The head of the Bank of Japan says he has a plan to finally end the battle with deflation
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Unconcerned: the BoJ governor says preventing inflation from rising beyond the 2 per cent target is 'less challenging'
For one and a half decades, the Bank of Japan insisted it was unable to end the country’s ongoing, albeit mild, deflation. The government of
Shinzo Abe rejects this defeatism. It demonstrated that last January, with the joint declaration by the government and BoJ that the bank would pursue an inflation target of 2 per cent, the current norm for high-income countries.
Aspiration turned into action in April, after the appointment of
Haruhiko Kuroda, a bank outsider who was critical of the BoJ’s orthodoxy, to be governor. Under his leadership the bank has acted with boldness, announcing its ambitious programme of
“quantitative and qualitative easing” (QQE) in April. The aim is to deliver the 2 per cent inflation target “at the earliest possible time, with a time horizon of about two years”. The central bank also committed to doubling its holdings of Japanese government bonds (JGBs) over the succeeding two years and more than doubling the average maturity of those holdings to seven years.
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IN ANALYSIS
So what progress has been made with the first of the
“three arrows” of Abenomics? Interviewed at the BoJ, the governor gave firm answers, punctuated by his infectious laughter.
“I think I can say we are half way,” he says. “The latest statistics show that the inflation rate has reached 0.9 per cent. But there is still a long way to go.” He says the bank intends to achieve the 2 per cent inflation target and maintain it in a stable manner. “It’s no good just to touch on the 2 per cent and then go down to 1 per cent or less,” he says.
“We envisage basically three channels through which the quantitative and qualitative easing would affect the economy. The first is the massive amount of purchases of Japanese government bonds, which would suppress long-term interest rates over the entire yield curve. The second channel is a ‘portfolio rebalancing effect’. Banks, companies and households would shift their portfolios, now dominated by fixed income assets, towards riskier assets, including lending to the economy. The third channel is shifts in expectations.”
Is the exchange rate a part of portfolio rebalancing? Mr Kuroda agrees that it is, adding that “initially, the rise in inflation reflected a depreciated currency”. But this has changed. The “core-core inflation rate”, which excludes energy and food, already shows a 0.3 per cent increase.
“If we look at the hundreds of items of household expenditure, we can find that more than half the items show an increase in price,” he points out.
Already, he notes, the median forecast of the members of the nine-person Monetary Policy Committee was that core inflation (which excludes food) would reach 1.9 per cent in fiscal year 2015 (April to March).
This has led to an upward shift in inflation expectations, which he notes have been “rising steadily but moderately. Many indicators show that expected inflation may be 1-1.5 per cent.”
Moreover, the output gap – a measure of excess capacity – is also falling. The BoJ thinks it might now be only 1-1.5 per cent of potential output. It also expects 1.5 per cent annual growth over the next two fiscal years. At this rate, the output gap would be closed within two years. This rapid growth would occur despite forthcoming increases in the consumption tax. “I think our monetary policy must have contributed to realising positive growth well above potential,” he says.
How is what the BoJ doing different from what other central banks are doing? Mr Kuroda responds by noting that the BoJ was the first to use quantitative easing, back in 2001. The difference between what it is doing now and its own past practice is that this time it is also extending maturities. So what the Bank calls QQE is much the same as what is called QE in the US and UK, albeit on an exceptional scale.
How far, one wonders, is the monetary policy committee Mr Kuroda largely inherited in agreement? Mr Kuroda says QQE was “adopted unanimously by the nine members. There may be some differences of nuance, difference of views, not about the channels through which monetary policy can affect the real economy but the extent. A few of them think that even in two years’ time, even with this QQE, consumer price inflation may not reach 2 per cent”.
It’s no good just to touch on the 2 per cent and then go down to 1 per cent or less
- The inflationary target
The implication, then, is that the MPC should do even more. This leads to discussion of what happens after the second year of the new policy. “Our QQE is not time-constrained,” Mr Kuroda responds. “Our guidance is condition-based. So without any new kind of decision, the current QQE can continue until the 2 per cent inflation target is achieved and maintained in a stable manner.”
The policy will continue for as long as it is needed. Nor is it yet time to consider what the exit strategy would look like, although Mr Kuroda is confident it can be managed.
Is the BoJ considering any other policy instruments – negative interest rates on bank reserves, purchase of foreign assets, more purchases of assets other than Japanese government bonds, more precise forward guidance?
“At this stage, we are not thinking about any other policy tools since we are on track and we are likely to achieve the 2 per cent inflation target within the two-years time band.
“I can say that those potential instruments, they are possible, and at this stage I don’t want to exclude any one of them.” But, he adds, the purpose of the purchase of foreign bonds is presumably to lower the exchange rate. That is the prerogative of the government.
The BoJ will do “whatever it takes”, to cite Mario Draghi, president of the European Central Bank. So why do forecasters refuse to believe it will succeed? “That’s a good question,” he says, “because if you look at the forecasts made by market economists, you can find that as far as real economic growth is concerned, there is not much difference. But, on the inflation rate, here there are differences.
“The differences for this fiscal year and next are small.” But in fiscal year 2015, the bank expects to reach 1.9 per cent inflation, while market economists expect the rate to stay around 1 per cent. He suggests that the source of this difference might be that the bank thinks that “as the actual inflation rate rises from negative to 0.5 per cent, 1 per cent, 1.5 per cent, and so forth, inflation expectations will also rise gradually”. Market forecasters may doubt this.
