A Fascinating, But Unintended, Consequence

In a recent blog, about Japan's new Prime Minister, Shinzo Abe, and his push since coming to office in December 2012 to reinvigorate the Japanese economy,  this writer cited the pernicious effect of Japanese citizens' deflationary expectations over the past 20 years. One word - stagnation - summarizes that experience. (The average annual growth in real Japanese GDP in the period 2005-10 was 0.3%.)

The Bank of Japan, under its new Governor, Haruhiko Kuroda, was given one overall mandate from Mr. Abe - to adopt an inflation target of 2%, to be reached in two years, to rid the country of deflation - essential if domestic demand is to revive. The Bank has, accordingly, massively expanded its purchases of long-term government bonds and other assets through its program of quantitative easing, with the goal of depressing their yield, thus spurring banks to lend, and companies to borrow and invest in the real economy, or abroad, where yields are higher. Though quite suddenly much bigger in scope, this mirrors Federal Reserve policy.

But here's the rub. Success in raising inflation expectations can lead - and did dramatically yesterday in Japan - to investors, uncertain as to how far such success may go, demanding a higher risk premium for holding government bonds. This is why Japanese 10-year government bond yields spiked yesterday - despite quantitative easing -  from near-zero, to above 1% at one point. Investors were suddenly, for the first time in many years, wondering, perhaps even concerned, about a re-emergence of inflation over the next ten years. Such worry carried over to the equity markets, with the Nikkei 225 plunging some 7.5% in one day after a nearly straight-up trajectory since December last year.

So, Japan's monetary policy experiment is producing some early surprises, and lots of volatility. Governor Kuroda's staff may have already engineered just a little more success than they counted on; mitigating volatility will be one of their daily tasks.