Because inflation has remained low for so long, inflationary risks have become underestimated. In most of East Asia expansionary public policies and high oil prices are building up inflationary pressures. Together with higher interest rates in the U.S. this will likely lead to significantly lower growth prospects for next year.

The valuation of Japan’s stocks and the Yen has been held back by political and economic risks. But economic fundamentals, from domestic to foreign demand, have proven to be quiet strong. Political risks now look manageable as well because the main contenders for Japan’s September election now compete on pro-reform platforms.

The BOJ increasingly has difficulties to carry out open market operations for its quantitative easing policy. Since banks are not distressed by bad loans anymore, they have little interest to hold excess funds in their current accounts at the BOJ. Though this is a recovery sign, a Monetarist analysis would show that monetary policy becomes more restrictive if nothing else changes. The main problem is that the BOJ’s liquidity target is an instrument for distress in a liquidity crisis. So a change in policy would be necessary at a time when the economic recovery solidifies. But since the long-term interest rates had fallen below Japan’s potential growth rate just before the policy meeting, the BOJ seems to have very little reason to start more outright buying of longer maturity government bonds. The bottom line is that the BOJ would rather risk some failures in operations for a while, than venturing into new policies at a time when markets can easily become unsettled.

Although the BOJ claims that the economy remains on a recovery trend, it is certainly concerned because liquidity demand keeps falling and limits the effectiveness of its policy. But the still bigger fear seems to be that the Koizumi government might defect from its fight against the huge budget deficit by issuing more bonds to the BOJ. So basically, the BOJ seems to share the markets optimism about the positive effects of Japan’s supply-side economics of corporate restructuring.

The focal point of attention before and during the London G7 Meeting is the question if Asian governments – and especially China – can finally be persuaded into accepting a weaker Dollar. Any currency related comment by American, European, and, for the first time, Chinese policy makers therefore drives speculative moves of Asian currencies – even though all G7 participants seem to agree that no major change in policy stance (and not even a mere change in the currency-related statement of last year’s Florida-meeting) would emerge.

See some comments that add up to a gradual change in Asia's currency regime by clicking below.

I have structured my thoughts on the dollar a bit. Here is the bottom line (click below if you like to read the more detailed arguments for Japan, China, and Korea):

The U.S. dollar has still some room to fall before major Asian central bank action, like interventions by the BOJ or an appreciation of the Yuan (which would produce some optimism for the dollar), could mark a turning point. It is, on the other hand, also unlikely that the dollar keeps falling to levels low enough to close the U.S. current account deficit single-handedly by currency revaluations. This is because it remains unlikely that major Asian central banks will withdraw from their dependence on the dollar and shift their reserves towards the Euro now. Central banks, especially Asian central banks, do not think in terms of direct profitability or losses of their dollar investments; they are rather concerned with the success of their policies to stabilize prices, exchange rates, and growth. Asian central banks will therefore likely start to support the dollar more forcefully if the dollar keeps falling, while they will also start to increase the pressure on China to appreciate and on the U.S. to set some clear strong-dollar signals soon.

Some answers to the following questions (click below):

Is it likely that the dollar keeps falling against the yen and other Asian currencies?

When are Asian central banks expected to react?

Central banks in Asia started to talk about reshuffles in their currency reserves against the U.S. dollar. How likely are such steps?

Will the dollar become a major issue at the current ASEAN+3 talks?

Would weaker Japan data have an impact?