Bank of Japan Governor Masaaki Shirakawa indicated April 27 that he expects the Japanese economy to finally pull itself out of the deflationary hole in which it has been trapped for many years.
Shirakawa said Japan’s “inflation rate may reach 1 percent in the not-so-distant future” and that it was possible it would hit that level in fiscal 2014.
However, the central bank chief’s remarks were immediately followed by a rise in the value of the yen, forcing Japanese stocks down the same day. It was clear that the financial markets are not buying the BOJ’s view that deflation in Japan will soon be history. They apparently think the bank’s efforts to free the economy from the grip of deflation are insufficient.
BOJ's scenario believed too optimistic
Japan’s core consumer price index (CPI), excluding fresh food, remained unchanged in fiscal 2011 from the previous year, escaping negative territory for the first time in three years, according to data released by the government on April 27.
On the same day, the BOJ decided in its Policy Board meeting to take additional monetary easing measures. In its latest Outlook for Economic Activity and Prices, released after the meeting, the central bank claimed that the period of deflation would soon end. The BOJ is expecting the nation's core CPI to rise 0.3 percent for fiscal 2012 and 0.7 percent for fiscal 2013, according to the report.
The bank’s forecasts of real economic growth are 2.3 percent for fiscal 2012 and 1.7 percent for fiscal 2013. Robust demand growth driven by reconstruction work in areas devastated by the Great East Japan Earthquake will pull Japan out of deflation and put it on a road to economic regeneration.
However, as the reaction to Shirakawa's remarks showed, the general perception in the market is that the BOJ’s optimistic scenario of how the economy will actually overcome deflation and embark on the road to renewed growth is far from convincing. In fact, it would not be surprising if the scenario is perceived to be a form of political support for the government, which wants to improve the climate for a consumption tax hike.
Inflation target of 2% desired
In its Policy Board meeting in February, the BOJ effectively set an inflation target of 1 percent in a move widely welcomed by market players.
But the BOJ’s actions in the following weeks raised doubts about its commitment to the effective inflation target. The bank failed to pump liquidity into the economy in an aggressive manner, provoking criticism of its tepid efforts to stoke economic growth.
The BOJ’s lukewarm attitude toward additional monetary easing that might ensure the inflation target is actually hit is not surprising. The concession on setting an effective inflation target was only adopted grudgingly by the BOJ in the first place.
Policymakers in the BOJ and people sympathetic to their views are still struggling to break free from the conventional wisdom in central banking that excessive monetary easing is driven by political pressure and is bad policy.
Behind their basic ideas about monetary policy is a strong sense of mission based on the notion that the BOJ should be the leading champion of the fight against inflation.
Central bank policymakers and their supporters are not strongly aware that their basic policy tenets are causing the bank’s anti-deflation measures to be half-hearted and of doubtful effectiveness from the viewpoint of the markets.
If it wants to be a powerful driving force in helping the economy emerge from deflation, the BOJ should consider taking the bold action of raising the inflation target to 2 percent.
If it is difficult for the bank to revise its 1-percent target so soon, the bank could achieve the same effect by announcing it will continue monetary easing until it is sure that the level of inflation has settled in the higher 1-percent band and then sticking to this policy.
It is widely believed that the consumer price index tends to be about 1 point higher than the actual level of inflation due to a statistical quirk called “upward bias.”
That means deflation cannot be overcome if the BOJ terminates its easy monetary policy as soon as the index starts showing year-on-year rises of around 1 percent. In such a situation, the GDP deflator—a measure of economy-wide inflation used to adjust nominal GDP for inflation—could actually still be in the negative range, meaning that deflation had not been defeated.
In other words, the BOJ’s 1-percent inflation target indicates that the bank may start toning down the easy monetary policy with the approach of the end of deflation. This inevitably raises doubts about the central bank’s commitment to the fight against deflation.
In February, I put questions about this issue to Shirakawa. He said he would deal with the problem by ensuring annual examinations of data that would look at the actual effects of the bias and at changes in people’s perceptions about the price trend. To me, his comment appeared to be an attempt to reassure the public by promising a flexible response to the price situation.
At that time, Shirakawa also suggested that adopting an inflation target of 2 percent could heighten uncertainty.
Shirakawa and other top BOJ policymakers appeared to fear that setting a 2-percent inflation target might send out the wrong signals and lead to a sharp fall in government bond prices, which would mean a steep rise in long-term interest rates.
I can understand the reasoning behind Shirakawa’s concern, but the BOJ can avoid the risk of causing turmoil in the markets by clearly stating its determination to make flexible and bold responses to any sharp drop in bond prices or overshooting of the inflation target, while at the same time implementing its monetary policy in a way that effectively raises its inflation target to 2 percent.
By adopting this approach, the BOJ would be able to win markets’ confidence in its commitment to the battle against deflation and make sure that its prediction of a 0.7-percent rise in the inflation rate for fiscal 2013 proves accurate. That would mean the central bank would actually strike its 1-percent inflation target and thereby lay the foundation for Japan’s renewed economic growth. The risk of not doing so is that Shirakawa’s words will be remembered as mere wishful thinking.
Even if the BOJ doesn’t take such aggressive steps, the Japanese economy will gradually overcome deflation through growth powered by improvements in corporate profits due to reconstruction-related demand. However, the progress will be frustratingly slow.
Given the situation, the BOJ would be acting in the best interests of the Japanese economy if it switched to a more aggressive anti-deflation policy.
Consumption tax factor
Political factors also need to be taken into account. The Diet will soon start considering a government-drafted bill to raise the consumption tax rate to 8 percent in April 2014 from the current 5 percent and increase it further to 10 percent in October 2015.
The bill, if enacted in its current form, would have the short-term effect of slowing Japan’s economic growth and thereby delaying its emergence from deflation. The government claims the proposed consumption tax increase would have positive long-term effects on the economy as it would push the nation toward financial health and help maintain international confidence in Japanese government bonds.
If a revision is made to the bill to include measures to temper the impact of the tax hike, such as exempting food products, its enactment would not do much harm to the economy.
A group of lawmakers of the ruling Democratic Party of Japan led by former party chief Ichiro Ozawa is stepping up its political campaign against the consumption tax increase. As a result, the odds are growing that the bill will be carried over to the next Diet session, which would mean that the tax hike would likely be postponed until after Japan’s emergence from deflation.
Considering that political situation, it seems unlikely that the consumption tax issue will be a major obstacle to policy efforts to bring an end to deflation.
The pay-off if those efforts are successful could be great. As it overcomes deflation, the Japanese economy would emerge from its prolonged stagnation and stand on the cusp of a new era of healthy growth.
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The author is a senior staff writer of The Asahi Shimbun, who has written extensively about fiscal and tax issues. He served as chief editor of The Asahi Shimbun’s Economic News Section and deputy director of the Editorial Board.
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