The Bank of Japan (BOJ) will achieve its target of a 2% year-on-year increase in consumer prices (excluding fresh food) within about two years. Launched in April 2013 with this target, the BOJ's quantitative and qualitative easing (QQE) policy has turned out to be a failure. The latest monthly figures show that Japan's core consumer price index (CPI), which excludes fresh food prices, fell by 0.4% from a year earlier. The year-on-year drop is deeper than those in the final months of former BOJ Governor Masaaki Shirakawa's term.
Given these developments, the BOJ's Policy Board decided on November 1, 2016 to push back the deadline for achieving 2% inflation from "within FY2017" to "around FY2018," marking the fifth postponement in the past three and half years (Figure). With this, the BOJ effectively admitted that it is unable to achieve its target under Governor Haruhiko Kuroda whose term is to end in April 2018, i.e., after working toward it for five years.
The BOJ has purchased 250 trillion yen worth of Japanese government bonds (JGBs) and increased the current account balance to 300 trillion yen. Despite all of this, why have prices failed to rise? In this article, I would like to consider this question by focusing on expectations, a factor that supposedly plays an important role for the success of quantitative easing in a zero-interest rate environment.
The theme of Kuroda's speech delivered on August 27, 2016 in the United States was "Re-anchoring Inflation Expectations via Quantitative and Qualitative Monetary Easing with a Negative Interest Rate." Even today, he is referring to inflation expectations as a key element of monetary policy.
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In an economy in a normal state, monetary policy is merely interest rate policy. Then, how can we ensure the effectiveness of monetary policy when interest rates are essentially zero? While nominal interest rates have a lower bound, real interest rates are what affect the behavior of businesses and households. "Decreasing real interest rates" is the starting point of the transmission mechanism of Kuroda's monetary easing policy, according to the official view of the BOJ. Real interest rate is nominal interest rate net of the expected rate of inflation. Therefore, even in the case where nominal interest rates cannot move downward, real interest rates can do so if inflation expectations rise.
Inflation expectations are expectations for changes in the general price level. Thus, by necessity, how the general price level is determined is the biggest question. Reflationists believe that an increase in the amount of money in circulation will definitely push up the general price level. Underlying this belief is the quantity theory of money (QTM). According to this theory, deflation is a phenomenon attributable an insufficient supply of money. Indeed, increasing money supply is the only policy option available to stem deflation.
The logic of the QTM is more robust than reflationists claim. The BOJ's "Comprehensive Assessment," released on September 21, 2016, cites a steep fall in crude oil prices since summer 2014 as one of the major reasons why the general price level has failed to rise, contradicting the initial expectations (in April 2013). However, Milton Friedman, a U.S. economist and leading exponent of the modern QTM, emphasized that the general price level is not subject to the influence of crude oil prices and determined by the quantity of money.
The BOJ also said that its monetary policy has failed to deliver its intended effects because of the prolonged deflation and the resulting fall in the potential growth rate. However, this view also contradicts the QTM, which states that the general price level is determined by the quantity of money, not by real economic growth.
Under the classical QTM, the relationship between the quantity of money and the general price level was a black box and expectations had no special role to play. It is only with the rise of a new breed of macroeconomics over the past 30 years that the term "expectations" has come into vogue. A new macroeconomic theory, upon which reflationists base their arguments, posits that a significant increase in the money supply by the central bank results in a rise in the expected rate of inflation and hence an increase in the general price level. This is the message of the new breed of macroeconomics, which has now become the global standard.
The question is whether this macroeconomic model properly reflects real-world economies. In an economy assumed in a theoretical model, there is just one "representative consumer" who believes in the QTM. My view is that a mainstream macroeconomic model does not properly reflect the reality of real-world economies.
To be sure, some people point out that inflation expectations have been on the rise since the introduction of the QQE policy in April 2013. The BOJ often refers to statistics on inflation expectations. However, such statistical figures do not provide a meaningful picture of inflation expectations, because it is the expectations of individual businesses and households regarding the future interest rate that count in the context of the BOJ's monetary policy goal.
While the difference in returns on inflation-indexed and nominal government bonds, i.e., the risk premium, is one measure of inflation expectations, those are no more than agreed-upon expectations among financial market players trading inflation-indexed bonds. It is an offspring of a Keynesian beauty contest.
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To begin with, in considering the general price level, we must first make a clear distinction between market-oriented commodities, such as crude oil, and a broad range of goods and services that constitute the CPI. Prices for those in the former group—i.e., primary commodities including agricultural produce and crude oil—are determined by the international market at a level where supply equals demand. For many of those commodities, there is a futures market where expectations play a significant role.
However, things are completely different for manufactured goods and services. Producers set prices for their goods and services, and the cost of production is the top of their concerns.
At the same time, however, they need to set prices that are acceptable to those on the demand side, namely, companies and individual consumers. A bakery would lose its customers if it raises prices without due consideration and customers finding the higher prices unreasonable. In contrast, the cost of production is observable and convincing for both buyers and sellers. In such a micro-level price setting process, the QTM has no role to play. No buyers would raise the prices of coffee or steel plates because of an expected rise in the general price level in the future.
The cost of production is composed of the costs of labor and raw materials (including the costs of energy consumed as well as consumable supplies used for manufacturing finished products). Yen-denominated prices of imported raw materials are subject to changes depending on the international prices of primary commodities (denominated in U.S. dollars) and the yen-dollar exchange rate. A decline in crude oil prices and an appreciation of the yen cause domestic prices to fall, whereas a rise in crude oil prices and a depreciation of the yen work to push up domestic prices.
Thus, lower crude oil prices surely has the effect of bringing down the general price level. However, no other advanced economies have fallen into deflation. As a variable that holds the key to explaining Japan's deflation, I am focusing on changes in nominal wages, a factor that have a significant impact on the cost of production. The reason why advanced economies were spared the experience of deflation in the period following the end of World War II is that, unlike in the prewar period, nominal wages did not fall in the postwar period. In other words, the downward rigidity of nominal wages served as an anchor against deflation. However, in Japan, the anchor has been lost from the late 1990s through the 2000s.
Expectations have no significant role to play in the process of wage setting, either. The term "expectations" here refers to people's expectations about future events, such as an increase in the general price level. It is impossible for two economic agents—be it a buyer and a seller, or a company and a labor union—to agree on future events. Past and present events are what matters when these two agents decide price or wages. In this regard, the real-world economy is intrinsically different from financial and asset markets, where players are always looking to the future.
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The experiment, carried out over the past three and half years since April 2013, has shown that deflation is not a monetary phenomenon. Although some people say that the QQE was successful in the first year, it is questionable whether such is the case. A closer look at the CPI reveals that prices rose in the first year of the QQE not only in "energy" but also "fuel, light and water charges," and the impact of increased utility costs is observed in a broad range of "services."
The main factor behind the changes in the general price level was not the quantity of money but oil prices. Expectations played no role at all in determining the general price level in the past three and half years and will never play a significant role in the future.
* Translated by RIETI.
November 29, 2016 Nihon Keizai Shimbun
