The BOJ Should Provide Long-term Inflation Projections to Show Unwavering Commitment to Fight Deflation
Faculty Fellow, RIETI
In a bid to counter the global financial crisis that began in September 2008, U.S. and European central banks introduced a series of unconventional monetary policy tools, which drastically expanded their balance sheets (assets and liabilities). In doing so, they focused strongly on a level around 2% as the desirable inflation rate and have generated intended results. In contrast, the Bank of Japan (BOJ) shied away from expanding its balance sheet and, as it turns out, Japan has yet to find a way out of its deflation.
Since the 1990s, many central banks have adopted inflation targeting, a policy framework in which a central bank announces its target inflation rate toward which it attempts to guide actual inflation. Among central banks in advanced economies, the BOJ, the European Central Bank (ECB), and the U.S. Federal Reserve have refrained from officially adopting inflation targeting. However, even though they did not use the term "target," they have referred to specific - and almost identical - figures as the "desirable" inflation rate range, which is "below, but close to, 2%" according to the ECB and "1.5 to 2%" according to the Federal Reserve. Meanwhile, in its statement "Clarification of the 'Understanding of Medium- to Long-Term Price Stability'" issued in December 2009, the BOJ said that the "medium- to long-term price stability" is understood as a situation in which a year-on-year change in the consumer price index (CPI) is "in the range approximately between zero and 2%, with most Policy Board members' median figures at around 1%."
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Critics say that the global financial crisis revealed the limitations of inflation targeting. Their reasoning is that the U.S. and European central banks - those indicating and pursuing the desirable inflation rates - had been so complacent with the steady pace of CPI change that they were taken off guard and failed to contain bubbles in the financial markets.
However, those espousing this argument are asking too much, expecting monetary policy to achieve too many goals with one instrument, the policy interest rate. Meanwhile, inflation-targeting central banks use two target variables - the inflation rate and the output gap (or the unemployment rate) - for their monetary policy. Pursuing two goals with just one instrument is difficult enough because of an inevitable trade-off between the two goals. And using the policy interest rate to achieve yet another goal, stability in the financial system, can easily lead to a situation where none of the goals can be achieved. Other policies and instruments - not just an interest rate policy - are needed to restore and ensure stability in the financial markets.
For instance, financial supervisory authorities should be given power to set bank capital requirements, implement appropriate loan-to-value (LTV) ratio rules, and/or restrict banks from having imprudently large exposure to a specific industrial sector, as appropriate, in response to increased risks (e.g. rapid expansion of bank credit, soaring stock and land prices). Furthermore, they should be empowered to intervene in the event of a looming systemic crisis. For instance, should a major bank - whose failure could trigger a systemic failure of the financial market - become severely undercapitalized, the financial supervisors should be able to temporarily nationalize the bank and proceed to liquidate, or sell the bank of its assets, in a way not to stir up fear over possible systemic contagion, letting the bank continue to operate all the while. The primary cause of the global financial crisis of 2008 was regulatory failure on the part of financial supervisors in the United States and many countries in Europe.
The global financial crisis sent the U.S. and European economies into the tailspin and pre-crisis inflation concerns were quickly replaced by concerns over deflation. In its quarterly Inflation Report published in November 2008, the Bank of England (BOE) projected inflation two years ahead to be 1%, 1 percentage point below the central target rate.
In March 2009, the BOE decided to introduce quantitative easing and started purchasing government bonds and other assets in the market. In May 2009, the BOE expanded the scale of quantitative easing and its projected inflation rate moved closer to the 2% target subject to the assumption that the stock of purchased assets would increase to 125 billion pounds. The projected inflation rate reached 2% in August and November on the assumption of a further increase in asset purchases to 175 billion pounds and 200 billion pounds respectively. Through such combined use of quantitative easing and inflation projections, the BOE has been maneuvering monetary policy in a way to fend off the risk of deflationary expectation. These quantitative easing steps expanded the BOE's balance sheet by threefold in a very short period of time.
