Set Inflation Target at 2%

Masazumi WAKATABE (Professor, Waseda University)

The recent policy switch to end quantitative monetary easing was prematurely implemented and could wither the expectation of inflation that finally has begun to emerge. In order not to retrace to deflation, the Bank of Japan should continue zero interest rates until inflation exceeds 2%. If a deflation-led recession recurs, discussions on re-revision of the Bank of Japan Law could commence by way of arguments on the responsibility over monetary policy.

Why now?

Cessation of quantitative monetary easing was effected over a month earlier than the market had anticipated. It could be interpreted as a determination of the BOJ led by President Fukui. While it is obvious that the quantitative easing policy must end at some stage, the question of "why now" lingers.

CPI increase over the past months (excluding perishables) has been minimal. Estimated CPI "excluding perishables and energy prices" shows only 0.1% increase over the last year.

Business conditions are reported to be recovering, so why must we throw a chill over it? Price estimates by BOJ Policy Board members indicate no sign of imminent risk of inflation.

Does BOJ fear the emergence of a bubble economy? The central bank does not have sufficient expertise to conduct monetary policy by setting asset prices as the policy objective. Because the undesired backlash of policy measures to crush the bubble is so immense, it has been the lesson learned in many countries, including Japan, that such policy intentions produce no productive results.

There is a misunderstanding in asserting that the ending of quantities monetary easing is permissible because real interest rates would remain below zero because nominal interest rates will be maintained at 0% while deflation ceases. "Real interest rate" in terms of monetary policy is a number obtained by subtracting "expected" change of prices from the nominal interest rate, not by subtracting the "real" change of prices.

This is valuable knowledge acquired only during the past 30 years. During the 70s, FRB Chairman Paul Volcker curbed fierce inflation by stubbornly suppressing the anticipation of inflation. Alan Greenspan, when he was chairing the FRB around 2002, effectively prevented the emergence of the fear of deflation by announcing that the FRB has other policy means, even if the interest rate becomes zero.

Two risks with regard to macroeconomics

Since the 90s, many countries began to adopt the mechanism of inflation targeting in order to influence inflation expectation. The key to understand the policy is the term "expectation."

The current issue, therefore, can be rephrased as how inflation expectation will change in accordance with the termination of quantitative easing. The figures derived from indexes such as inflation-index bond prices show Japan's recent recoveries concur with the decline of deflation expectation and the rise of inflation expectation.

According to a study by Yoichi Takahashi (presently a Minister's Secretariat Counsel at the Ministry of Internal Affairs and Communications), the trend of the BOJ's current-account deposit balances has been in perfect line with expected inflation rates. If so, it means termination of quantitative easing could facilitate the risk of depressing inflation expectation.

Furthermore, the continuation of a zero interest rate policy, which was understood to be the presupposition for the termination of quantitative easing, is now at stake. The quantitative easing policy was initially introduced after the BOJ embarrassed itself by departing from the zero-interest rate policy prematurely in August 2000. At the time it was impossible for the BOJ to reclaim confidence by simply resurrecting the zero-interest policy, so quantitative easing was implemented as an additional measure.

When the quantitative easing policy was deemed effective, it functioned as a protection from the termination of the zero interest rate policy. But now as the restriction is removed, it is possible for the BOJ to seek departure from the zero interest policy at an early stage. In fact, the BOJ may initiate actions earlier than many expect.

Currently, Japan's economy and the BOJ face two risks. One is the risk of policy failure. As with any policy initiative, monetary policy incorporates uncertainty. Most of the uncertainties are due to fundamentally complicated probability calculations. FRB chairman Alan Greenspan was praised for his risk control capabilities to consider and prepare for the worst possible scenario in this fundamentally uncertain environment.

The BOJ claims it follows the path of Alan Greenspan, but the worst scenario now is the inability to completely pull out of deflation. It seems, however, that what the BOJ considers risk is rather the risk of inflation and the bubble economy.

