SCOREBOARD: BoJ inflation airs

The Bank of Japan's latest minutes underscore its contentment with zero inflation, which could make exiting QE more difficult.

US markets were closed for the Memorial Day Holiday and they were closed in the UK as well (Spring Bank Holiday). That’s not to say markets were subdued though, as gains in Europe were solid.

The Dax for instance was up 0.9 per cent and the CaC was 0.97 per cent higher, not so much on any major macroeconomic news or anything – it was more a confluence of stocks specific news, the balance of which was obviously positive. The only other thing to note for the price action really was that the Australian dollar ended a little changed at 0.9635 this morning (after a high of 0.9666 overnight).

There's not really much else to comment on, so I would like to draw your attention to the drama the Bank of Japan is currently having. Certainly Japan watchers might have found the central bank's minutes yesterday interesting.

In those, a few board members noted that the bank's policy “might initially have been perceived by market participants as contradictory”. That would be true for those who took the bank's rhetoric seriously. I guess that holds for all central banks though, not just the Bank of Japan.

Anyway, recall that the Bank of Japan wanted to target an inflation rate of 2 per cent, apparently. Taken at face value, this is contradictory because higher inflation means higher bond yields, yet they were buying bonds to lower yields to get an inflation rate of 2 per cent. Thus the confusion – except that I think it’s quite obvious that they weren’t targeting an inflation rate of 2 per cent.

Japan is quite happy with zero inflation. The targets are firstly USD-JPY, which in what appears to be a bilateral agreement with the US has been set around 100 (currently 101). Then we have the budget deficit and public debt position. Japan has way too much debt and simply could not afford the interest repayments if bond yields rose. That’s why they don’t actually want inflation – well, anticipated inflation anyway. That’s why they’re happy with zero inflation, as it allows them to sustain much higher levels of debt at lower yields.

The other reason they want lower interest rates of course is because any significant rise would threaten already fragile bank balance sheets, eroding capital.

If you recall, inflation initially didn’t feature in the Bank of Japan's sabre rattling. They were explicit in wanting a lower yen. But this incurred the wrath of the US Treasury, who urged them to reframe the policy in terms of growth and inflation outcomes, given sensitivities over the ‘currency wars’. This is exactly the tactic the Fed uses – thus the problem. The Bank of Japan is meeting with bond traders apparently to discuss the ‘confusion’ – to work out some way of enticing them to still buy bonds without jeopardising the above policy targets.

The mistake they made was going too hard on the inflation idea as a way to market increased bond purchases. That spooks the Japanese government bonds market, even if most of those participants already know the Bank of Japan had no intention of hitting that target. Remember the odd comment from Japanese officials who, having announced the target, added shortly after that they may not be able to achieve it!

We will probably never know the actual deal that will be cut. But this sad episode highlights two things: firstly, the grave difficulty the world’s major central banks will have exiting QE; and secondly, why you should stay clear of all government bonds. Do not under any circumstances touch them. Retail investors will be the last to be let in on any policy changes.

Looking at the day head, the SPI suggests Aussie stocks will fall a further 0.3 per cent in what looks like a quiet day. There is no major news or dataflow to speak of in our session and even tonight it’s relatively quiet.

The key US data to watch includes US house prices (currently surging), the Richmond Fed manufacturing index, consumer confidence and the Dallas Fed manufacturing index.

Have a great day…

Adam Carr is a leading market economist.

Follow @AdamCarrEcon on Twitter.

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