Rising inflation in Japan can shake bond markets

Tokyo

The world economic and financial scene appears too good to be true. Growth has strengthened. Inflation is subdued. Financial markets demonstrate rich valuations and low volatility. Extraordinary monetary easing and expansionary fiscal policy have eased balance sheet pressures stemming from the 2008 financial crisis. Yet abnormally high liquidity has built up in financial markets, together with a debt overhang from excessive borrowing by governments in many advanced countries and corporates in emerging economies.

Some adjustment to these decade-long excesses is inevitable, potentially setting off a market shock. One possible trigger largely dismissed by financial markets is a resurgence in inflation, particularly in Japan. The annual rise in Japanese consumer prices is running below one per cent, despite the low unemployment rate of 2.8 per cent. Japanese inflation expectations are anchored around zero, against 2 per cent in the US and one per cent in the euro area. However, as early as autumn/winter 2018, Japanese inflation could reach the long-targeted level of 2 per cent, reflecting the tightest labour market in 50 years, higher commodity prices, and a probable late-2018 surge in consumer spending. Because it has long been considered a most remote possibility, news that 2 per cent inflation is imminent can shake government bond markets - not just in Japan but also in the US and Europe.