by Adam S. Posen, Peterson Institute for International Economics
Published in the Nikkei Asian Review
May 29, 2014
© Nikkei Asian Review
The Bank of Japan's policies over the last 14 months are a welcome return to sanity. Mainstream economists inside and outside Japan had been asking the BOJ to stand up against deflation for nearly two decades.
Under Governor Haruhiko Kuroda's leadership, there are three important improvements that the BOJ has made to its monetary regime. It is not just about the specific targets and tools pursued—a new monetary regime is one that creates a larger set of expectations about policy that ripple through to price- and wage-setting decisions in the entire economy.
First, the BOJ has, over the past year, been buying long-duration government bonds, the right kind of assets to actually make a difference. Although the BOJ supposedly engaged in quantitative easing from 2003 to 2006, it really had little impact. Its effectiveness was limited primarily because the BOJ purchased short-duration government securities, things very similar to cash. The main impact of quantitative easing comes by getting investors to change their portfolios and move to riskier assets. The more you buy something that is unlike cash, the bigger the effect on private portfolios.
The second component of change between the old deflationary regime and the new reflationary one is the statement of a clear, positive inflation target. The announcement of an inflation target is the key both to making clear that the central bank cares about ending deflation and to anchoring expectations. I do not expect the BOJ to necessarily meet precisely the 2 percent consumer price inflation target (excluding fresh food) in April 2015. What matters is the bank will be at 1.5 percent inflation by the end of 2014 and very close to 2 percent by 2015. More importantly, inflation will be expected to stay at that level.
The third component, which is so important, is how the BOJ reacts to shocks. This sounds technical, but it is very straightforward and is the basis of how you define your monetary regime. Under the old, counterproductive BOJ regime, there was a belief held by many BOJ officials that inflation or asset-price bubbles would re-emerge very quickly. As a result, any time the economy showed signs of significant revival, the BOJ would be there to say it would not accommodate that risky expansion. This meant there was always a risk the BOJ would raise rates and hurt bond markets as they did in 2000, and the fear persisted, even when the inflation forecast gave no reason to raise rates.
This new regime of accommodating positive price shocks, at least under the current circumstances, is an extremely powerful shift. Look at what happened with the exchange rate. The yen has depreciated by 30 percent from the announcement of the new Shinzo Abe government in January 2013 through the present. This has already had an effect on prices and wages.
This effect, however, only was as large as it was because people knew the BOJ, at present, will allow the exchange-rate impact to pass through to the economy rather than trying to offset it. This can be seen in all the market projections a year or more ago that Japan's currency would have to move an even larger amount just to generate a fraction of the inflation we have already seen.
Better Late than Never
Under the old regime, because everyone knew the BOJ would not allow inflation to any extent, when yen depreciation did occur, its impact on the economy was very small. This shows how powerful the regime shift has been: that the inflation pass-through of exchange-rate movements is now up to 10 times larger than people estimated, based on the recent past.
The BOJ has already begun to see the full impact of its regime shift in various measures of inflation expectations. There is no one true measure of inflation expectations for Japan or any other major economy. But the BOJ is right in both its policymaking and communications to emphasize several measures—some from surveys; some from markets, such as inflation indexed bonds; and some from forecasts.
This brings the BOJ back in line with standard central banking practice, a move that is 20 years overdue. We will only know the BOJ has truly succeeded when price inflation averages 2 percent over a multiyear period. It is, however, well on its way to that useful goal.