Oh, Oh... News From The Bank of Japan

"The Bank of Japan on Friday said it would allow the current account balance to fall temporarily below its liquidity target, the first step towards normalising monetary policy since quantitative easing was introduced four years ago."

This news in today's FT might send shivers down a number of spines. The issue is essentially deflation. As the FT itself observes this seems signal the beginning of an end to Japan’s unorthodox quantitative easing policy even though deflation has yet to be beaten. Prices have been falling for seven years and - as I reported earlier in the weak - deflation has recently accelerated: indeed the even the BoJ itself does not expect a return to inflation until the year to April 2007.

"Quantitative easing which floods the market with excess liquidity was introduced in March 2001 to fight deflation in the absence of the BoJ’s ability to move interest rates below zero. Pessimists fear that rushing to mop up liquidity before deflation is beaten is dangerous. Liquidity targets should be maintained, or even expanded, until inflation is firmly entrenched, they argue."

Morgan Stanley's Takehiro Sato - writing before the announcement, advised aginst such a move, in part because:

"The Bank runs the risk of making a serious error similar to ZIRP (zero interest rate policy) abandonment in August 2000 if it mistakenly revises the current account target at a time of heightened uncertainty in global financial markets, including recent speculation about the possibility of massive losses at hedge funds from the GM shock. Policy action would leave the Bank open for criticism from almost anything that goes wrong later on".

A bit of technical background. As feared by Keynes, Japan has effectively created a liquidity 'black hole' in its attempts to over come the 'zero-bound' problem. This is why you get a reading like the 'five times over the liquidity required to maintain interest rates at zero' mentioned by the FT. Essentially the faster you pour money in, the slower it moves around. Quite a headache.