Just one month ago, I excoriated our good friends at the Bank of Japan (motto: Making the Fed Look Good, Aren't We?) for withdrawing excess liquidity from their current account at the very moment the world was discovering it was in a credit crunch. The end results of that boneheaded move have included a stronger yen and a drop in long-term inflation expectations in Japan to the 0.391% level ... and that is up from 0.32% the previous week.

A disaster? Hardly. The good news, if we may call it that, for risky assets is an environment conducive to Japan turning the liquidity taps back on and reigniting the global yen carry trade that financed so many of the world's asset price bubbles over the past dozen years.

If we throw in a few moves, such as the Federal Reserve's 50-basis-point rate cut and the Bank of England's de facto nationalization of Northern Rock, we have the makings of a pretty good inflationary party, don't we?

Small Changes, Big Impacts

Lest you think this is nothing but a broadside against the BOJ and the politicians at the Ministry of Finance, let's grant them their due in two matters. First, the last increase in overnight "mutan" rates (the Japanese equivalent of the fed funds rate) occurred in late February, marked with a green arrow on the chart below. This was well after 10-year break-even rates of inflation had declined to just over 0.43%. A subsequent rebound to 0.64% in early June suggests the February rate hike is not to blame for the current state of the Japanese inflation market.

Short-Term Interest Rates and Long-Term Inflation Expectations

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Source: Bloomberg, Howard Simons

Second, while the BOJ has reduced the excess funds in its current-account balance, the overall level simply is near the low end of its range over the past year. The yen weakened substantially with the current-account balance near its present level of ¥10.62 trillion, so we cannot blame the current bout of yen strength on liquidity withdrawals.

The Yen and Japanese Excess Liquidity

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Source: Bloomberg, Howard Simons