Discussion turns to the governor’s support for a rise in the consumption tax from 5 per cent to 8 per cent, due in April. Is concern about “fiscal dominance” – the determination of monetary policy by out-of-control fiscal policies – the reason for his support?
“There is a clear division of labour between the central bank and the government,” he replies. “The central bank is in charge of monetary policy and the government is in charge of fiscal policy. We don’t want to be involved in fiscal policy.”
We are not thinking about any other policy tools since we are on track to achieve the 2 per cent inflation target within the two years
- Other policy instruments
There are two kinds of risks. One is the tail risk of delaying fiscal consolidation too long and so suffering a loss of confidence in the public finances. “Long-term interest rates would shoot up in that event.” The other is the risk that premature fiscal consolidation would slow the desired economic reflation.
The probability of the first risk may be far lower than that of the second. But “if the second risk happens, the government, as well as the central bank, can do something to ameliorate the situation. If the first risk is realised – I would say it’s very low – then it’s almost impossible for the government and the central bank to do anything.”
Moreover, Mr Kuroda adds, he is in favour of the second stage of the increase in the consumption tax, to 10 per cent, due in October 2015, not just the first. Indeed, further tax increases will be needed: “There would be about 2 per cent of gross domestic product primary fiscal deficit, even in 2020. So 2 per cent of GDP equivalent fiscal deficit reduction is necessary.”
Japan’s high public debt (the International Monetary Fund forecasts gross debt at 244 per cent of GDP at the end of this year) is a well known risk. But what if the bank succeeds in destabilising expectations of deflation but fails to re-anchor them?
. . .
Mr Kuroda is not worried. “Raising the inflation rate as well as the inflation expectations from negative to 2 per cent, that is quite challenging. On the other hand, to stop inflation from rising beyond the 2 per cent target, that is less challenging.”
Yet rates of interest would then rise, perhaps sharply. So banks and other companies would stand to lose money. The Japanese government stands to pay more interest. Does he really think this would be easily manageable?
“Every year we have been making a stress test of the banking sector,” he says. “Even with a 300 basis point rise in interest rates across the yield curve, the financial system would not be damaged much.
“The government may have to pay more interest for new borrowing but the financial sector can also gain from higher interest rates of newly issued bonds. The Japanese banking sector has huge capital – enough capital.”
How about the government? If interest rates rose, because of a rising inflation rate or an improving economic situation, the government would gain through significantly increased tax revenue.
“Yes, if interest rates rose, that certainly would make the government pay significantly more interest,” he says. “So consolidating the fiscal position continues to be a challenge.”
Why is eliminating deflation so important? After all, the Japanese economy has not done badly. Between 2000 and 2012, Japan’s increase in real GDP per worker was the second-fastest in the G7 after the US. The working population is shrinking but monetary policy will not produce children. So why is Japan going through this upheaval, particularly since deflation was steady?
Because prices are declining, people just tend to delay expenditures. So we have a continuous demand shortage and the gap has been filled by continuous fiscal stimulus
- The importance of deflation elimination
“Actually, deflation started around 1998,” he responds. “But it has been relatively mild. On average, a 0.5 per cent decline in prices year-on-year. Because prices are declining, people just tend to delay expenditures. So we have a continuous demand shortage and the gap has been filled by continuous fiscal stimulus.
“Second, holding cash became relatively profitable. So corporations accumulated cash. At this stage, they hold nearly 50 per cent of GDP in cash. And they don’t invest much. In the past 10 to 15 years they invested less than their cash flow in physical assets.”
Is the implication of this argument that the move from deflation to inflation is the most important structural policy? After all, Mr Kuroda’s answers are more structural than monetary.
Mr Kuroda disagrees: “I think the third arrow is still important. The government intends to raise the potential growth rate to 2 per cent.” That will not be achieved merely by eliminating deflation.
Yet does that not imply unrealistically high productivity growth for an advanced economy?
Again, the governor disagrees. “I don’t think it’s extremely difficult, although not so easy. How do you raise your potential growth rate? One way is to increase the quantity and quality of the labour force. The second is to raise labour productivity.”
. . .
One solution, he argues, is to help women stay in the labour force even when they become mothers. “There is also huge room for labour productivity increase, particularly in the services sector,” he says.
The discussion turned to wages: it would presumably be bad if inflation went to 2 per cent and nominal wages did not rise equally. That would be disastrous for Japan’s policy aims, not to mention the living standards of ordinary Japanese.
This does not worry Mr Kuroda. “In Japan, in the past 20, 30 years, including the 15-year deflationary period, if you look at wage increases and price increases you find very similar movements. That means that unless wages are rising, prices will not continue to rise, and unless prices are rising, wages will not rise.”
He adds that total compensation is rising as employment is showing “substantial improvement”.
As we leave, the governor stresses the unique challenge the bank confronts. “In the US, UK or other countries, inflation expectations are stably anchored around 2 per cent. But we are trying to raise inflationary expectations towards 2 per cent. The tools are quite similar. But the objective is a bit different.”
Mr Kuroda radiates determination to achieve this. It should soon become clear whether he is going to succeed.
