Priorities for the Japanese Economy in 2016 (January 2016)

Would Achieving the Government's Inflation Target be Good for the Japanese Economy?

OKIMOTO Tatsuyoshi
Visiting Fellow, RIETI

House of Councillors election and economic policy

2016 almost certainly will be a crucial year for the Japanese economy. Politically, Japan will hold its House of Councillors election in July, and the United States will elect a new president in November. There is a strong possibility that large-scale economic policies will be undertaken with an eye on the House of Councillors election in particular, and these policies are likely to have a great impact on the Japanese economy. In fact, there was a recent report that a policy had been agreed to in principle for the government to provide special payments of 30,000 yen to approximately 12.5 million people, including low-income seniors. Additionally, it seems the discussion about reduced tax rates has finished its first stage and that the main points have been decided. Both policies aim to ease the tax burden on low-income people and support private consumption in the quest to promote the "dynamic engagement of all citizens." However, the first of the two policies--providing payments--is a short-term policy that is not likely to support long-term consumption. The second policy, which would lower taxes on food and beverages excluding alcohol and dining out, includes some high-end food, confectionary, and other luxury items, which, for the most part, low-income people are not likely consuming anyway. So we cannot deny the possibility that the benefit received by each low-income person will be less than that received by each high-income person. It is easy to imagine that narrowing down the scope of tax cuts under more practical standards would take time and money. However, if we reflect on the whole purpose behind implementing tax cuts, clearly everyday foods should be included in that scope. And it would be difficult to change the scope of tax cuts once they are decided, so I wish that the government undertook this discussion more carefully. In any case, new policies are supposed to be announced going forward based on the government's amended budget and the budget for the coming fiscal year. It is hoped that, instead of policies with only short-term effects on the Japanese economy, the government will announce and carry out policies to support employment and child rearing as well as fiscal reconstruction policies with a long-term point of view, in part to avoid the risk scenarios that I will describe below.

The Bank of Japan's inflation target, and our current status in relation to it

Another point deserving of attention in the Japanese economy in 2016 is whether the Bank of Japan (BOJ) can achieve its target of 2% inflation. Actually, at its Monetary Policy Meeting (MPM) on October 30, 2015, the BOJ moved back its forecast of when the 2% inflation target would be achieved, from "around the first half of FY2016" to "around the second half of FY2016." Strictly speaking, therefore, the BOJ is not necessarily aiming to get to 2% inflation in 2016. Nonetheless, it should become clear during 2016 whether Japan will achieve a 2% inflation rate in the second half of FY2016. Depending on whether it does, therefore, the BOJ may come under pressure to act, and that is the issue I would like to address here.

First, let's look at the current situation, touching on some of my recent research on the expected inflation rate. The expected inflation rate is the inflation rate expected over the long term. Since this cannot be observed, economists usually have to estimate it by substituting survey data or using models instead. I used a time series model based on the Phillips curve to estimate the expected inflation rate from data ranging through September 2015. The results suggest that the expected inflation rate has risen significantly since the BOJ clarified its aim of 2% inflation in January 2013. Specifically, up until about the end of 2012, the expected inflation rate had been estimated at a largely uniform level of about 0% for over a decade. When the inflation target was announced in 2013, the expected inflation rate rose to about 1%.

However, the results suggest that the drop-off in crude oil prices since the second half of 2014 pushed immediate inflation down by about 0.5%. Japan's core inflation index, which is defined as the consumer price index (CPI) exclusive of fresh foods, was close to 0%. Crude oil prices, of course, are not something that the BOJ can control. Therefore, the BOJ has recently also started emphasizing the core-core inflation index, defined as the CPI exclusive of both energy and fresh foods. Because falling oil prices have very little impact on core-core inflation, that index has recently trended higher than core inflation, but the estimated inflation rate is only about 0.6%, which is even lower than the core inflation index.

