Chart of the Week: Japanese inflation endgame in sight?

Long-dated Japanese government bond yields recently climbed to their highest level in more than 20 years, raising questions about the sustainability of the country’s public finances. Bond yields have risen in many advanced economies in recent months, amid concern about US fiscal sustainability. For years now, Japan has been in a relatively unique position of having very high levels of government debt (higher than any G7 country as a share of GDP since the second world war), and lower-than-average bond yields and inflation. Could that be set to change? Headline inflation in Japan has been above the Bank of Japan’s 2% target for three years, while core inflation is currently above 3%. After years of negative interest rates, this uptick in inflation has prompted the Bank of Japan to raise interest rates three times over the past year or so, with some analysts expecting another rise later this year. Rate increases may help the country boost its productivity, with higher borrowing costs potentially shaking out the country’s least efficient firms, or ‘zombies’, but it also adds pressure on government finances, as it means the government (and taxpayer) need to pay more interest on their large stock of debt. For now, this may be under control, as nominal growth rates (which will drive tax receipts) are higher than nominal borrowing costs. But further increases in long-term interest rates, if coupled with slowing economic growth or inflation, have the potential to change this dynamic. Could the Bank try and curb the long-end of the curve through more QE, while raising rates at the short-end of the curve? What effect would that have on investor confidence, or inflation? However this plays out, Japan’s great fiscal experiment looks set to get a lot more interesting in the coming months and years. Watch this space.

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The views expressed in this article are the views of the author, not necessarily those of LSEG.

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