The BOJ decision has global ramifications, not just for market expectations for global liquidity from its action alone, but also for major central bank policies.


A senior LDP politician who has been a key voice in monetary policy stated earlier this week that the BOJ could wait until later this year to see if its super-aggressive policies would work before easing further. This turned out to be prophetic, as the BOJ meeting essentially extended its CPI target period and reduced its certainty factor in achieving it. Some may say that the BOJ lost some credibility in doing this, but it was not truly its fault, but rather OPEC's refusal to yield more of its market share to producers using deflationary new technologies, especially for shale energy.

For nearly two years, the BOJ has very aggressively approached its problem with deflation and achieved some major success, especially by returning the Yen to a more normal level (especially given the trade deficit caused by the nuclear plant shutdowns), but by targeting its own unique form of core CPI that included energy, it set itself up for missing its goal if OPEC made a major decision not to cut production. So, the BOJ finally needed to admit that it does not control the oil price and, thus, its core CPI. It actually long knew this, but it did not want to "muddy the message" and thereby de-emphasize its determination to reach its target so that it could change deflation expectations.

Now, with this new reality, the BOJ should begin to watch "true core CPI," which excludes food and energy, more closely and it will be difficult to reach 2% YoY for this measure. For such to occur, housing rent is a key factor, as it comprises nearly 30% of "true core." Unfortunately, although it has stabilized a bit, the CPI measure for rent has yet to move upwards in any meaningful way. While there are indications of upward pressure on housing rents in Tokyo, there is less certainty of such occurring nationwide. Thus, clearly, it is key for investors to watch the rental component very carefully.

Japan is not alone in its difficultly with overall inflation. The ECB and the Fed both officially target overall inflation, but the Fed has long concentrated on core inflation and continues to do so in its intention to hike rates this year despite the overall CPI moving likely into negative YoY territory in the coming months.

Meanwhile, the US core CPI is likely to decelerate to 1.5% in the months ahead, but this is seemingly reassuring enough to the Fed for it to escape its "emergency stance," at least if the economy is growing well. Furthermore, the Fed believes that the core CPI will, along with overall CPI, accelerate later in 2015, and thereafter, to more reasonable levels.

Housing rent, together with its affiliated measure called "Owner's Equivalent Rent,", comprise about 40% of US core CPI, and are rising fairly significantly, but the other components, like autos and consumer electronics, are heavily affected by statistics that adjust for quality improvements in a highly deflationary manner. Thus, even keeping the US core CPI at 2.0% is quite a challenge unless the statistical methods are altered to show that technology is not adding as much value as previously assumed. Indeed, quality adjustments, originally introduced to reduce the CPI measured inflation, pose a similar deflationary problem for the BOJ and the ECB, as well.

We long expected the ECB decision to begin sovereign QE, but we admit that it is a very aggressive move relative to its peers now, especially if the purchases are actually achieved in large size. The Eurozone has a negative overall CPI YoY rate despite a weak exchange rate, and this overall deflation will likely continue in the 1HCY15, but its core CPI will likely hover at 1.0% YoY through then.

The ECB probably considers the core CPI to be too low, but it is only moderately below the US level and there are severe questions about how well Eurozone housing rents are measured. Regardless, it is joining the "G-3 club" with full sovereign QE, and certainly wants to take the opportunity of this deflationary period to add this QE arrow to its permanent quiver. However, it needs to reconsider moving towards the Fed and the BOJ regarding increasingly looking at core CPI, as several of its leading members have suggested for the past few months.

The likely truth is that 2.0% CPI targets, either for core or overall CPI, are not a logical goal for G-3 central banks as long as quality adjustments (and other statistical methods) deflate many of its components. Now that oil prices have declined, if a central bank targets its overall CPI at 2.0% for 2015, it would likely be labeled as being overly aggressive and perhaps attempting to unfairly weaken its currency. This is especially true if that country already runs trade and current account surpluses, as the Eurozone does.

In fact, it probably would be best if G-3 central banks target 1.2%-1.5% core CPI and rapidly harmonize statistical methods for measuring quality improvements and housing rents, which vary quite widely by country. Even if the resulting statistics are not perfect immediately, they should be used as an important gauge and could help prevent severe disharmony among central banks in the coming years.

None of the above means, however, that the BOJ or other central banks cannot make aggressive moves to support liquidity or increase risk-asset prices if necessary; it is just that the rationale for doing so should be increasingly separated from overall CPI targets, at least for this year, with somewhat more influence given to core CPI measures.

In the meantime, all G-3 central banks have extremely accommodative policies that should continue to generate economic growth, especially after the turbulence created in the commodities sector subsides.