In the UK we’ve had quantitative easing for so long now that one of the bonds that the Bank of England started buying in August 2009 is about to mature. When that happens, on 7 March, the Bank says that it will re-invest the £6.6bn in more bonds. Is that monetary loosening? My brain hurts just thinking about it.

That same day in-coming Bank governor Mark Carney invited a debate on its inflation-targeting mandate and a few hours later still (monetary policy history gets made quickly, nowadays) ECB president Mario Draghi was asked whether he was concerned that the strength of the euro posed a threat to Europe’s fragile economic recovery, and dropped a bombshell.

“The exchange rate is not a policy target,” he said, “but it is important for growth and price stability, and we [….] will alter our risk assessment as far as price stability is concerned.”

Now that Japan has joined the global currency war, Europe’s policy looks even tighter than it did before. Since July 2012 the yen has lost more than 25% of its value against the euro.
This is worrying for Europe for two reasons. First, one bright spot over the past five years has been its exporters, which gained a lot of market share from Japan’s – gains under threat now Japan has abandoned its pacifism.

Second, in the past low rates encouraged borrowing and spending in both the euro-zone periphery and Japan. But while the euro-zone periphery ended up with net foreign liabilities of 80% of GDP and moderate inflation, the Japanese balanced their government’s profligacy by saving at home and investing abroad, rather than
bingeing on credit, and now enjoy net foreign assets of 60% of GDP and no inflation. That translates into a lot of ammo in a currency shooting war. Pair that with productivity losses and export market share losses in Europe, and things look stagflationary.

Bond markets recognise this. Since July 2012, breakeven inflation in the US, UK and Germany has risen – but most of that has come from real yields falling rather than nominal yields rising. The exception is at the longer end of the US curve, perhaps reflecting greater confidence in its economy. In the UK, at two years 100% of the move in breakeven inflation has come from real yields falling; at five years it is 84% and at 10 years 51%. On the German curve, at both two and five years the entire move has come from real yields (five-year nominal yields actually fell); and even at 10 years 73% came from real yields. Inflation expectations are up, but where is the appetite to rotate out of ‘risk-free’ assets?   
Equity markets are behind the curve, but they did sell off in response to Draghi’s comments: at last markets are greeting loose talk by central bankers as a sign of bad news, not good. As I argued last month, that re-focusing on fundamentals could result in a re-pricing of risk downwards.