The Japanese government says that the BOJ is "asleep at the wheel" on deflation. Last week the BOJ elected to maintain steady monetary policy, keep interest rates near zero and upgraded its economic assessment. According to the BOJ statement, Japan's economy is picking up and the BOJ expects improvement in the economy to be moderate until the middle of fiscal 2010. The BOJ expects the rate of Japan's growth to gradually rise in 2011. The BOJ also signaled that it is nearing the end of its ultra-easy monetary policy and beginning to withdraw its support for the corporate bond market. The Japanese government does not agree with the BOJ's upgrade of Japan's economic outlook or the start of its exit strategy. After the BOJ policy meeting Friday the Japanese government issued a report declaring that the economy is back in deflation for the first time since 2006. The government declaration that the Japanese economy is back in deflation was directed at the BOJ to encourage the BOJ to continue to support the domestic economy and help fight deflationary pressures.

In August, the Democratic Party took control of the Japanese government for the first time in 50 years and pledged to enact measures to boost the domestic economy and make Japan's economy less dependent on exports. The new government will need to issue a substantial amount of bonds to fund the cost of spending to boost the domestic economy. Japan's public debt burden is estimated at 170% of GDP. The size of the Japanese debt burden will make it difficult for Japan to significantly increase spending. The Japanese government is pressuring the BOJ to do its part to fight deflation and boost growth because of the restraints on government borrowing. The BOJ has responded aggressively to the global financial crisis and recession in Japan buying corporate and commercial paper to boost liquidity. Japan's Q3 GDP rose the most in two years signaling that the Japanese economy has emerged from recession.

As the Japanese economy has emerged from recession the BOJ signaled it will begin an exit from its extraordinary monetary policy measures and begin to wind down its purchase of corporate bonds. Japanese government officials are concerned that the BOJ's exit plans could jeopardize the Japanese recovery. The government has been pressuring the BOJ to maintain accommodative measures to boost growth. In some of the strongest language to date, Japan's Cabinet Minister Kamei said that he thinks the BOJ is asleep at the wheel on deflation. Japan's Finance Minister Fuji said that the economy cannot be supported with fiscal policy alone. The FSA said that the Japanese government is considering an additional ¥11trln of new stimulus. The increase in stimulus generates concern about increased JGB bond issuance and contributes to rising bond yields. The rise in bond yields is an additional threat to the Japanese recovery.

Part of the BOJ's justification for beginning its exit from ultra-accommodative monetary policy is concern that the government spending plans contribute to rising long-term yields. The BOJ wants to combat the rise in long term bond yields and act as a counter balance to increased government spending by limiting its contribution to increased liquidity. At last weeks policy meeting the BOJ pledged to maintain interest rates near zero and said with demand weak there is little the BOJ can do to boost prices. The BOJ expects prices to continue to fall the next three years. The Japanese government would like the BOJ to increase bond purchases and drive long term yields down. The minutes for the November BOJ policy meeting will be released on Wednesday. The trade will be looking at the BOJ minutes for clues to BOJ policy outlook and a time frame for BOJ's exit strategy.

The row between the Japanese government and BOJ is likely to intensify after the release of Japan's CPI report Friday. On Friday, November 27th Japans October CPI will be released expected to post an annual decline of 2.5%.The CPI report is expected to confirm the government's conclusion that Japan is back in deflation. Friday's CPI report may make it more difficult for the BOJ to assert its independence and resist pressure from the government to boost growth. The implication of the dispute between the Japanese government and the BOJ for the JPY over monetary policy is not clear. Rising JGB yields and improving risk sentiment are competing for the price direction in the JPY. The October CPI report may encourage the BOJ to delay further withdrawal of stimulus and this could be a modest positive for the JPY.

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