Stephen King: The central bank that matters for now is not the BOE - it's the Bank of Japan

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The Independent Online

Do we control our own destinies? Luckily, this is a column about economics, not about the philosophical problems of freewill and determinism. Nevertheless, in economics, destiny matters. After all, policymakers exist because, in some sense, they think they can make a difference. They believe they have some influence over our destinies. For rugby union, we have Jonny Wilkinson. For cricket, we have Paul Collingwood. For the British economy, we have Gordon Brown and Mervyn King.

It's no surprise, then, that we've had constant speculation over the past few weeks about what the Bank of England will or won't do with interest rates. Underneath all this gossip is the idea that, somehow, the Bank of England is in control of our collective economic destinies.

Of course, there is some truth in the idea. If, for example, Mervyn King and his colleagues on the Monetary Policy Committee were to wake up in particularly grumpy moods tomorrow morning and raise interest rates by 10 per cent, I'm sure the UK's economic destiny would change rather abruptly. In reality, though, the Bank would never do something so silly. Like other central banks these days, the Bank of England believes in gradualism. It has no desire to rock the economic boat.

It is, of course, reassuring to believe that our monetary masters and mistresses are constantly regulating the economy in ways that will ensure that inflation is neither too high nor too low, thus creating the conditions for maximum non-inflationary growth.

In reality, though, the Bank's control over the UK economy is rather limited. If you don't believe me, simply take a look at current inflation rates. They're all a lot higher than the Bank planned a year or two ago, suggesting that our economic destiny is not, after all, entirely controlled by our monetary mandarins.

I want to make a rather bold suggestion. The central bank that really matters for our collective destinies over the coming months is not the Bank of England. Nor is it the European Central Bank or the US Federal Reserve. The one central bank that really matters at the moment is the Bank of Japan. The actions of Governor Fukui and his colleagues may, inadvertently, be having a significant impact on economic developments well beyond Japan's borders. The UK is not immune.

To understand why, it's worth thinking about what the Bank of Japan has been up to over the past few months. Hoping for a recovery in Japanese domestic demand, the Bank of Japan was planning to raise Japanese interest rates. During Japan's earlier deflationary funk, these had been set at zero per cent. The Bank managed one 0.25 per cent rate increase in 2006. The economic recovery, though, has subsequently faded. Initially built on a pick-up in exports and capital spending, the authorities hoped that consumer spending would eventually kick in. Consumers, though, stayed at home and now there are signs that other parts of the economy are also beginning to wilt.

Disappointing growth has, in turn, reduced expectations of higher interest rates. The Bank of Japan might still raise interest rates this month, but the chances seem to be receding. Meanwhile, the yen has softened. Many have taken their money out of Japan and headed elsewhere. Some investors have borrowed in yen - at remarkably low interest rates - to invest in higher-yielding currencies elsewhere in the world. This so-called "carry trade" has placed even more downward pressure on the yen, bolstering the performance of other currencies.

If people are able to borrow in yen and reinvest the proceeds in other countries, it's no great surprise that asset prices elsewhere start to go up. With rising asset prices, people are able to borrow even more and financial institutions are willing to lend more. In effect, the Bank of Japan's decision to keep Japanese interest rates at remarkably low levels is contributing to looser monetary conditions elsewhere in the world.

Of course, the Bank of Japan is not the only influence on global monetary conditions. You only have to glance around the streets of London to recognise that property prices are being increasingly influenced by what might broadly be described as foreign money (or more specifically, in some of the more high-profile transactions, Russian money).

Nevertheless, whatever the source, the influence of "outside money" on the UK economy is becoming increasingly large. The Bank of England knows this: much of the acceleration in monetary growth in recent times has come from deposits held by pension funds, insurance companies, hedge funds and private equity vehicles, and their deposits, in turn, often come from foreign sources.

These flows of money create serious problems for central banks. If someone borrows in yen and buys sterling, the pound rises in value. Many economists would regard this as a tightening of UK monetary conditions, pointing to lower inflation (a higher exchange rate squeezes exporters and lowers import prices).

However, if the increase in sterling is accompanied by a rise in money deposits in the UK, it's just as easy to argue that there's been a loosening of monetary conditions because those higher deposits might find their way into rising equity and house prices. These in turn, lead to higher demand and, maybe, higher inflation.

This ambiguity is creating a severe headache for policymakers. The Europeans are becoming increasingly anxious about the Bank of Japan's actions (or lack thereof) because, in both the eurozone and the UK, the ambiguity is writ large. Both the euro and sterling have appreciated rapidly against the yen in recent years while, simultaneously, monetary growth has been uncomfortably strong.

The Americans, though, won't criticise the Japanese. They don't want to deflect attention away from their own main agenda, namely the demand for greater market reforms - and more exchange rate flexibility - in China.

The US position is hardly surprising. Unlike the euro and sterling, the dollar has been rather weak. US money supply growth is moderate, at least compared with the figures coming out of the UK and the eurozone. Americans have less reason to worry.

Again, international factors play a role in these varying experiences. Foreign investors think the US Federal Reserve has finished raising interest rates but are not sure about prospects in the eurozone and the UK, so surplus funds tend to be held on deposit on our side of the Atlantic. Meanwhile, at least some of those surplus funds come from Middle Eastern countries where leaders fear that US-based holdings might be sequestered by the US authorities.

The Europeans hoped to push the yen issue to the top of the G7 finance ministers' meeting held in Essen this weekend. The Americans wouldn't let them: Hank Paulson, the US Treasury Secretary, emphasised well before his plane touched down in Germany that the Americans regarded the yen's weakness as a product of market forces, not of deliberate manipulation by the Japanese authorities.

Whatever the underlying reasons, though, the fact remains that Japan's actions - and those of reserve managers in many emerging markets - are increasingly altering monetary conditions in the West. The value of sterling, the degree of house and equity price inflation and the level of long-term interest rates are increasingly being affected by developments outside our borders. When it comes to monetary policy, we are not alone.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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