Interest-rate impact

How will higher short-term interest rates in Japan impact expected inflation? Japan has had an inflation-linked bond market since April 2004. While this history is nowhere near as long as we would like it to be, we can make three intriguing observations by mapping 10- year expected inflation against overnight call money.

First, while the expected inflation rate more than doubled between August 2005 and May 2006, it fell sharply in November 2005 (green arrow) when BOJ Governor Fukui warned of an impending credit tightening. Second, expected inflation peaked in May 2006 (magenta arrow) just before the BOJ raised rates. Third, inflation expectations hit a local bottom in early March 2007 (blue arrow) and then rebounded sharply as the BOJ injected liquidity into the banking system. The BOJ’s current account balance jumped from ¥5.88 trillion on March 7, 2007 to ¥12.51 on April 3, 2007. Those inflation expectations then fell sharply as the global credit crunch developed in July 2007.

It would appear from this limited history that higher short-term interest rates lower inflation expectations unless offset by an increase in the monetary base. This provides the BOJ with a tool for ending its years of low interest rates and quantitative easing. If Japan was an economic as well as geographic island, it could maintain higher levels of expected inflation by keeping excess money in its account while raising nominal interest rates to levels that would maintain the global yen carry trade without repeating the disruptions of May 2006 and March 2007. However, Japan’s large external sector and its exposure to those who have borrowed massive quantities of yen over the years subjects its domestic inflation policies to global cross-currents.