Japan to escape deflation this year

Both the Bank of Japan and the consensus of outside forecasters expect deflation to persist in Japan well into 2006. In contrast, we expect inflation to return this year. With next-to-nothing in terms of interest rate increases priced into the futures market, Japanese government bonds are clearly vulnerable if inflation does indeed make a surprise return. However, other asset markets should benefit, including equity and property prices, as well as the yen.