Towards a New Regime for Monetary Policy---To Adopt Inflation Targeting

Kikuo IWATA (Professor, Gakushuin University) and Yasushi OKADA (Chief Economist, CSFB, Japan)

Serious Effects of Deflation

It is often said that the main cause for Japan's economic slump is the slowdown in the U.S. economy. But the reason why Japan is most severely affected by the U.S. slowdown is because the Japanese economy has been caught in a deflationary trap.

First of all, under deflation nominal wages tend to be sticky relative to the prices of goods and services, and therefore corporate profits will be depressed and investment and employment will be reduced. Second, real interest rates tend to increase as prices fall, since nominal interest rates are already near the bottom. This means that the real burden of existing debts tends to increase. Third, deflation will reduce future returns on assets and thus decrease asset prices themselves. Declines in stock and real estate prices will increase the total amount of bad loans and impair the intermediary function of financial institutions.

It seems widely believed that without structural reform the Japanese economy cannot be revived. While structural reform may be necessary for long-term growth and efficiency of the economy, deflation, if unchecked, will make it impossible to carry out reform measures and to revive the economy itself. In fact, there is no precedent of successful structural reform under deflation in history. Former U.S. President Reagan and former British Prime Minister Thatcher both pushed structural reform to deal with low growth under inflation. Structural reform to "cut waste for economic revival" lead to the Great Depression in the U.S., as well as the Showa Depression in Japan in the 1930s.

BOJ to Buy More Government Bonds

The principle for administrating economic policies is called a policy regime. Recent studies in macroeconomics show that changing a policy regime tends to have a greater impact on the economy than adopting ad-hoc policy measures, since the established regime will be embedded in the behavioral patterns of private parties. This is not a matter of theory, but can be confirmed by many observations. According to empirical studies on inflation we can find many examples where hyper-inflation, say over 50% per month, was brought under control in a surprisingly short period of time due to a shift in the fiscal and monetary policy regime. On the other hand, we experienced the situation where deflation stopped as the policy regime changed from the adoption of the gold standard with fiscal restraint to the abandonment of the gold standard with fiscal stimulus in the early 1930s.

What Japan needs now is a clear shift in the policy regime in order to avoid deflation by all means. That is all the more necessary now, since deflationary pressure is getting stronger due to the terrorist attacks in the U.S. Although the zero interest rate policy appears to be a powerful measure, people's deflationary expectations will not change as long as they anticipate that the Bank of Japan would adopt credit-tightening policy again once the deflation rate slows down. It is impossible to turn around deflationary trends as well as expectations unless people are convinced that the Bank of Japan would continue to adopt substantial credit-easing policy by somehow increasing money supply until deflation is halted.

I argue that the Bank of Japan should introduce an inflation-targeting policy and try to turn people's expectations around by setting approximately a two percent inflation rate as its policy target and by purchasing long-term government bonds and foreign bonds without limit until the target is achieved.

The problem is that the Bank of Japan is refusing to adopt this kind of policy. There seem to be two types of arguments against this policy. First, it may be said that this kind of policy would fail to stimulate the economy, and therefore could not stop deflation because the monetary base increased by the Bank of Japan would be used to purchase government bonds or left as a deposit for the Bank of Japan and would not lead to any increase in money supply to the private sector, as banks could not offer more loans due to the bad debt problem. I do not agree with this argument. Bank's purchase of government bonds will have essentially the same effect as bank loans in increasing money supply to the private sector. Rather, the main reason for the ineffectiveness of increasing supply of the monetary base seems to be the Bank of Japan's unwillingness to turn deflationary expectations around, as implied by its stance to end the zero interest rate policy in August 2000 in the midst of deflationary trends.

The second type of argument against the inflation targeting policy is that such a policy would cause hyper-inflation beyond control. Actually, the Bank of Japan seems to admit officially or unofficially that unlimited purchases of government bonds or foreign bonds would effectively curb deflation. They are refusing to adopt it because they fear the possibility of uncontrollable inflation in the future. It would be just like a heavy stone on the top of a hill; once it is rolling down the hill there would be no stopping. However, inflation can be controlled in view of historical experiences in various countries unless inflation over 10 percent is left unchecked for some reason. What we are talking about here is an inflation rate around two percent, and no country has ever failed to curb such mild inflation by adopting credit tightening policy.

(English translation of the Japanese article published in the November 15, 2001, issue of Nihon Keizai Shinbun.)