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Japan Faces Its Moment of Truth on Inflation

Japan Faces Its Moment of Truth on Inflation #Japan #Faces #Moment #Truth #Inflation Welcome to Lopoid

The Bank of Japan is fighting an increasingly lonely battle. So far it has beat back speculators testing its resolve to keep interest rates low. But the market is betting that a plunging yen and rising inflation will eventually force its capitulation.

Bets that the

Japanese central bank

would follow its peers and raise rates this year have fallen flat despite the increasingly strong inflationary winds blowing. Futures on 10-year Japanese government bonds fell 1.4% last week but bounced back this week after the Bank of Japan bought a record 9.24 trillion yen of government bonds last week, according to CEIC. The central bank reiterated its so-called yield curve control policy to cap 10-year bond yields at 0.25% at last week’s policy meeting.

In theory, there is nothing to stop the Bank of Japan from buying unlimited amounts of government bonds to maintain its target. The central bank owns $3.8 trillion of government bonds, equivalent to nearly half of the total outstanding. It owns more than 80% of some newer issuances.

But the bank could be tripped up by the side effects of its loose monetary stance when many others are tightening, especially when an election is coming up next month. The Japanese yen has depreciated 15% against the dollar this year as interest rate differentials drive capital out of the country. That worsens the jump in prices of energy and food, which are mostly imported. The Bank of Japan added a line in last week’s statement that it would pay attention to the financial and foreign markets and their impact on the country’s economic activity and prices.

Japan’s inflation hit 2.5% in April, still low by global standards. But that is the highest since 1997 for Japan, excluding 2014 and 2015 when data was skewed by the increase in consumption tax. For a country long mired in deflation, this should be good news. But unfortunately, most of the rise was driven by imported energy prices.

Excluding energy and fresh foods, inflation in April also went back to positive territory at 0.8%. The dilemma for the Bank of Japan is that it will be loath to risk pushing the country back into deflation fighting price surges caused largely by external factors. A more sustainable rise in domestic prices and, more important, wages could eventually nudge the bank to raise rates less grudgingly. But a continuing weaker yen, which pushes the cost of living higher, may force it to make the switch earlier.

And an exit from yield curve control could be chaotic. The market will move pre-emptively when it senses that the central bank’s commitment is fading. Take Australia as an example. The central bank there formally announced that it had given up the policy last year only after the market had already pushed government bond yields way above its target. The Reserve Bank of Australia’s Gov.

Philip Lowe

said this week that the way the target ended last year was disorderly and caused some reputational damage to the bank.

The battle between the market and central bank isn’t over in Japan yet.

Write to Jacky Wong at jacky.wong@wsj.com

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