Scrap all the focus on the Federal Reserve and the next move in the federal funds rate; focus instead on the oafish attempts by the Bank of Japan to manage the supply of money.

The oafs are at it again. Immediately after liquidity infusions by the European Central Bank, the Federal Reserve and for all I know the Central Coconut Repository of Vanuatu between Aug. 10 and 16, the BOJ heard the beat of a different drummer. It allowed both the price of short-term yen (as measured by three-month LIBOR) rise and the quantity of excess yen (as measured by the BOJ's so-called current account balance) shrink, marked by the arrow on the chart below.

Finally, last Friday, Aug. 17, an 875-point drop in the Nikkei 225 induced the BOJ to open the taps a little. Its intransigence may have set the stage for the Federal Reserve's discount rate cut.

Bank of Japan Contributed to Liquidity Stress

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Source: Bloomberg, Howard Simons

Those Who Carry Get Carried Out

In the middle of what appears to be the worst global financial disruption since August 1998 -- and certainly the one with the greatest degree of macroeconomic risk -- the BOJ appears to be taking a bad situation and making it worse. Higher interest rates for yen borrowings and a lower available supply of yen threaten the yen carry trade, described here most recently in January.

Those who have borrowed yen must repay their loans at some point and therefore are at risk in case of a stronger yen. We can measure the anxiety of those borrowers about prospective yen strength by looking at the volatility of three-month yen forwards; as panic increases, so does volatility. That volatility shot higher this past week as the BOJ's policies took effect. The currency market is pricing in a stronger yen to come. This is not quite the scenario I had in mind this past May when I called for a bottom in the yen, but the net result is the same.

The Great Yen-Buying Panic of 2007

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Source: Bloomberg, Howard Simons