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August 2, 2004

Inflation Target Needed, Not a Reference Rate

Kikuo IWATA (Professor, Gakushuin University)

While Japan's economic recovery seems to be gaining momentum, one of the key policy factors is how to end, or "exit" from, the current quantitative easing policy.

The Bank of Japan has expressed the conditions necessary to end the ultra-loose monetary policy as: 1. consumer price index (CPI) to stay above zero for several months consecutively; 2. CPI is not anticipated to fall again to a sub-zero figure; and 3. quantitative easing may still be considered appropriate to continue depending on economic conditions and price fluctuations.

These conditions are, however, insufficient in the sense that the inflation rate the BOJ envisages is not evident. In addition, there is no indication as to what sort of monetary policy will be adopted once the current policy is terminated. Such a crude policy framework would not enable the market to forecast the outcome of inflation and interest rates with a comfortable level of certainty, resulting in a nervous market where rate fluctuations become erratic in reaction to trivial bits of information.

"Inflation reference rate" versus "inflation target"

Recognizing the problem, some policy board members of the BOJ have suggested introduction of an "inflation reference rate" as part of the "exit" process from the current policy. The inflation reference rate is described as "the increase of prices in terms of core CPI" as preferred by the BOJ, and, incidentally, the promoters of the idea seem to assume the figure to be around 1 to 2 percent p.a. What then is the difference between "inflation reference rate" and "inflation target"?

"Inflation target" is a number committed to by the central bank that the bank considers the objective in executing various policies, which, in effect, would define the framework of the entire monetary policy. It would oblige the central bank to manage monetary policies to show that the bank has committed to the target in order to build credibility among market participants. By thus acquiring the confidence of the market, the central bank would be able to influence the formulation of expectation concurrent with the inflation target.

The important element in adopting such a policy is for the central bank to recognize that making a commitment means bearing responsibility for the consequence. The Bank of Japan's habit of casting the cause of inflation or deflation onto factors other than monetary policy should be halted, as such an attitude would not help win the confidence of the market.

The inflation reference rate, while it also is an indication of what the BOJ deems desirable, apparently lacks the commitment mentioned above from the explanations provided so far. If that is the case, the BOJ would not be able to acquire the confidence of the market by releasing such a figure, and the effect on the formulation of expectation would become uncertain.

However, an inflation reference rate still could have a favorable effect on inflation and the stabilization of the interest rates, as it shows the pace of inflation deemed desirable by the BOJ in real numbers. This is because the market would assume that the BOJ would endeavor to realize that publicized number, as the figure declared is supposed to be what is considered preferable by the bank.

Commit to inflation target

It would be undesirable for the formulation of expectation within the market if the basis of the monetary policy is changed abruptly in a discontinuous manner. It is, therefore, unadvisable to stick to the above-zero CPI target with the current monetary policy until the target is reached, and then suddenly announce a new target and framework of the monetary policy. If the basis of formulation of expectation becomes unstable, so would the real prices and interest rates in the market.

Changing the framework of monetary policy abruptly upon termination of the quantitative easing policy must be avoided. What needs to be done now is for the Bank of Japan to announce its inflation target and commit to its attainment.

(The original Japanese article appeared in the July 24, 2004 issue of Weekly Toyo Keizai)

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