Japan faces a tough inflation-growth trade-off – and it’s not alone

Global bond markets are in turmoil, with yields on 30-year US Treasury bonds reaching a record high of 5.3% on August 17, up from 4.8% in mid-June. The average yield on long-term debt across the Group of 7 advanced economies is also at its highest since 2008. This surge is attributed to the expansion of longer-dated debt issued by major tech firms to fund AI investments, particularly for data centers, as well as worries about governments' ballooning public debts due to pandemic support measures.

However, the challenges to raising interest rates loom larger. The US Federal Reserve's hesitance to increase rates, despite persistent inflation, is a major driver of high long-term bond yields. Nohshad Shah of Citadel Securities explained that policymakers are struggling to address issues while economic growth remains strong. In Japan, the central bank faces pressure to raise interest rates more aggressively after the economy grew by a weaker-than-expected 1.1% in the second quarter.

Despite a currency intervention by the US and Japan, there is a 80% probability of a rate hike next month, up from 25% before the intervention. Bank of America expects Japanese rates to reach 2% by mid-year, but the government's fiscal stimulus plans and concerns about lingering deflation make this challenging. The yen's weakness necessitates higher rates, but the government's commitment to growth hampers decisive action.

Japan is not alone in this dilemma. The Philippines grapples with the highest inflation among Southeast Asia's top economies due to energy costs, while Indonesia's economic governance issues hinder policy credibility. South Korea, despite strong AI-related growth, must balance higher rates with a K-shaped economy where job growth is stagnating.

Bond markets worldwide are anxiously awaiting central bank decisions, with a predominant concern being the risk of insufficient inflation control.