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Former BOJ Policy Maker Sees Japan Inflation Dilemma

Consumer Prices
Consumer prices excluding fresh food have been at a five-year high of 1.3 percent since December. Photographer: Tomohiro Ohsumi/Bloomberg

The Bank of Japan faces a “terrifying dilemma” of inflation forcing it to tighten monetary policy just as the central bank most needs to support the bond market, according to a former board member.

There’s about a 50-50 percent chance the BOJ will achieve its 2 percent goal for consumer-price increases, which could push the 10-year yield above 3 percent, said Kazuo Ueda, who served as a BOJ policy maker from 1998 to 2005, and was also senior adviser to the Government Pension Investment Fund. Bond market expectations for inflation have risen to 1.36 percent from 0.94 percent in October, data compiled by Bloomberg show.

“If the 2 percent inflation goal becomes imminent, the BOJ should be tightening policy rather than loosening,” Ueda, now a professor of economics at the University of Tokyo, said in a May 8 interview. “That means that we will face a terrifying dilemma that the central bank won’t be able to increase JGB buying to support the bond market.”

The BOJ’s unprecedented stimulus program, under which it buys about 7 trillion yen ($68.5 billion) of sovereign bonds a month, helps keep borrowing costs for the world’s heaviest debt ratio at the lowest globally. Governor Haruhiko Kuroda indicated on April 23 the central bank won’t buy bonds just to keep down debt-servicing costs after achieving its inflation goal.

Six of the 28 economists surveyed by Bloomberg from May 2 to May 8 said the BOJ will start tapering in 2016.

Potential Loss

Investors who bought the 10-year bonds yesterday, with yields at 0.61 percent would lose 8 percent if the benchmark rate were to rise to 3 percent by the end of fiscal 2015, when the BOJ projects the inflation target will be met, according to data compiled by Bloomberg. The 10-year yield reached 0.57 percent on March 3, the lowest in a year.

“Current nominal yields show the inflation expectation in the bond market is dead,” said Ueda, whose role as the head of the investment committee for the world’s largest pension fund ended last month. “What’s scary about this is that once it becomes clear to everyone that prices will start rising, there’s a risk that bonds will be heavily sold off.”

The 10-year breakeven rate, derived from the difference between yields on conventional and index-linked bonds, rose to 1.37 percentage point on April 30, the highest close since the government resumed selling of 10-year linkers in October. Consumer prices excluding fresh food have been at a five-year high of 1.3 percent since December.

No Distress

There is little sign of distress in the market. Credit-default swaps that insure Japan’s sovereign debt against default for five years fell to 42.5 basis points yesterday, the lowest since Jan. 6, according to data provider CMA. The contracts decline as perceptions of creditworthiness improve.

The yen traded at 102.19 against the dollar as of 10:14 a.m. in Tokyo, a 3 percent gain this year.

Sixty-day price volatility for JGBs was at 1.1 percent yesterday, the lowest since January 2013, according to data compiled by Bloomberg. It surged to 4.65 percent in September 2003, when 10-year yields jumped to 1.68 percent from about 0.4 percent. That violated banks’ internal restrictions based on the so-called value-at-risk model for estimating potential JGB losses, triggering a further selloff. The rout was dubbed the “VaR shock” by traders.

BOJ Concern

“Market participants are doubtful the BOJ’s stimulus program will succeed,” said Ayako Sera, a Tokyo-based market strategist at Sumitomo Mitsui Trust Bank Ltd. “What’s different now from the VaR shock is that the BOJ is a powerful JGB buyer.”

Central bank officials are increasingly concerned the nation’s debt market is failing to reflect emerging inflation, according to people familiar with the matter. The risk of abrupt moves in bond prices will increase if 10-year yields stay near 0.6 percent regardless of improvement in the economy and faster gains in consumer prices, said the people, who asked not to be named because the discussions were private.

“I’m relatively bullish on the domestic economy, and expect consumer prices to gradually rise, albeit at a slower pace than the BOJ’s projection,” said Shuichi Ohsaki, a rates strategist in Tokyo at Bank of America Merrill Lynch. “The low volatility environment reminds us of the calm before the storm we saw ahead of the VaR shock. It’s possible some risk event could trigger a smaller-scale surge in yields.”

The government’s obligations will grow to 242 percent of national gross domestic product this year, compared with 107 percent in the U.S, according to International Monetary Fund estimates.

“The government’s finances will not be sustainable if we see benchmark yields stuck at 4-5 percent because the interest payment for its debt will balloon faster than the increase in tax income,” said Ueda, who has called for the GPIF to adopt a short-term strategy to deal with the risk of a bond rout. “The BOJ may have to overlook the sudden surge in yields and some damage because there’s no point in trying to repress it forcefully.”

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