It is one thing to set an inflation target, but quite another to reach it.
Japan’s high government debt burden, poor demographics, and the prospect of a VAT tax hike next year all suggest that the exit from deflation will not be straightforward. At the very least, with Japanese stocks now trading at 17-times consensus 2013 earnings (a 20% premium to the global average), the bullish case for Japan has shifted from a “trust me” story to a “show me” story. Having promised so much, policymakers now have to deliver.
Fortunately, there are reasons to be optimistic. Many of the key drivers of deflation – falling land prices, corporate deleveraging, the shift of workers from highly paid full-time positions into lower wage temporary contracts – have largely run their course. The geopolitical threat posed by China’s ascendency in the region has also emboldened Japanese leaders to finally bring the economy out of its funk. In an auspicious sign, GDP grew 3.5% in Q1, boosted by exports and improving consumer confidence.
In any case, investors are in for a bumpy ride. The Bank of Japan is trying to raise inflation expectations (which is bad for bonds) by buying bonds (which is good for bonds). Threading this needle will not be easy. Ultimately, the BOJ’s policy actions should translate into somewhat higher nominal JGB yields but lower real yields. Real rates in Japan have declined significantly but remain above comparable real rates in the U.S. As real rates in Japan continue to drift lower, Japanese stocks, after a much needed consolidation period, will eventually resume their ascent, while the yen will come under renewed pressure.