Alroy Commentary - Pros and Cons of Inflation in Japan
Japan suffered from deflation from long time. Recently, the Bank of Japan (BOJ) set 2 percent inflation for the first time and committed to achieve the target via open-ended asset purchases. Yes, it is too early for us to say when BOJ can achieve its inflation target. In the latest forecast by BOJ, the consumer price index will increase by 0.4 percent and 0.9 percent in year 2013 and year 2014 respectively. However, you can get some concepts of inflation and its advantages and disadvantages in this article first.
Inflation is not necessarily a bad thing. Inflation allows companies to increase its selling prices and generates higher revenue. Government can collect more tax and reduce the deficit. However, inflation also creates uncertainty. Yes, companies can increase their revenue by raising price, but at the same time they need to pay more for their input. And their employees would request for higher pay. For companies without pricing power, the profit of companies may hurt under inflationary environment.
Inflation can reduce the real value of debt too. Assume that banks lend billions of dollars at a fixed interest rate at 2 percent. If inflation increases from 1 percent to 2 percent, then borrowers' real interest rate paid would be reduced from 1 percent to 0 percent. The borrowers will repay a lower interest rate if the inflation is considered. However, if inflation goes out of control, it will create uncertainty and lenders are less willing to lend money and businessmen are less willing to invest. High inflation rate can result in lower economic growth and investment.
Unexpected jump in CPI will send the bond yield higher, as bond holders request higher return to compensate for the eroding in purchasing power. It is especially worth Japanese to monitor closely. As the public debt level is at a very high level, rebound in bond yield will increase the interest rate payment of Japanese government. If investors do not believe the Japanese government, Japanese government bond may suffer from out-of-control surge in bond yield and induce further depreciation of Japanese Yen in medium to long term.
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