The Dark Side of Japan's Creating Inflation

As the world falls in love with Prime Minister Shinzo Abe's plans for Japan, it's forgetting the ultimate arbiters of his success: the bond vigilantes holding sway over borrowing costs.

What Abenomics bulls haven't yet explained away is what happens if Japan's prime minister gets his way. Imagine, for a moment, that the Bank of Japan succeeds in pushing gains on consumer price to 2 percent or 3 percent. The resulting rise in 10-year bond yields would shake Japan Inc. to its core.

Just ask Takahiro Mitani, president of Japan's public pension fund, which has $1.16 trillion in assets. On Feb. 1, he told Bloomberg News he's consideringthe first changes to the fund's asset structure in seven years as Abe's new government pursues policies that could erode the value of $747 billion in local bonds.

Ending Japan's decade-long bout with deflation is a righteous goal, and one that has eluded governments since the early 2000s. But the view that the process will unfold smoothly needs revision. Nothing would destabilize the world's third-biggest economy more than a surge in debt yields. In Japan's risk-adverse financial system, bonds are the main financial asset held by banks, pension funds, insurance companies and households. If rates suddenly jumped higher, an entire economy -- make that a whole nation -- gets hurt.

That's why the Ministry of Finance and Bank of Japan are so obsessed with maintaining calm in bond land. Until now, Japan has benefited from a uniquely compliant audience of buyers, a product of a market in which more than 90 percent of IOUs are held domestically. But what about the bond vigilantes, who often take matters into their own hands?

Abenomics could change that tranquility in very short order and drastically boost Tokyo's 0.77 percent 10-year borrowing costs in dangerous ways.

It's great that Abe is serious about ending deflation. Just don't expect the process to unfold gently.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.