There exists a great single currency zone, consisting of the USA, China and Japan. By decision of the central banks of China and Japan, their currencies have for quite some time been locked to an essentially fixed exchange rate to the US dollar. So we can think of this as the dollar-yen-yuan currency zone. This zone is afflicted with three central banks. The BoJ, the Bank of China and of course our own Federal Reserve. It is also afflicted with three free-spending and deficit-ridden governments which continue to create debt at huge rates.

The Federal reserve has attempted to rein in liquidity by raising short-term interest rates. This has had absolutely zero effect, because the BoJ in particular has been willing (until very recently) to provide unlimited liquidity at zero interest. The Bank of China has also been forced to print yuan to maintain the exchange rate with the dollar (sterilizing the trade surplus by buying up the excess dollar with freshly printed yuan). But in any event, when a Caribbean-resident hedge fund can borrow euroyen at a fraction of a percent and hedge against any movement against the dollar for another fraction of a percent, then Greenspan and now Bernanke are pissing upwind in trying to restrain credit growth and hence economic inflation. They are not in the driver’s seat, Fukui-san is.

Within the last few weeks, Fukui-san has started to rein in his own excesses. He has drained much of the excess free liquidity from the Japanese banks and the result has been a sudden pulling back by the hedgies of their riskier plays as they see the end of the game approaching. He has, however, eased up on the reins after seeing the effect of this gentle tug - after all, he has not raised interest rates one whit yet - by putting back some of the liquidity he took away.

But clearly we can say that “Now this is not the end. It is not even the beginning of the end. but it is, perhaps, the end of the beginning” (Churchill). Fukui-san has made it clear that he intends to restore normal interest rates in Japan and end the ZIRP (Zero Interest Rate Policy).

The Bank of China announced yesterday that it was increasing reserve requirements by half a percent. This is, of course, a move to tighten credit and perhaps pop the Chinese real estate bubble.

The Federal Reserve will lose all inflation-fighting credibility if it fails to raise interest rates again at the June 29th. meeting, given the latest numbers where year-over-year consumer inflation (as distinguished from economic inflation, which might better be described as debasement) is now up to 4.2% even given the highly understated measurmenets used.

Anyway, it is clear that all three central banks in the zone are in tightening mode. This is disinflationary. The tightening will inevitably slow the US economy. The consequences of this slowing are unpredictable, given how over-extended the US consumer is interms of indebtedness. Deflation (and depression) will only result if the housing bubble in the US bursts so catastrophically that it cripples the US credit system - like the Texas S&L fiasco, only on a much larger scale. This is by no means an unlikely outcome, but there is no sign of it yet.

In any event, asset prices are bound to come under pressure in coming months as credit dries up.