cheers for Japanese deflation!


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