Japanese and U.S. Government Bond Yields

August 17, 2010

Japan provides a good example of what happens to long-term interest rates when very low inflation or outright deflation occur. The ten-year JGB yield has averaged 1.45% since the end of 1997.  Such dropped below unity recently and is presently at 0.95%.  The yield first plumbed below 1.0% in 1998 during the Asian debt crisis, touching a low of 0.67% that year.  The yield spiked to 2.36% in early 1999 amid concerns about government deficit financing when regional growth began to improve, but the yield fell to as low as 1.23% later in 1999 as it became apparent that Japan’s price bias was deflation, not inflation.  In no year since 1998 has the yield not been as low or lower than 1.54%.  Sub-1.0% levels were hit again in 2002 of 0.91% and 2003 of 0.44%.  2.0% has been an effective ceiling since 2Q99.  The yield surpassed 1.85% briefly in 2000, 2004, 2006, 2007, and 2008, but those advances always failed to extend above 2.0%.  Over the past 12.5 years since end-1997, Japanese real GDP advanced on balance by only 7.7% or 0.6% per annum.  Nominal GDP, which also embodies deflationary price trends, was 7.8% lower in the second quarter of 2010 than such had been in the final quarter of 1997.

The United States doesn’t have deflation, but the margin of safety from a state of falling prices has been squeezed.  Total consumer price inflation dropped from 2.7% at the end of 2009 to 1.2% in July, and core non-energy, non-food inflation slipped under 1% to 0.9% from 1.6% last December, 2.0% in November 2008, and 2.9% in September 2006.  Consumer price behavior since the end of 1949 suggests that America’s long-term natural rate of inflation is 2.4%.  From the end of 1949 to the end of 1965 sixteen years later, the CPI index climbed at an annualized rate of 1.9%.  From the end of 1985 to the end of 1999 fourteen years later, the CPI rose 3.1% per annum, and over the 10 years and seven months of this century, the pace has been 2.4%.  2.4% is also the trend rate over these three chunks of time totaling 40.6 years.  I dismiss the 20 years from end-1965 to end-1985 as an aberration.  The CPI rose 6.4% per annum through those two statement decades and reached peak on-year changes of 14.8% on all items and 13.6% on the core index during the first half of 1980.  That trauma was was sufficiently severe to flip America from unemployment-phobic to inflation-phobic.  Since inflation is still trending downward a whole generation after that economic accident ended, it makes sense to exclude the high-inflation decades from calculations of the U.S. long-term inflation rate.

Long-term Treasury yields at their extremes have been very poor predictors of long-term inflation.  The 20-year yield in October 1981 got as high as 15.18%, a sensational return considering that consumer price inflation averaged only 3.3% per annum during the ensuing twenty years.  Current yields of 3.75% on the 30-year bond and 2.63% on the 10-year maturity likewise suggest a prolonged deflation, and the 0.50% two-year yield implies a second recession that just might be bad enough to produce such a scenario.  Or will it?

Other factors suggest a different and less extreme U.S. price path is more likely.  Producer prices rose 4.2% in the most recent 12-months to July, with a comfortable core rate of 1.5%.  In Japan, all price trends were sucked into the red by the deflation.  Currency trends matter, too.  The yen soared from a bit more than 260 per dollar in February 1985 to 120/USD by end-1987 and an all-time high of 80/USD briefly in the spring of 1995.  It’s a safe bet that the dollar will do nothing resembling the yen’s very big appreciation.  Finally, Japan went down the path of deflation in part because the ingrained central bank culture at the Bank of Japan considers a zero rate of inflation less worrisome than a 2% rate of  inflation.  Fed officials firmly believe otherwise.

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

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