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The BoJ disappointed investors by failing to offer further stimulus. The yen soared in value. No surprise there. And Japanese stocks fell sharply–no surprise there. European and American stock futures also fell on the news. That would be a surprise if you believed the phony hype about “currency wars.” In fact, macro is not a zero sum game, as I keep emphasizing. What’s good for Japan is good for the world. What’s good for Germany is good for the world. What’s good for China is good for the world. What’s good for the US is good for the world. Indeed what’s good for Zimbabwe is good for the world.

So what should the BoJ do? Is 2% inflation the right number? (Put aside the fact that they should be targeting NGDP, not inflation. Let’s say they insist on inflation.)

For the moment, Japan could restore full employment with 1% inflation, perhaps even zero percent (using the GDP deflator.) That’s because wages are very well behaved.

On the other hand Japan needs an inflation rate that is high enough to keep them away from the zero bound. Yes, if they had NGDPLT then the zero bound would not be a problem. But if they inflation target it is a big problem. So maybe the inflation target should be even higher than 2%.

There is also this ominous warning:

To encourage more investment, the government plans to draw up plans for tax reform by the autumn, when it is due to decide whether the recovery is strong enough to endure the blow to demand from sales tax hikes due in 2014 and 2015.

The tax increases are needed to cope with a growing public debt that already is more than twice the size of Japan’s economy.

While Abe’s “Abenomics” economic policies have helped boost share prices and raised hopes for a sustained recovery, the central bank remains far from its target of achieving 2 percent inflation within the next two years.

I can tell them right now—the recovery is not “strong enough to endure the blow,” and indeed a 5% hike the sales tax would likely cause a recession, unless Japanese inflation rises more rapidly than most people expect. The new BoJ policy has clearly helped, but Japan is far from being out of the woods.

Japanese stocks have fallen as the yen has recently risen from 103 to 96 to the dollar. That’s still better than the exchange rate of 80 last year, but 96 is not going to get the job done. Try 120.

Source: Should Japan Aim For 2% Inflation?