BOJ/JAPAN: Rather than a frontal assault on Japan’s ingrained climate of monetary deflation, early indications are that the Bank of Japan’s much-anticipated overnight announcement adopting “drastic” easing measures could prove to be another in a long series of futile gestures. Initial disappointment with the BoJ was evident in the foreign exchange markets where, after falling to a new 22-month low of 123.6 to the dollar in the immediate aftermath of the announcement, the yen was trading above 123 in New York by mid-day Monday. The reversal came after BoJ Governor Masaru Hayami dismissed the notion that a weaker currency should be part of the central bank’s strategy. During a news conference following the BoJ policy meeting, he even suggested the Japanese authorities would act to keep the currency from falling too far. Such comments, of course, do nothing but feed skepticism about the central bank’s competence to handle the task confronting it. The credibility of the bank’s long-overdue shift into a “quantitative” easing mode is rendered suspect by the chief policymaker suggesting he doesn’t appreciate the need for currency reflation as part of an ostensible anti-deflation policy thrust.  Other elements of today’s announcement raise similarly vexing issues:

• The primary quantitative objective of the BoJ policy change is a Y1 trillion increase in bank reserve deposits at the central bank  -- “current account balances” in BoJ nomenclature -- up about 25% from a current daily average around Y4 trillion. The BoJ says that within six months, increased reserve balances should produce monetary base growth of about 7% year-on-year, from 3% in February. The potential for error in adhering to such an arbitrary target, however, is enormous. Over the past year, y-o-y base growth has varied from 12% to –5.6% -- and current account balances from 51% to –56% -- with little or no correlation to market-based liquidity indicators such as the yen/dollar rate or yen gold price, which has remained in a narrow range around Y30,000 per ounce.  The problem: there is no way of knowing whether the targeted growth of high-powered liquidity will at any given time be in surplus or deficit relative to market demands. Previous attempts by central banks to operate with rigid reserve-growth targets – notably, the early years of Paul Volcker’s tenure as Fed chairman during 1979-82 – usually ended in disaster. Moreover, if Japanese authorities remain committed to keeping the yen from further significant depreciation, it’s conceivable that the bank would be compelled to sterilize its domestic liquidity injections by selling dollars for yen in the foreign exchange market. The end result would be neutral for global yen liquidity availability, and thus meaningless to monetary conditions in Japan. In this regard, it’s possible that the public stance against a weaker yen is at least in part a misguided effort to mollify the new U.S. administration of George W. Bush, who received Japan’s lame-duck Prime Minister Mori today at the White House. Treasury Secretary Paul O’Neill, the former Alcoa CEO, reportedly lobbied against giving the Japanese a green light to depreciate the yen as part of a recovery strategy.   |
   

• The BoJ is using the core CPI as a policy guideline, and says its new procedures will remain in place until the index, currently running at about –0.6% y-o-y, stabilizes at zero or registers a y-o-y increase. This statistical measure, however, almost certainly understates the extent of current-price deflation. Expectations of future deflation are, to considerable extent, an even bigger problem for Japan than falling current prices. Those expectations are probably best captured by the abnormally low yields on 10-year Japanese government bonds, now trading at just over 1.1%, down about 75 basis points in the last six months.  Against an internationally competitive real yield in the range of 3.5-4%, current JGB yields imply long-term deflation expectations up to about 3% per year. Thus, the core CPI could well provide a premature signal that Japan’s deflation is past.
   

• From that perspective, it follows that termination of current deflation and longer-term deflation expectations would be marked by a significant rise in bond yields. Indeed, a sustained bear market in JGBs would be among the more hopeful signs that the deflation is, in fact, being overcome. The fact that portfolio investors continue to find competitive real value in Japanese paper at current yields speaks to the overpowering deflation sentiment that now defines Japanese finance. Logic would suggest that the last thing a central bank would want is to encourage such sentiment. Such logic, though, escapes the Bank of Japan. In an explanatory note accompanying the policy decision, the BoJ said it expects that its actions will be consistent with “a decline in interest rates across the yield curve.”

FED:  Japan would also be among the first beneficiaries of any move by the FOMC tomorrow that was deep enough to positively affect the availability of dollar liquidity. At Y123/$, a bump in the dollar price of gold to the $285 level from $260 would imply a yen gold price above Y35,000/oz., foreshadowing significant monetary relief on both the eastern and western shores of the Pacific. That, though, appears to be a vain hope at this point, as even a 75 basis point move tomorrow would leave the funds rate at a level – 4.75% -- representing a restrictive, liquidity-scarce, policy stance. It’s also unlikely that Greenspan & Company. will be inclined to confirm the market’s fondest hopes for a better-than 50 bp move at tomorrow’s meeting. While Greenspan might still be loath to risk disappointing expectations, neither is he likely inclined to appear to be placating market demands. Such considerations, of course, belong in the realm of institutional prerogatives and precedent rather than the real-world monetary conditions that are supposed to be the overarching concern of the central bank. At this point, it’s a good bet that a consensus of the policymaking panel accepts that this cycle will not be complete until the funds rate is brought down to a level no higher than 4%. The best outcome for the economy, the markets and the Fed’s ability to get ahead of the liquidity-demand curve would be to get to that point as quickly as possible, preferably tomorrow. Even at 4.75%, the entire yield curve under 10 years would be inverted relative to the overnight rate, distorting and restraining the mechanisms of liquidity and credit creation which normally are keyed to the funds rate anchoring the term structure.