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Listening to Japanese economic policy experts might lead one to the conclusion that the apt parallel to current Japanese economic policy is Japan in 1995. They draw this conclusion based on the weakening of the yen that took place between 1995 and 1998, and the fact that current policy is focused on a similar weakening of the currency, not simply lower interest rates. To me, the more interesting parallel is to the United States in 1979.

To be precise, in 1979 the U.S. economy was facing significant inflationary pressure partly caused by a politicized central bank throughout the 1970s. Modern Japan faces an eerily opposite problem -- they have deflation and a central bank that has avoided political pressure at all costs. This avoidance of political pressure by Japanese central bankers is largely a reaction to years of undue political pressure causing unsustainable monetary policy. Regardless of the reason, the relationship between politics and modern Japanese monetary policy creates a mirror image of what the U.S. faced in 1979.

As many readers may recall, in 1979, William Miller was appointed Treasury Secretary, thereby allowing him to gracefully bow out from his brief and unsuccessful tenure as Federal Reserve Chairman. In his place, Paul Volcker was appointed Chairman of the Fed. The result was a central bank that bucked political pressure to increase the cost of borrowing and decrease the money supply in order to drive down inflationary pressure. This caused a painful recession that calmed inflation and laid the groundwork for economic growth.

At present, Japan is undergoing the precise opposite problem. A deflationary spiral has weakened economic growth and created political upheaval. Shinzo Abe was just elected to be Prime Minister on a platform of overt pressure on the Bank of Japan to increase stimulus and raise inflation targets. So far, this pressure seems to be working. The BOJ has already increased stimulus and promised additional stimulus of 50 trillion yen over the next year. Economic advisers to Abe have also gone on the public record stating that the BOJ should pursue an even more aggressive strategy of unlimited bond buying and a higher inflation target in the 2-3% range, rather than the existing 1% target. In other words, politics is pressuring the BOJ to completely change course in order to avert further financial ruin based on existing policies.

In 1979, the U.S. needed the Fed to buck politics and inflict economic pain to correct a disastrous course. Modern Japan needs the BOJ to understand political pressures and open the floodgates to prosperity in order to correct their current disastrous course. This may sound like kowtowing to political interests, and to some extent it is, but like the Fed in the late 1970s and early 1980s, this redirection by the BOJ represents a paradigm shift away from years of policy inertia. Like the Volcker Fed, this means that the BOJ will need a great deal of will and leadership to pursue its redirection. However, unlike the Volcker Fed, Japanese political support will provide cover for the BOJ and help them slowly shift toward acceptance of higher inflation.

Investors should watch for the BOJ to continue significant monetary easing through 2013, and raise their inflation target in an effort to devalue the yen and make Japanese-made products competitive on the global market. With full political support, these policies are likely to be successful in the short-term (one to three years), but the longer-term, structural problems with the Japanese economy are likely to rear their head again soon. Since Japan is an aging post-industrial society, inflationary pressure to diminish their debt load and maintain their export status might sound appealing, but it is unsustainable in the long term and the BOJ is likely to face an even more complicated stimulus exit strategy than the Fed. So, investors should look for solid growth opportunities in 2013 in Japan as the yen depreciates, but great care should be taken when looking for longer-term investments in an economy facing myriad economic challenges.

Source: BOJ Faces Inverse Volcker Revolution