Inflation test for a Japanese relaunch

The Bank of Japan must find a way to gently pull at inflation, not too hard and not too soft. With that policy set right, the nation's economic reset has a chance.

Shinzo Abe, Japan’s prime minister, continues to astonish. He could hardly have chosen a more radical team than the one he has appointed to run the Bank of Japan. Haruhiko Kuroda, a critic of the BoJ’s past passivity, is now in charge of monetary policy.

Make no mistake. Kuroda not only wants to deliver 2 per cent annual inflation, but considers this to be within the power of the central bank. He can also expect to have the backing of the government and the new deputy governors, Kikuo Iwata and Hiroshi Nakaso. The BoJ may grumble. But a shift in policy seems sure. The question is: will it work? Indeed, what might 'work' mean?

One must start by noting Japan’s peculiar position. Expectations of deflation are well entrenched, in bond markets, if not in surveys, with yields on government 10-year bonds now at 66 basis points (see chart). Real rates of interest have remained positive, even at the short end. Deflation has also been very sticky. Finally, the distribution of debt has shifted from the private to the public sectors: according to economic advisers Smithers and Co net debt of non-financial companies has fallen from 150 per cent of equity in 1995 to 30 per cent. But government net debt has jumped from 29 per cent of gross domestic product at the end of 1996 to 135 per cent at the end of 2012.


These facts have deep implications. First, ending deflation is going to be far harder than it would have been in the late 1990s. Second, it would be helpful if higher inflation also made real interest rates negative, which would encourage people to spend. Third, negative real rates would also redistribute wealth from the state’s creditors towards future taxpayers.

Such negative real rates can be achieved either by making inflation higher than expected or by capping interest rates. It is not, in fact, clear whether the Japanese authorities want to create strongly negative real rates of interest. But they should, even though this would also create the risk of a political backlash.

How should this be done and how transparently? The BoJ could insist that it is aiming at 2 per cent inflation, but follow policies likely to bring higher inflation than this. That would be risky deceit. Alternatively, it could announce the aim of higher inflation, while announcing a lengthy period of low nominal interest rates. This would be an open inflation tax.

Either way, policy could be buttressed by a temporary move to a target for price or nominal GDP levels. The argument for this is that bygones should not, in this extreme case, be bygones. The current price level is 30 per cent below where it would have been if annual inflation had been 2 per cent since 1997.

Similarly, nominal GDP is 40 per cent lower than it would have been if it had grown at 3 per cent a year. If the BoJ sought to return to the level of nominal GDP implied by 3 per cent annual growth from 1997, it would be committing itself to an annual increase of close to 9 per cent a year over the next decade. That could surely reduce the real burden of debt! Thereafter, policy makers might return to a 2 per cent inflation target. This is illustrative, not a recommendation. But the case for such a degree of radicalism is that it could change economic prospects quickly. Normal targets may not be enough.

It is not just a matter of new targets. Policy instruments also matter. The new heads of the BoJ must consider a wider menu of asset purchases, including monetisation of government deficits. Richard Werner of Southampton University has long argued that fiscal monetisation would best come from direct borrowing by the government from banks. At the limit, Japan might use "helicopter money”, as discussed in my column of February 12. If the BoJ uses fiat money it does not wish to withdraw, it will also have to impose explicit reserve requirements on commercial banks.

The traditional view at the BoJ has been that monetary policy cannot raise inflation. This shows a surprising lack of imagination. In principle, the BoJ can use its fiat money to buy everything in the world, at any price it wanted. This would certainly lower the purchasing power of the yen. It is not a question of whether inflation can be achieved, but whether that achievement can be managed, particularly when one is trying to shift strong expectations of sticky deflation. The risk, rather, is that it would be like pulling a brick with a piece of elastic, instead: little movement at first, and then too much. This is why the target matters: the policy shift must be both credible and credibly contained.

One can envisage two big and clearly interrelated dangers. First, the new approach might be seen as a deliberate attempt at beggar-my-neighbour policies and would, as a result, cause dangerous retaliation. Second, it might stimulate flight from the holders of yen and so a currency collapse and soaring inflation. The first is a more immediate danger and the second a more remote one. Both show that the policy shift needs to be anchored with a credible exit to normality.

Finally, then, is a radical change in monetary policy enough? The answer is: no. In the short run, the government can and should monetise its deficits. In the long run, however, it will need to rebalance the economy away from dependence on government-created demand.

As I argued on February 5, the government must ultimately reduce its structural fiscal deficit. If it is to do this, the Japanese private sector must reduce its counterpart structural financial surpluses. Thus, in the long run, the excess of retained earnings over investment in the Japanese corporate sector must shrink. A permanent increase in the current account surplus, which is the alternative, must not now be adopted by the world’s third-largest economy: it would destabilise a global economy suffering from a savings glut.

Japan is trying to fly a monetary kite long stuck on the ground. Some will argue that the independence of the central bank has been violated. The response to that is that the BoJ had failed to deliver on its price stability mandate. The question is rather whether the new team can raise inflation and lower real interest rates without destabilising domestic or global economies. Maybe, working to a 2 per cent inflation target will deliver what is needed. But I suspect that a more radical target, for levels of prices or nominal GDP, may be needed, at least for a while.

The new team at the BoJ will have to avoid doing too little, even though it risks ending up doing too much. It will need much judgment and some luck. The world should wish it well.

Copyright The Financial Times Limited 2013

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