How Far Have We Come in the Fight against Deflation? Credit squeeze risk has all but vanished

Faculty Fellow, RIETI

The consumer price index (overall CPI excluding perishables) in October 2017 recorded an 8% year-on-year growth. If deflation is defined as a continuous price decline, the deflation that has been cited as the root cause of Japan's economic stagnation over the past 20 years or so is coming to a close. In addition to external factors such as the global economic recovery since the financial crisis in 2008, a series of monetary easing measures under the Abenomics policy of the Shinzo Abe administration and the ensuing weakness of the yen are contributing to the fight against deflation.

Abenomics, whose goal is overcoming deflation, is succeeding in terms of arresting the price downtrend. On the other hand, the CPI growth still remains lower than the inflation target of 2% adopted by the Bank of Japan (BOJ), thus there exist lingering doubts as to whether Japan has yet to fully overcome deflation. As the BOJ assumes that the CPI growth is likely to reach approximately 2% around FY2019, the central bank has announced its intention to continue expanding the monetary base (money supply) until then.

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Why is deflation considered to be an evil that must be overcome in the first place? Deflation negatively affects the real economy because there is a floor below which the nominal interest rate cannot fall. As a result of the negative interest rate policy implemented by the BOJ and the European Central Bank, it has become clear that the floor is around -0.5% to -1%. However, lowering interest rates deep into the minus column would have the unintended effect of making financial institutions cautious about lending by undermining their profitability.

In any case, the existence of a floor for nominal interest rates means that real interest rates (the nominal interest rate minus the expected inflation rate) remain high when deflation occurs. This leads to a stronger yen in the exchange market, thereby shrinking exports and capital investment. Furthermore, if the weakness of overall demand spreads to land and other asset prices, a credit crunch will occur.

This situation could trigger a deflationary spiral, which was once a focus of concern. Therefore, preventing deflation from negatively affecting overall demand is the primary goal of the fight against deflation. As for the current status of the Japanese economy, the supply-demand gap has almost been eliminated, and the drop in land prices is coming to a halt. We may conclude that these risks have all but disappeared.

Then, why has the inflation target been set at 2%, rather than zero? One possible explanation is a somewhat passive reason—that if the BOJ alone aims for an inflation rate lower than 2% at a time when other major central banks have adopted an inflation rate of around 2% as a target or a long-term goal, the yen could appreciate.

There is also a more positive reason—that the BOJ is aiming to create room for implementing interest rate cuts in the event of a future recession by guiding the expected inflation rate to a relatively higher level when the economic conditions are favorable so that nominal interest rates can be kept at a sufficiently high level. If the expected inflation rate and nominal interest rates both stay at around zero, there will be no room for interest rate reduction when the natural interest rate (the real interest rate at which supply matches demand) falls below zero. This equates to a risk of falling back into deflation.

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There are two problems with the BOJ's inflation targeting. One is whether the inflation rate of 2% is a feasible target, and the other is the possibility that unintended negative effects and other risks involved in the policy of aiming for the inflation target of 2% may be too great relative to the benefits expected from the policy. As for the former, we must keep in mind that the inflation rate has been trending somewhat lower in many countries around the world since the global financial crisis (see Figure below).

Figure: Inflation Rates in Japan, United States, and Europe
Figure: Inflation Rates in Japan, United States, and Europe
Note: The price indicator used is the consumer price index excluding perishables in the case of Japan, the personal consumption expenditure price index (PCEPI) in the case of the United States, and the Harmonized Index of Consumer Prices in the case of the euro area. From the FY2014 figure for Japan, the impact of the consumption tax rate hike, estimated at 2%, was deducted.

Even in the United States, where the unemployment rate has fallen to around 4% amid the favorable economic conditions, the inflation rate has remained lower than 2%. Improvement in the employment situation and a rise in the capacity utilization rate are no longer easily reflected in inflation. That may be in part a consequence of the process of creative destruction, in which technological innovation destroys the value of existing products and business models.

Achieving the inflation target of 2% in Japan is expected to be very difficult or will take much longer given that the country has scarcely experienced general price growth over the past 20 years and more.

