A slowing outlook for inflation in Japan

Japan's macroeconomic situation is a global outlier, confounding the traditional monetary-policy playbook: even as inflation eases, the nation's central bank has signaled that it would increase interest rates again if necessary.

The market is suggesting that Japan is likely to see a decline in near-term inflation. The narrowing spread between the two-year Japanese government bonds (JGBs) and the one-year JGB from a high of about 0.2 percentage points in July to as low as 0.1 percentage points in early August, just after the Bank of Japan shocked global markets with its rate hike. Since then, the spread has crept back up to about 0.15 percentage point, though JGB yields have also posted an overall downward shift this month (as our second chart shows).

A more dovish inflation outlook tends to narrow these spreads, as do prospects for a weaker economy: Japan has posted two consecutive quarters of negative GDP growth. (The economy shrank 0.9% and 0.8% y/y in Q1 and Q2 of this year, respectively.)

Of course, the Bank of Japan's hawkish signals should be viewed in terms of a more normalized Japanese economy more broadly after decades of stagnation, deflation and extraordinary monetary policy. Years of negative interest rates were only recently abandoned, along with large-scale bond purchases. A yield curve control (YCC) policy from 2016 saw the BOJ target 0% for 10-year JGB yields; that range was later widened and recently abandoned.

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