Bond Market Hysteria: A Japanese Case Study

February 4, 2010

Global financial moments are in the grip of an “enough already” psychology.  Risk aversion has spiked because of fear that fiscal deficits have gone beyond the point of safe return and that much higher inflation is inevitable.  European peripheral nations like Greece, Spain and Ireland have been the main object of the panic, but concern also runs very deep about prospects in the United States, Britain and Japan.

The deficit spending has a huge cyclical component.  Tax revenues plunged in the Great Recession, and public spending rose to fill the vacuum of imploding private demand.  Considering how much GDP fell, it can in fact be argued that governments were  restrained in their response.  U.S. government expenditures, for example, rose just 1.6% between 4Q08 and 4Q09 and made no contribution to incremental economic growth last quarter.

Japan’s lost decade was caused by bursting asset bubbles and therefore has much to teach about the inflationary potential of the global policy response to the Great Recession, which also was triggered by a pile-up of unprofitable bank assets and generally dysfunctional financial markets.  During the 1990’s Japan’s government introduced several big fiscal stimulus packages, and the deficit ballooned as a share of GDP.  Expansionary fiscal policy was complemented by central bank rate reductions.  By September 1995, the overnight money rate target had fallen to just 0.5% and has not been higher than that level since then.  Ten-year Japanese government bond (JGB) yields, which hit peak levels of 8.72% in 1990, 7.13% in 1991, and 5.71% in 1992, plumbed as low as 1.58% in 1997 and got no higher than 2.69% that year. 

Finance Ministry officials had meanwhile become increasingly restive over the soaring budget deficits.  A horrible policy mistake was made in April 1997, when value-added taxes were bumped up to 5% from 3%.  Japan’s economy was still laboring under the burden of very weak balance sheets, and the fiscal measures taken to rein in the deficit produced the opposite result by sending the economy back into full-fledged recession with help from the Asian crisis.  By mid-September 1998, the ten-year JGB yield fell to 0.67%.

Investors had still not shaken their deficit worries, however.  With a whiff of recovery in the air as the economy recorded positive GDP growth in both the third and fourth quarters of 1998, the 10-year JGB yield advanced rapidly to 1.93% by the start of 1999 and kept on climbing to 2.44% on February 3rd, a 3.6-fold jump in the space of 20 weeks and the highest level since June 1997.  Investors were smelling inflation, but it was in their imagination, not the air around them.  On-year CPI inflation in fact dipped below zero in February 1999.

Japan never did reap inflation even though public deficits remained huge and debt climbed past 100% of GDP and is now nearing 200% of GDP.  Government demand substituted for vastly reduced private sector demand, and economic slack in the economy kept building.  In the ten years to 1998, real GDP had expanded 2.0% per annum, and consumer price inflation averaged 1.5%.  These trends hardly validated the inflation phobia that flared in late 1998, but investors were thinking of the coming ten years, not the period in their rearview mirror.  Well, the ten years to 2008 saw real growth slow to 1.2% per annum and a net deflation of 0.1% per annum.  Then the roof collapsed last year in Japan and elsewhere.  Consumer prices for the whole year fell 1.4% following an increase of 1.4% in 2008, and they dropped by 1.7% on a December-over-December basis.  Real GDP is likely to record a full-year drop of 5.3%, stretching Japan’s output gap considerably further.

Elevated bond yields ultimately have to be validated by fundamentals that justify the fears.  The hysteria lifted in Japan’s market almost as quickly as it struck, and the ten-year yield dropped more than a percentage point in 1999 from 2.44% on February 3 to 1.23% by May 17.  The annual highs were 1.97% in 2000, 1.63% in 2001, and 1.56% in 2002, and a new record low of 0.44% was set on June 12, 2003.  Over ensuing years, the long-term rate has fluctuated between 1.00% and 2.00%, with lows of 1.20% in 2004, 1.18% in 2005, 1.42% in 2006, 1.41% in 2007, 1.17% in 2008 and 1.20% last year.  The 10-yield is presently at 1.38%.

The U.S. and world economies face different long-term and short-term risks.  The short-term outlook is dominated by a jobs deficit.  U.S. jobless insurance claims averaged 468.75K over the four weeks to January 30, 12.5K more than during the prior four weeks and no different from the four weeks to December 5.  Employment has contracted 7.2 million since end-2007 and lies more than 13 million below where such would be if it had risen at the average pace of 1950-99.  It’s hard to see how inflation will be anything but subdued in the face of that kind of headwind.  On the other hand, runaway deficit spending and attacks on central bank independence constitute a textbook recipe for inflation some time down the road.  Investors have to ask themselves ,”but at what distance from here?”  One doesn’t get to the long run without going through a lot of short runs. I suspect that the disciplining force of market fears and conservative political forces pushing to cut budget deficits now, not tomorrow, will confine America and other economies to stay in a purgatory of short runs in which higher inflation remains a possibility but not the reality. 

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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