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Guest Comment: The Re-Emergence Of Inflation Expectations In Japan - Nikko AM

Yu-Ming Wang

Nikko Asset Management

26 February 2013

Editor's note: This article, looking at the important issue of inflation pressures and recent global moves to reflate the world economy, looks in particular at Japan, and the actions recently taken by the newly-elected administration. This item is written by Yu-Ming Wang, chief investment officer, international, at Nikko Asset Management. 

Over the past few years, those who have raised concerns about inflation in the developed economies have been met with scepticism. The argument that has prevailed thus far is that the slack built into developed economies has made it difficult for real inflation to take hold, at least until unemployment levels recede. This view is held by Keynesians, who view inflation as the result of an economic bottleneck in the form of full employment and economic growth exceeding its natural rate. In today’s slow- or no-growth environment across the developed economies, inflation has not been an issue.

Whether inflation rises from the current level or not, it is the market's expectation of future inflation that is factored into asset prices. Asset prices are, by definition, the discounted present value of future purchasing power. If investors start to believe that inflation is on a rising path, then asset markets will start to price in the risk of higher inflation in favour of inflation-friendly asset classes.

We believe that there are several indications that higher inflation expectations are in the early stages of taking hold in the asset markets' discounting mechanisms. The most compelling of these is the publicly stated inflation targeting policy as recently announced by the Federal Reserve and the Bank of Japan. Indeed, this is an epic change for one of the world's largest central banks, the impact of which could unleash a new wave of liquidity into global financial markets as well as revise inflation assumptions priced into Japanese government bonds (JGBs), equity markets and exchange rates.

Central bankers around the world have been busy fighting against deflationary risks from the debris of the 2008 global financial crisis. To arrest plunging global demand and skyrocketing unemployment levels, the only powerful tool left for the central bankers was the money printing press, euphemised under the label of "quantitative easing" or "QE". In general, this aggressive monetary medicine succeeded in its purpose of stabilising confidence and preventing a downward deflationary spiral. This frenzied money printing and endless debt buy-back may well cause hyperinflation, such as the monetarists have been warning us about for years.

In the US, where the global financial crisis first took hold with bad loans in the housing market, the economy is starting to look a little better in places. The US housing market, for example, is now surging and even the outlook for the seemingly hopeless Euroland is improving. The more aggressive debt buying program that started in 2012 has helped the peripheral countries stem its downward trend and stabilised its markets. As for fast-growing China, which is now a much larger portion of the global economy, general inflation, including housing prices, is rising significantly once again.

Sitting idle 

Money injected into the global economy by central banks has been sitting idle as cash held by corporations or financial institutions and there is still plenty of slack in all the major economies. With unemployment rates remaining stubbornly high, despite the stimulus pumped in by G7 governments, the capacity utilisation rate is well below what economists would call inflationary territory. Additionally, loan demand has dwindled and companies have little incentive to invest.

While the aggregate money supply has undoubtedly expanded after the crisis, the velocity of money has slowed, as little of that high-powered liquidity has been channelled into demand-generating purposes. In this type of environment, inflation does not have much of a root to take hold and sprout.

Many investors remain sceptical that inflationary expectations will rise, but a major structural change is now happening at the Bank of Japan in that a new governor will be appointed soon for a five-year term. This will cause monetary policy to be much more aggressive for the long-term.

Moreover, the Abe administration has much firmer foundations than the previous five governments, so its reflationary policies will likely be long-lasting. Thus, we expect inflationary expectations to rise in Japan up to the BOJ’s new 2 per cent inflation target level. Since Japan is a very significant economy with massive savings, this will have a major effect on global inflationary expectations.

Investors have many reasons to pay attention to this trend. If Japan is even halfway successful in achieving its reflationary goal, the implications on investors' future purchasing power and capital markets' valuation levels will be powerful and long lasting. This erosion in purchasing power cannot be offset by the measly returns currently offered in JGBs or Treasury bonds. Meanwhile, a stronger pricing power in the revenue generation of the companies may cause a healthy jump in earnings yield and may gradually lead to a price/earnings expansion.