Are low JGB yields here to stay?

How can the fact be squared out that in Japan, both the rate of unemployment and the 10-year government bond yield are now at, or around, 20-year lows? After all, surely the scarcer labour becomes, the more likely it is that wage and price inflation will rise, leading to tighter monetary policy and higher long-term borrowing costs?

 The answer does not appear to be a breakdown in the relationship between unemployment and inflation. Admittedly, the "natural" rate of unemployment, below which wage inflation would normally accelerate, may have fallen. (This could have occurred, for example, in response to Prime Minister Abe's supply-side labour market reforms.) But the basic relationship has remained intact - as the unemployment rate has declined this decade, so inflation has ground higher once volatile items and tax effects are excluded.

What's more, an increase in actual inflation has been accompanied by expectations of higher inflation in the future. For example, the average rate of inflation that is expected over a five year period beginning in five years' time has climbed from around zero to close to 1% over the past three years. There has also been a significant increase in the average rate of inflation expected over the next decade.

However, a rise in the prevailing rate of inflation has not been the major cause of expectations of higher inflation. Much more important has been the bolder monetary policy of the Bank of Japan (BoJ) since the start of "Abenomics", aimed at achieving an inflation target of 2% at the earliest possible time. With this in mind, the decline in long-term Japanese government bond (JGB) yields makes sense, since monetary policy will need to be exceptionally loose for a long time to come in order to achieve this objective.

 Indeed, the view is that monetary policy needs to become even looser. Our Japan Economics service is the place to look for detailed analysis. In brief, though, we think that the recent weakness in activity has left a sizeable amount of spare capacity that will dampen price pressures for a considerable time, adding to the pressure on the Bank of Japan (BoJ) to do more. Japan's major trade union is not pushing for big pay increases this year either, which makes the BoJ's job harder still.

"We think the chances of a significant rise in long-term JGB yields are very slim. We think that the 10-year yield will still be only 0.5% at the end of 2017, compared to a current level of 0.3%", says Capital Economics in a research note.