Inflation Targeting and Negative Interest Rate Policy

Mitsuhiro FUKAO (Professor, Keio University)

First, I would like to emphasize how dangerous it is to leave unchecked the current deflationary trend in the Japanese economy, which seems to be falling into a deeper recession. We need to think of proper policies to stop deflation without causing uncontrollable inflation in the future.

Regarding the non-performing loan problem, from financial statements of banks, we can show that it is impossible for them to secure enough net interest return to cover the risk of default, even in mild deflation as we have been experiencing in recent years. Banks’ capital base has become insufficient, and as of spring 2002 banks’ own capital, excluding public funds, is almost depleted.

Of course, the government could inject more public funds to avoid a financial crisis. However, the accumulation of government bonds and the decline in tax revenue would lead to rapid deterioration of credit ratings for the Japanese government. If deflation is left unchecked, then Japanese government bonds would be downgraded to speculative grades (below BB). Such downgrading of the government bonds would adversely affect not only public finance, but also the international operations of private financial institutions and corporations. Furthermore, in the worst case, capital flight from Japan could lead to fiscal crisis.

What to do to reduce Japan’s budget deficit while getting rid of deflation? Policies will be ineffective unless the size of the policy measure matches the economic condition. Taking aspirin would not be good enough to deal with pneumonia. My estimate is that the deflation rate in terms of the GDP deflator is about one and half percent, and the GDP deflation gap is about six percent. This means that we are facing a serious situation where deflation will gradually be accelerating unless GDP is increased by six percent from the current level.

My proposals are as follows. First we should set and announce to the public a target for price stability (inflation target) around 1.5 percent of consumer price inflation plus/minus 1 percent per year for three years.

To achieve this target, laws must be revised to allow the Bank of Japan to buy all securities, not just bonds, for its open market operation, and purchase real assets such as TOPIX based mutual funds and REIT (real estate investment trusts) up to a few trillion yen per month. This should stop decreases in the value of real assets in terms of cash and bank deposits.

If that does not stop deflation, then the interest rate should be made "negative" by taxing the balance of all government-backed financial assets such as bank deposits, government bonds, postal savings, cash, etc., at the rate that is slightly higher than the deflation rate until deflation is stopped. In times of deflation, people are increasing their holdings of cash and bank deposits, because doing so is safest and best in portfolio management. We should encourage investments in stocks and real estate by taxing cash and bank deposits.

The negative interest rate policy is expected to decrease savings and stimulate investment. For example, we could impose a two percent tax on cash by converting old 102 yen into new 100 yen. Then, the total tax revenue for the government would amount to about 20 trillion yen. While such a conversion might cause some confusion, the government could make use of the tax revenue to reduce its budget deficit, re-capitalize deposit insurance funds or to improve its anti-unemployment policy.

Once deflation is overcome, the nominal interest rate would rise, possibly causing the bankruptcies of corporations with excess debts and the failures of banks and life insurance companies due to sharp falls in bond prices. Therefore, we need to take sufficient precautions for risk management. Without overcoming deflation and experiencing the pain associated with the end of deflation, the Japanese economy will never recover. If the Koizumi government leaves deflation unchecked, we will face the worst case where the government would go bankrupt.