Estimates like these will vary depending on the model being used and include some estimation error, so they should not be completely trusted. However, even accounting for estimation error, it is nearly certain that the expected inflation rate will not reach 2% under the monetary policy in effect at the end of September 2015. Additionally, at its December MPM, the BOJ came up with supplementary measures for quantitative and qualitative monetary easing. However, these were merely supplementary measures and seem unlikely to have a major impact on current circumstances.

Possible scenarios going forward

Based on these results, there are two main scenarios we can think of in terms of achieving the BOJ's 2016 inflation target. The first scenario is that the BOJ will further move back its estimated date for achieving the inflation target. Low oil prices and stagnation in newly emerging economies such as China are the main drags on the immediate core inflation index. In addition to this, there is a possibility of low inflation worldwide in 2016 as a result of the interest rate hike by the United States Federal Reserve Bank. As these are all completely external factors to Japan, their consideration could impel the BOJ to further delay its estimate for achieving the inflation target. I believe that these circumstances are a justifiable reason for pushing back the target date. However, considering the fact that the original target was in the middle of FY2015, repeated postponements of that date could be a problem for the credibility of the BOJ.

The second scenario is that the BOJ will implement additional monetary easing as it tries to reach the 2% inflation target. However, it is doubtful that additional monetary easing by the BOJ will help Japan quickly attain it. Although BOJ Governor Haruhiko Kuroda claimed at a press conference that "There are no limits on the tools at our disposal," the BOJ already has a very large-scale monetary easing policy in place, so any additional monetary easing, in fact, will be very limited. Perhaps Governor Kuroda has some great new weapon ready, but even if that is the case, past experience ironically has proven it difficult to make any impact on the real economy, including prices of commodities.

Finally, although it seems a long shot, I would like to talk about a third possible scenario: oil prices and other aspects of the external environment improving and enabling Japan to meet its 2% inflation target. Oil prices have fallen sharply since the latter half of 2014. Specifically, the price fell by two-thirds in just a year and a half. Though it is hard to imagine prices returning to their earlier levels, geopolitical risks and other factors could still cause them to run up quickly. And while there are also uncertainties (i.e., the United States' push to raise interest rates), a strong U.S. economy and greater than expected recovery by newly emerging economies could still put the world economy on the right track. What would happen, then, if such improvements in the external environment caused Japan's inflation to hit the 2% target? Inevitably, the BOJ would have to look for an exit strategy from its massive monetary easing policy, but unless there is a structural reform of the Japanese economy, that will be an extremely challenging problem. Presently, the BOJ is purchasing Japanese government bonds at the rate of 80 trillion yen annually and buying exchange traded funds (ETF) at a pace of 3.3 trillion yen annually (counting the supplementary measures of December). It seems this has lightened Japan's fiscal burden and held up the stock market. So conversely, if the BOJ were to scale back its purchases of assets, there could be a large impact on the Japanese economy. There is an inherent risk of this leading to a spike in Japanese government bond interest rates and a precipitous fall in share prices. Thus, if we were to achieve the BOJ's target of 2% inflation without moving to support employment and child rearing as well as taking fiscal reconstruction measures, it would not be an exaggeration to say that reaching this goal in fact would put the Japanese economy in peril.


2016 will be a major milestone in Japan's monetary policy. As I noted above, the BOJ is very limited in what additional steps it can take, and even if it had more tools, it is very possible the effect on the Japanese economy would also be limited. Reaching the 2% inflation target and getting to our real goal of a sound Japanese economy will be hard to achieve with monetary policy alone. The quickest way to get to 2% inflation instead is what I described at the start of this paper: rather than short-term policies, announcing and carrying out policies to support employment and child rearing as well as fiscal reconstruction over the long term would ease the people's worries about the years ahead and help them have a bright future. On the other hand, if we do not do so, achieving our 2% inflation target ironically could put the Japanese economy at risk. To prevent that, it is my hope that in 2016, Abenomics 2.0 will be successful and that the government will announce and carry out policies to make the future brighter.

December 25, 2015

January 18, 2016

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