China's reserves rose at a record pace in the second quarter topping $2 trln. The rise in China's forex reserves may increase the risk of inflation. China added $178 bln in reserves during the second quarter. The rise in reserves suggests that hot money (speculative capital) is pouring into China as investors anticipate an economic rebound. The increase in reserves comes as China's economy is recovering, the money supply is rising and bank lending rose at a record pace in June. China's June M2 money supply growth rose 28.5%. The price of China's real estate and equities has risen sharply over the past few months. The rise in lending, money supply, equities and asset prices generate concern about the risk of inflation in China. In response to this risk, the Central Bank of China implemented a modest tightening of monetary policy Wednesday stating that the accommodative phase of monetary policy is over.

The Bank of Japan (BOJ) concluded a two-day monetary policy meeting Wednesday and elected to hold rate policy unchanged at 0.1%. The BOJ also reduced the expansion of its quantitative ease at today's policy meeting to three months from six months. The BOJ introduced an expansion of quantitative ease earlier in the year. The BOJ elected to increase purchases of corporate bonds and commercial paper to boost liquidity to combat the impact global financial crisis on Japans economy. The addition of liquidity by the BOJ is starting to have impact. The BOJ says that Japan's economy has stopped worsening. By reducing the timeframe for expansion of quantitative ease the BOJ appears concerned about the long term impact of expanding liquidity. The reduction in the time frame for the Bank of Japan's expansion of quantitative ease is a sign that the Bank of Japan is preparing for an eventual exit strategy from accommodative monetary policy. The BOJ forecasts a -1.3% core inflation rate for fiscal 2009. Infation is not a risk in Japan but as the Japanese and global economy recover, the BOJ will need to take back stimulus and exit quantitative ease. This is a modest positive for JPY.

Today's report of record rise in China's reserves and the actions taken by the Central Bank of China and Bank of Japan may have significant impact on global equity, commodity markets and the USD. The increase in China's reserves may be used to buy commodities. The reserves may also be diversified into non-USD denominated assets. This could fuel higher commodity prices and a weaker USD. The BOJ's decision to reduce the timeframe for quantitative ease is a signal that the Bank of Japan sees the global recession nearing an end. If this is the case, equity markets and commodity markets may continue their current rally supported by improving risk sentiment and optimism about the global economy. The commodity currencies may experience increased demand. The actions taken by the Bank of China and Bank of Japan suggest the risk of global deflation has been reduced by prior central bank actions to boost liquidity and governments to increase fiscal spending. Central bank officials in China and Japan are concerned about the impact of the stimulus plans. The central Bank of China's next policy move will be to tighten policy and the BOJ is setting the stage for to exit quantitative ease.