Any notion that the Bank of Japan’s decision late Monday to delay terminating its zero-rate policy would have a positive market impact vanished overnight as the Nikkei plunged 2%, back below 17,000. Not that a hike to 0.25%, which was expected up until late last week, would have been the right move. But the zero target on overnight rates in place since early last year has in itself been a reflection of the BoJ’s deflation-biased policy stance. Maintaining that policy target for an indefinite period going forward thus will do nothing good for Japan’s economic and investment outlook. The perverse nature of the BoJ’s operating paradigm was underscored again Monday. At the same time the bank was announcing its policy decision, it also released new balance sheet data showing a near 2-trillion yen contraction in its asset base in the most recent reporting period. At just above Y80-trillion, BoJ assets have shown no net growth in more than two years. The continued scarcity of yen liquidity is best captured by the yen gold price, which has hovered in a range around Y30,000 yen per ounce for several months, down nearly 25% in the past two years.

The BoJ’s clumsily worded statement accompanying the rate decision, citing the high-profile bankruptcy of the Sogo retail chain, also did more to sow doubt than inspire confidence. Was the central bank unaware until now that deflation has been wringing the life out of scores of Japanese debtors?  It’s also difficult to share the enthusiasm of the Wall Street Journal editorial page for the Sogo shutdown. Yes, the government bail-out schemes have been transparently shortsighted band-aids allowing LDP mandarins to paper over their economic failures by transferring part of the risk from creditors to taxpayers. But given the monetary burden hanging over the economy, it is a bit far-fetched to posit – as the Journal does – that Sogo’s collapse heralds some new free-market economic order. More likely, it foreshadows a surge of bankruptcies that will again threaten to cripple the Japanese financial system and ultimately necessitate funneling additional taxpayer-financed, life-support funding to the banks. Meanwhile, any hope for economic relief on the fiscal front appears increasingly improbable. The long-awaited report of the government’s Tax Commission was also released yesterday and, as expected, recommends a series of individual and business tax hikes to overcome Japan’s soaring debt burden. That burden, of course, is the consequence of Japan’s decade-long slide into economic gloom, which no tax hike could possibly help reverse. An ill wind, indeed.

HUMPHREY-HAWKINS: GREENSPAN STEPS OUT. On the eve of Alan Greenspan’s Thursday testimony to the Senate Banking Committee, markets continue to signal a high degree of uncertainty over the near- to medium-term course of Fed policy. Interest-rate futures rate the chances of a 25 basis point move at the Aug. 22 meeting as a toss up, but still are positioned odds-on for a 6.75% funds rate by year-end. That reflects a considerably more favorable environment than was present two months ago, when futures were on their way to pricing in expectations for a 7.25% overnight rate. Still, the Fed’s backward looking, fine-tuning approach is feeding a distorted view of economic reality. Bonds sold off again yesterday, for example, on the news that May business inventories rose a stronger than expected 0.8%. The inventory build, it was reported, could add as much as a full point to second quarter GDP growth, which is unlikely to be greeted warmly by the Fed’s output-gap modelers. Fact is, though, last quarter’s inventory build could lead to next quarter’s growth-depressing inventory liquidation, particularly if, as elements of yesterday’s report suggested, businesses are overstocked for the pace of final sales. Retail inventories, for example, rose 1.4% in May, the highest in more than five years, against a 0.3% rise in sales.

This round of hearings also comes as internal intellectual fault lines at the central bank show signs of surfacing publicly. The Phillips Curve/NAIRU orthodoxy, which has served as the theoretical backbone for the past year’s rate-hiking campaign, is increasingly coming under challenge within the system. Under the authority of bank president and FOMC voter Jerry Jordan, the Cleveland Fed used its recently published annual report to attack the Phillips Curve as an archaic and deeply flawed conceptualization of the inflation mechanism. Moreover, several of the reserve bank presidents who never pledged their fealty to the output-gap model were known to be appalled by Greenspan’s language in several speeches identifying productivity growth as an inflation risk factor. More recently, that concern has been replaced by acknowledgment that the massive investments of the information technology revolution have greatly expanded the economy’s productive capacity. The logic of this rhetorical shift suggests that Greenspan is placing less weight on a “wage-inflation” view of monetary risk given the technological transformation of the capital stock. Whether Greenspan has assembled a working consensus for this view, and overcome resistance from the Phillips Curve stalwarts assembled around Governor Laurence Meyer, will be the key issue for the forthcoming hearings.  

TAXES: ‘SUPPLY-SIDE DEMOCRAT’ may no longer be the oxymoron that it has been for the past generation of class-warrior Democrats. This was made clear by the Senate vote Friday to repeal the estate tax, which picked up the support of nine Democrats, including Diane Feinstein (Calif.), Senate Dem leader Tom Daschle (S.D.), and Ron Wyden (Ore.). Wyden, a reliably leftish vote on most issues, took to the Senate floor to deliver one of the more impressive statements supporting repeal. “The estate tax is a wildly clumsy, inefficient tax that basically is a full employment program for lawyers and accountants,” he said. “We ought to be phasing out the estate tax, and we should work toward a tax code that is both progressive and entrepreneur-friendly.” In this election year, both parties have decided that they’ll get better mileage politically using estate tax repeal as a bone of contention, rather than actually enacting it. Nevertheless, the erosion of blind Democratic commitment to class-warfare ideology, spurred importantly by the rising wealth of middle-class voters, together with the ever-mounting surpluses in government budget accounts, increasingly bodes well for a pro-growth tax agenda.