The second risk is of a political economy nature. Independence of the central bank in a democratic society is an assertion with inherent tension. Independence of the central bank cannot mean it is detached from - untouchable by - a democratically erected government. Presently, even if the BOJ makes a wrong judgment, the fate of the chairman is left for the BOJ itself to decide. If a system is to be incorporated to make the BOJ accountable for the results of its policies, explicit rules are necessary to define its, and its officers', responsibilities. It would ultimately lead to re-revision of the Bank of Japan law.

Whether re-revision of the Bank of Japan law would impose risks to Japan's economy as a whole depends on how it would be re-revised. The 1998 revision was compiled in the frenzy of the discussion on the dismantlement of the Ministry of Finance, whereby leaving out the discussion on clarification of the BOJ's responsibilities. It could brew up a fierce debate if a proposal to again subordinate the BOJ to the government were suggested.

Re-revision of BOJ law might be considered if its policy fails

What could happen going forward? If the policy decision to terminate quantitative easing wipes out the inflation expectation so far accumulated, and, instead induces interest hike anticipation, it would have a negative effect on the prospect. As there is a lag in policy actions to materialize as real effects in monetary measures, there is a risk of the economy plunging and becoming deflationary six to nine months from now.

This is where inflation targeting can become effective. First, inflation targeting would involve the BOJ more heavily in the task of breaking away from deflation and maintaining the rate of inflation. The BOJ also would be able to better communicate its intentions to the market.

Second, major developed countries adopting inflation targeting as a policy objective are faring well. Japan and the U.S. are practically the only two among the major developed countries that have not introduced inflation targeting as a policy objective. In fact, the U.S. under the lead of new FRB chairman Ben Bernanke is rumored to introduce an inflation target.

Third, there is political-economy merit. While currently there is no means to challenge the BOJ's policy failures, an inflation target could make the BOJ's responsibilities clearer while maintaining a certain level of independence from the government.

The problem of the ambiguity of the expression "the mid and long term price stabilization understanding," nevertheless considered to be the key element in the policy decision this time, could thus be resolved. Some interpreted this phrase as a "de facto inflation target," but BOJ Governor Fukui has flatly denied it. If, however, the BOJ is opting for more transparency in its policies, why does it not use such a clear term as "inflation target"? Is the BOJ attempting to make its policy ambiguous contrary to its previously expressed intentions?

There is a problem in the number itself as well. Among the 20 countries adopting inflation targets, Thailand is the only economy setting the target's lower limit at zero percent. Zero means there is a risk of diving into sub-zero, or deflation. According to the BOJ, the reason for setting the zero percent bottom is because of the low inflation experienced since the 90s, and economic activities are conducted under the assumption that it will remain so.

But the assumption that inflation will remain low was developed through the period of deflation during the 90s. The BOJ does not seem to realize that the BOJ itself was the central player in bringing about that deflation.

The BOJ might not wish to use the expression "inflation target," but on the other hand, the central bank's announcement of such a figure would carry significant weight. The BOJ's inconsistency and ambiguity is problematic.

In any case, the die is cast. During the hearing in the Diet, Governor Fukui, in responding to the question of how the BOJ is going to take policy responsibility, responded by saying that the BOJ is not allowed to always be afraid of mistakes and is taking risks in policy implementations. But it is the people who are to be victimized by economic failures.

It is best if Japan's economy would continue its recovery. But since there is a risk still remaining, the BOJ should declare that they will stick to zero interest so as not to fall back into deflation for the next nine months unless inflation tops 2%. In the meantime, the BOJ should revise the lower limit of inflation from the announced 0%. In other words, enhance the so-called "understanding" to an inflation target as defined by the global-standard.

In case deflation were to recur, the BOJ would be held responsible, and re-revision of the BOJ law should be seriously considered. Obviously, the government must keep a close eye on the development without adopting other austere measures such as tax increases. This is the crucial phase in finally breaking away from deflation.

(The original Japanese article appeared in the March 20, 2006 issue of Nihon Keizai Shimbun.)