Behold the Not-So-Mighty Yen. Photographer: Akio Kon/Bloomberg
Behold the Not-So-Mighty Yen. Photographer: Akio Kon/Bloomberg

What a year for Japan: Its currency lost 18 percent of its value against the U.S. dollar, the Nikkei index rose 57 percent, and inflation returned for the first time in five years.

If Japan wants 2014 to go as well as 2013, it needs to do just one thing: Keep the presses going. That’s because Japan is easing monetary policy to break deflation and reboot real economic growth. It’s won neither battle yet, even if it’s made great progress. Markets think that more easing would still do more good.

Much of recent rise in inflation -- now running at 1 percent per year -- is due to a one-off jump in energy prices. Core inflation hasn't yet returned. That’s important because the prices counted in that “core” are changed rarely, so economists have long thought they reflect businesses’ expectations of future inflation. Growth in nominal wages isn’t back yet, either -- something Japan will need to see before any return of inflation can be deemed sustainable.

Yet the critical reason Japan should do more is that investors have signaled that its monetary easing hasn't reached the point of diminishing returns for real growth. We can see that by doing a simple analysis of the relationship between changes in the yen-to-dollar exchange rate and changes in the value of the Nikkei index.1 If currency depreciation is buying smaller gains in Japanese equities, that would be a compelling sign that the Bank of Japan has done enough.

The data show, however, this point of diminishing returns hasn't yet appeared. The market is convinced that another 10-percent depreciation of the yen would buy another 15-percent increase in the Nikkei -- just as the market thought when Abenomics launched.

When stocks are so driven by inflation expectations, it indicates that monetary policy remains too tight, as David Glasner, an economist at the Federal Trade Commission, has shown. That’s true of Japan: Weekly changes in the yen-to-dollar exchange rate explain half of the weekly changes in the Nikkei.

Now, the Nikkei is not a perfect indicator of the Japanese economy as a whole. Like most stock markets, it’s biased toward large corporations. Publicly traded Japanese corporations, given their bent toward exports, may benefit more from further easing than would the Japanese economy as a whole. But we’re short for alternatives to size up the marginal effect of easing without it.

The best solution to that problem would be for the Bank of Japan to adopt a target for nominal gross domestic product and create a futures prediction market so that it can apply the wisdom of the market in policy making. Yet that isn't what Japan’s central bankers apparently have in mind. As they run out of bonds to buy, reports have indicated, they want to peg interest rates on long-term government borrowing.

That’s a bad idea. The Bank of Japan has just unanchored its economy’s expectations of slight deflation. It needs to re-anchor those expectations now where it wants them, not cut away the anchor line by surrendering the independence of monetary policy.

(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)

1 Specifically, I’m comparing the weekly percentage change, from Friday close to Friday close. As always, I’ve made my data and computations available for download here.