In the U.S., the Federal Reserve took the unusual step of directly purchasing private-sector securities in the market, which had been virtually without buyers, under its version of quantitative easing known as "credit easing." Furthermore, the Federal Reserve set up and extended credit to special entities to manage toxic assets it assumed from Bear Sterns Co., Inc. and American International Group (AIG). As a result of these programs, the Federal Reserve's balance sheet expanded 2.5-fold from the size prior to the crisis. In a similar move, the ECB purchased covered bonds, a type of secured corporate bond, in the market, expanding the size of its balance sheet by 50%. The BOJ, however, did not take any step that would result in the expansion of its balance sheet ( chart ).
Sources: Respective central banks
The Federal Open Market Committee (FOMC) releases its members' projections of inflation on a biannual basis. In its report presented in July 2008, shortly before the collapse of Lehman Brothers and when the U.S. inflation rate was above 3%, FOMC members projected that inflation would settle approximately in the range of 1.5 to 2% two years ahead. However, in the next report released in February 2009 after the Lehman shock, FOMC members significantly marked down their projections, with the lower bound of the projected inflation rates two years ahead falling to 0.2%. They also suggested the need for additional credit easing steps. Indeed, the situation was such that the U.S. economy could have fallen into deflation if hit by a further shock.
In the February 2009 report, the FOMC for the first time provided long-run economic projections for inflation 1.5 to 2.0%, in addition to those for the next two years,. Long-run projections, defined as representing the "rate to which each variable would be expected to converge over time under appropriate monetary policy and in the absence of further shocks," can be approximately interpreted as equivalent to a target range set under inflation targeting. That is, the U.S. Federal Reserve adopted de facto inflation targeting, joining those central banks already pursuing such policy. Deflation concern is what prompted the Federal Reserve and the FOMC has continued to publish long-term projections in its subsequent biannual reports.
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Like the FOMC, the BOJ Policy Board releases its members' economic projections in "Outlook for Economic Activity and Prices," known as the "Outlook Report," published twice a year. As of October 2009, inflation projections for fiscal 2011 ranged from minus 0.3% to minus 1%, respectively representing the most optimistic and pessimistic of the assessments made by the BOJ Policy Board members. That is, all the Policy Board members believed that it would be impossible to end deflation in two years' time. Yet, they did not formulate long-term projections, such as those provided by their U.S. counterparts. Was it the case that they had given up on bringing inflation back to the positive territory?
The BOJ seems to have subsequently become more enthusiastic about fighting deflation, issuing the aforementioned statement, "Clarification of the 'Understanding of Medium- to Long-Term Price Stability,'" in December 2009. In an interim assessment in January 2010, Policy Board members upwardly revised their inflation projections for 2011, concurring that price trends in the forthcoming years would be less deflationary than they had expected in October 2009. Still, more needs to be done. The BOJ may find it impossible to bring itself to clearly declare the adoption of inflation targeting. But even so, it could at least provide long-run projections in its Outlook Report as the Federal Reserve has done in the FOMC report.
A variety of prescriptions have been proposed to pull Japan out of its persistent deflation. Many of these suggest that even under a zero interest regime, the BOJ could turn to nontraditional policy tools, i.e. those other than interest rate policy, to stimulate the economy. However, setting the lower bound of the target inflation range in normal time somewhat higher - at 1.5% or above - would reduce the risk of interest rates falling to zero in the first place.
In February, Olivier Blanchard, chief economist at the International Monetary Fund (IMF), suggested that central bankers may consider setting their normal-time inflation target higher, for instance, around 4% to leave more room for maneuvering in times of emergency. His idea, which has provoked a big controversy, is that at a 4% inflation rate as a target, there would be very little risk of running into the zero interest rate constraint. Many central bankers remained opposed to his proposal. They say that while a global financial crisis, such as the one triggered by the Lehman collapse, is a rare event, 4% inflation would be too costly and having such a high inflation target would easily lead to a hyper inflation spiral.
However, Blanchard's argument should not be turned down simply as being too extreme. Instead, it should be looked at from the viewpoint of what lessens can be derived from the recent global financial crisis, which is the main theme of his argument. One important lesson, as I see it, is that inflation targeting did not lose any of its viability in the global financial crisis, or rather the crisis served as an occasion to confirm its importance.
* Translated by RIETI.
April 15, 2010 Nihon Keizai Shimbun
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