Asia: Bank of Japan shifts to reserve targeting

There is no real evidence yet that Japan's central bank is flooding the market with reserves, but analysts are keeping a close watch on the monetary base for confirmation of a major shift in policy that just might put an end to the country's crippling deflation.

"Our analysis shows that the

"We believe that history will view this policy shift as being truly monumental," Rosenberg says. "It is roughly on the same level as the Federal Reserve policy shift engineered by [former chairman] Paul Volcker in the late 1970s and early 1980s, when the Fed shifted from interest rate targeting to reserve targeting."

While the Fed's historic shift was designed to give it more room to maneuver in pursuing an aggressive tightening in monetary policy to bring US inflation down permanently, the Japanese central bank's move will be "Volcker in reverse," Rosenberg says.

The change could give the Bank of Japan more room to pursue an aggressive easing of monetary policy to help push Japan's inflation rate permanently higher.

Rosenberg says he is not surprised that there is no hard evidence yet that the BOJ is cranking up the yen printing presses and delivering on its promise.

"You have got to be realistic," he says. "Japan doesn't move that quickly. First it has to set up a framework, and then it will proceed slowly."

It will be difficult at first to decipher the effects of the BOJ's actions under the new policy, Rosenberg says. "The same was true when the Fed shifted toward reserve targeting in 1979. But the BOJ's new policy course will almost certainly give rise to a major decline in the yen's value. As a result, we have adjusted our already bearish yen forecast to show an even weaker yen than before."

Deutsche Bank forecasts that the yen will fall to 140 to the US dollar within a year's time, given that the Japanese central bank has finally shifted to reserve targeting. The BOJ has vowed to continue to infuse the market with liquidity, in what is known as a "quantitative easing," until such time as the trend in core consumer price inflation rises to zero or above.

The Japanese central bank may have to supply more reserves than it realizes at present, Rosenberg says, because the money multiplier, or the rate at which money changes hands, has been declining steadily. "They must neutralize the multiplier," he says. "But eventually, they will succeed."

In Japan, he notes, more than 90% of the monetary base consists of currency in circulation and less than 10% consists of bank reserves. The BOJ cannot control the volume of currency in circulation, which is determined by the private sector's preference to hold cash instead of time deposits.

The BOJ's stated goal is to raise bank reserves with the intention of raising growth of the monetary base. By speeding growth of the monetary base, the central bank is hoping to increase the rate of growth of the broad money supply.

Rosenberg says the BOJ will have to raise the rate of monetary-base growth sufficiently to more than offset the declining trend in the money multiplier.

"If the BOJ is successful in eradicating deflation in Japan, real interest rates should trend downward over time, which should be negative for the yen," Rosenberg says.