Specifically what unintended side effects and risks are involved in continuing the monetary easing policy with the aim of achieving the inflation target of 2%?

First, if the yen remains weak due to the monetary easing, exporting firms' earnings improve, but the terms of trade (export prices/import prices) deteriorate due to a rise in import prices. As the deterioration of the terms of trade leads to a fall in the people's purchasing power, or real income, consumption could be dampened depending on the crude oil price trend.

Moreover, the longer the monetary easing policy is maintained, the more violently the foreign exchange rate and asset prices could react when the time for an exit approaches. This risk increases uncertainty over the business environment and undermines the soundness of financial institutions. As the return on real estate investment in rural areas has started to decline, local financial institutions which have devoted resources to real estate loans must keep a careful watch.

Monetary easing also causes fiscal discipline to weaken. The argument that now is the time to increase government expenditure for infrastructure development and other items as interest rates remain low may appear to be rational from a short-term perspective. However, if government expenditure is increased now, it will be politically difficult to cut it back when interest rates rise in the future. The postponement of the goal of achieving a primary budget surplus by FY2020 means that this risk is becoming a reality.

Should Japan assume that it is only halfway through the fight against deflation and continue to strictly pursue the inflation target of 2%? Or should it conclude that deflation has been overcome and roll back the monetary easing? After all, the decision depends on whether emphasis should be placed on the benefits or risks from continuing with the monetary easing.

I place emphasis on risks. It will be more desirable if Japan retains the inflation target of 2% in order to avoid causing violent shocks to the foreign exchange market but recalibrates it as a long-term goal so that the monetary policy can be flexibly adjusted in accordance with the supply-demand gap and employment situations.

The BOJ's announcement in 2013 of a strict commitment to an inflation target of 2% as the first step of its qualitative and quantitative monetary easing was originally intended to strongly encourage the Japanese people to expect higher inflation. However, the target, which the BOJ initially aimed to achieve within two years, has not yet been attained in four and a half years. This means that the inflation target has outlived its original usefulness.

In September 2016, the BOJ introduced a yield curve control (control of short- and long-term interest rates), and this measure in effect means that the central bank has slowed down the pace of the expansion of assets on its balance sheet. It is high time for us to discuss the necessary sequence of exit strategy measures, from further slowing down the pace of the asset expansion and fixing the asset size to raising interest rates and shrinking the asset size. The discussion should also cover how to share losses expected to be suffered by the BOJ due to a future interest rate rise. The BOJ must engage in careful dialogue with the market with respect to the exit strategy.

Meanwhile, as the inflation rate remains less than 1%, it is important to raise the overall economic productivity in order to prevent the natural interest rate from slipping into the minus column. Although the government's "productivity revolution" initiative is a step in the right direction, there is still room for further consideration with respect to its specifics.

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First, the government is not sufficiently eager to reform labor market regulation so that workers can switch companies smoothly..

Second, setting a numerical target for capital investment may cause problems. By FY2020, the government aims to increase the capital investment amount by 10% compared with the FY2016 level. However, setting such target could foster disregard for investment in intangible assets, including brands, technical knowledge, software, and human resource development, which form the foundation of companies' main growth engine..

According to my joint study (RIETI) with Toyo University Professor Miho Takizawa and Hitotsubashi University Associate Professor Daisuke Miyakawa, one motivation for companies to hold liquid assets (e.g., cash, deposits, etc.) is securing funds for future investment in intangible assets. A policy attempt to reduce the holding of liquid assets could hinder investment in intangible assets and, by extension, companies' productivity improvement..

Third, increasing transparency and predictability concerning economic policy will also contribute to productivity improvement. According to my joint study (RIETI) with Professor Takizawa and Keio University Associate Professor Kenta Yamanouchi, which used micro data concerning Japanese companies, if uncertainty grows, overall economic productivity will decrease compared with the potential productivity of the Japanese economy because highly productive companies become cautious about making investment..

The government should renew its commitment to the fiscal consolidation target, while the BOJ should change its monetary policy approach that relies on surprise announcements and deepen dialogue with the market.

>> Original text in Japanese

* Translated by RIETI.

December 20, 2017 Nihon Keizai Shimbun

April 5, 2018