Wanted: A BoJ head who believes in monetary policy

Japan's central bank has long downplayed monetary policy as a legitimate trigger for solving the deflation crisis. The next BoJ governor must have the courage to pull the trigger.


It must be flattering for Shinzo Abe, a man whose knowledge of economics is matched only by Ben Bernanke’s expertise in ikebana flower arrangement, to have a whole new branch of the dismal science named after him. "Abenomics" has proved such a potent force that its mere invocation – before any real action to speak of – has helped knock a fifth off the value of the yen and put a third on the value of Japanese equities since October.

Yet at the heart of Abenomics lies a simple, and entirely orthodox, proposition: that deflation is a monetary phenomenon. In Japan, where prices as measured by the gross domestic product deflator have fallen 18 per cent since 1994, that amounts to a revolutionary concept. For more than a decade, the orthodoxy in Japan – at least at the central bank – has been the reverse: that deflation is a "real economy” phenomenon, essentially beyond the reach of monetary policy to fix.

To oversimplify, the BoJ view has been that demographics and cheap imports from places such as China have lowered Japan’s trend growth rate and produced a negative output gap in which supply perpetually outstrips demand. In this view, deflation cannot be beaten without real economic adjustments through fiscal consolidation, higher worker participation and raised productivity. Against these real economic forces, the BoJ view goes, monetary policy is a mere palliative, at best a tool to prevent systemic financial risk.

The most important attribute of the next BoJ governor – due to be nominated next week – is that he rejects this interpretation. He must embrace what Paul Sheard, chief global economist at Standard & Poor’s, calls "a cornerstone of modern monetary policy theory” – that central banks can influence prices over the medium term.

It would be unfair to suggest that the BoJ has sat on its hands for 15 years. Interest rates have been pinned at virtually zero since the late 1990s. Under the then governor, Toshihiko Fukui, the bank became a pioneer of quantitative easing, sharply expanding its balance sheet to buy a range of assets, including commercial paper. Yet for much of the time, the bank has barely disguised its view that quantitative easing doesn’t really work. It has announced innovative policies while holding its nose and unwound them with undue haste. Both in 2001 and 2006, it began to raise interest rates before deflation was safely dead in its coffin. Under Masaaki Shirakawa, the present governor, the bank has become more timid still, concentrating its purchase of assets on short-term government debt, precisely the sort likely to have least impact. (Purchases of more exotic assets, such as real estate investment trusts, have been token.)

Moreover, the central bank has given every impression that it is not displeased with the current deflationary equilibrium. In a weird way, it is true that Japan has learnt to live with deflation. Falling prices mean that many Japanese have been able to preserve their living standards. Prices for everything from houses to pork cutlets are back at 1981 levels. Deflation also means that the government can borrow from the huge trapped pool of household savings at ludicrously low interest rates – well below 1 per cent for 10-year debt.

In the long term, though, deflation is corrosive. It suppresses nominal growth, raising the debt-to-output ratio. It drains the economy of animal spirits. Deflation also tends to help older people at the expense of younger ones, protecting the savings of the former while making it unattractive for the latter to borrow money to start a business or buy a house.

Japan’s challenge is to move from the comfortable – but ultimately doomed – state of deflationary equilibrium to a new equilibrium based on mild inflation. Getting from here to there means walking a precarious path. Even with interest rates as low as they are, debt service swallows roughly half of tax revenue. If the yield on 10-year borrowing were to quadruple to 3 per cent, virtually the entire budget could be consumed in debt payments. Banks’ balance sheets are choc-a-bloc with government bonds since there has been little else to do with depositors’ money. A sharp fall in bond prices could wreak havoc with banks’ capital. Inflation will also make the Japanese feel poorer unless wages rise too. These are risks to be sure. Yet they are sometimes overstated. Before inflationary expectations take hold, nominal growth should rise, lifting long-depressed tax revenue. As rates rise, banks should be able to increase profits, offsetting capital losses from falling bond prices. And although the cost of government borrowing will eventually rise, it will be several years before all of the current, cheap debt must be rolled over.

Japan could use that window to narrow its budget deficit by phasing in tax rises or trimming expenditure. It could also enact long-delayed structural reforms – deregulating the health, agriculture and energy sectors for starters – in order to increase demand and improve the efficiency of supply.

None of this will be easy. Breaking the deflationary trap will require appointing a governor willing to say the BoJ has got it wrong for years. The bank will then need to set out on an inflationary road whose precise course cannot be known. That strikes some as reckless. But the alternative is to accept deflation – forever. That would be more reckless still.

Copyright the Financial Times 2013.

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