The yen has drifted between ¥96/US$ and ¥100/US$ in recent months, influenced by swings in investor sentiment linked to domestic fiscal reform and external risk developments (daily chart, next page). At home, Prime Minister Abe confirmed last week the planned hike in the sales tax (from 5.0% to 8.0% in April next year) as part of efforts to reduce the substantial public debt burden. That announcement was accompanied by a mini fiscal stimulus package to offset concerns about its negative effect on demand. True, the Q3 Tankan survey of business sentiment showed broad-based improvements in manufacturing, while weakness in the yen has contributed to an upturn in exports. However, critics warn of the drag from premature fiscal tightening as sluggish developments in employment and wages suggest that momentum in is not fully entrenched. Lingering doubts about growth sustainability partly reflect the stop-start performances of the recovery over the past decade. In addition, the dismal state of the public finances mean that the government will remain under pressure to adopt a higher degree of fiscal discipline, or risk a possible sovereign rating downgrade, as happened in 2011. Under these circumstances, the Bank of Japan has held (and might even be forced to extend) an expansionary monetary stance, despite concerns about policy credibility and higher long-term rates. Weakness in the US dollar caused by the Washington risk premium (page 3) has contributed to recent firmness in the yen. However, the consensus is predicting that the currency will depreciate somewhat over the next twelve months.
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