Round 8: Responses to Criticisms of Inflation Targeting Policy

Inflation targeting is one measure within the scope of standard monetary policy adopted by many developed countries other than the U.S. and Japan. New Zealand, Canada, Britain, Sweden, Finland, Australia, Spain, South Korea, the Czech Republic, Hungary and many other countries participating in the European Monetary System (EMS) can all be described as countries adopting inflation targeting because the European Central Bank (ECB) holds such a policy. Meanwhile, in the case of the U.S., it is difficult to set an inflation target as a single policy goal because the Federal Reserve Board is essentially held responsible for both controlling inflation and maintaining stability in the employment situation.

In Japan, there has been incredibly strong opposition to inflation targeting. To seek better understanding of the policy, I, together with Gakushuin University Professor Kikuo Iwata and others, coauthored "Mazu Defure o Tomeyo (Stop Deflation First)" (published by Nihon Keizai Shimbun, Inc.), explaining the effectiveness of inflation targeting as a measure to overcome deflation. In the book, we also refer to the reflation policy adopted at the time of the Great Depression. I hope that the book will be of help to readers.

Criticisms of inflation targeting, voiced in Japan, can be broadly categorized into the following two types:

1. Inflation targeting is unable to overcome deflation, a sustained reduction in the prices of goods and services. <>

1. Deflation is being caused by cheap imports from China and other countries therfore cannot be solved by Japan acting alone. [Import-caused deflation] There is no transmission mechanism through which the effect of inflation
2. There is no transmission mechanism through which the effect of inflation targeting policy can be disseminated in the real economy. [No transmission mechanism]
3. There are no known records or examples of the implementation of inflation targeting policy. [No examples]

2. Inflation targeting will bring with it detrimental side effects. <>

4. Inflation may become uncontrollable and turn into hyperinflation. [Fear of hyperinflation]
5. Nominal long-term interest rates will go up and may impair the balance sheets of the Bank of Japan and private-sector financial institutions. [Rise in interest rates]
6. Fiscal discipline will be loosened. [Fiscal indiscipline]
7. Structural reform efforts may be hampered. [Impediment to reform]

What is characteristic of the ongoing criticism of inflation targeting is that contradictory assertions - encompassing both types described above - often come from the same critics. Some, who have been arguing that inflation targeting is ineffective, have suddenly begun to warn against the possibility of hyperinflation. Also, many of the above arguments do not make clear a distinction between nominal and real figures. Meanwhile, some of the arguments stem from the layperson's perspective that inflation is bad and cheaper prices are good. (At one time, some people talked about "good deflation," though such arguments have subsided lately.)

Opponents of inflation targeting are also prevalent amongst bond traders and other market players who are engaged in bond and interest rate trading. They are believed to be against inflation targeting because they anticipate such a policy will push up nominal long-term interest rates by boosting inflation expectation (Fisher effect), resulting in valuation losses on bond holdings.

My responses to each of the aforementioned criticisms are as follows:

a. Is Japan incapable of dealing with deflation on its own because deflation is caused by cheap imports from China and other countries? [Import-caused deflation]

OECD countries, in general, have been experiencing a steady rise in their imports from China as measured as a fraction of their gross domestic product (GDP), but Japan is the only country suffering from deflation.

Out of all the OECD countries, South Korea, New Zealand, the Czech Republic and Hungary have seen a steeper increase in their Chinese import-GDP ratios than that observed in Japan, but none of these countries are in deflation. More importantly, all of these countries are adopting inflation targeting.

Some people say that Hong Kong is in deflation. But Hong Kong has a currency board system, under which the Hong Kong dollar is directly pegged to the U.S. dollar at a fixed rate, effectively limiting the volume of Hong Kong dollars circulating to that available in foreign reserves. When an economic shock, such as the 1997 Asian currency crisis, hits a country or a region having such a foreign exchange policy, it will cause deflation, pushing down the relative prices of goods and services within the country or region. The reason why Hong Kong has been unable to resolve its deflation is because it has abandoned its own monetary policy by adopting the currency board system.

All these facts suggest that imports from China are not responsible for Japan's ongoing deflation and that, even if they are, Japan should be able to solve that problem by adopting an inflation targeting policy.

b. Is there no transmission mechanism? [No transmission mechanism]

The relationship between the price of goods and money is quite simple. When there are more goods in the market, their prices fall. On the other hand, when there is more money, the value of money decreases (and the price of goods go up). This is what is known as Walras' Law, which sets out a theory that monetary and non-monetary sectors - when looked as a whole - are in equilibrium and that if there is an excess supply in the monetary sector there must be a matching excess demand in the non-monetary sector (such as for consumer goods, assets and labor). Based on this mechanism, an excessive supply in the monetary sector generates seigniorage in the broadly defined government sector (the government and the BOJ), which in turn generates an excessive demand in the non-monetary sector. In other words, when the government and the BOJ (the broadly defined government sector) issue currency, they generate seigniorage equivalent to the outstanding amount of currency in circulation and such revenue, from the coinage of money, will create effective demand, thereby increasing the price of goods.

There are various methods to calculate the GDP gap. But let us imagine it is between 5 and 6 percent, then, a net issuance of some ¥30 trillion in currency will suffice. More specifically, in schemes referred to as money-financed transfer, the government may print more yen notes, the Japanese national currency, to expand fiscal expenditure, or it may issue government bonds - with the central bank buying the equivalent amount of government bonds from the market - to finance fiscal expenditure and/or tax cuts, or to alleviate the burden of social insurance premiums. In practice, the issuance of currency by the broadly defined government is carried out at the same time as implementation of government measures such as fiscal expenditure, tax cuts and reductions in social insurance premiums. Therefore, there is not much point in drawing a line between monetary and fiscal policies when looked at in the scope of broadly defined government. (A policy accord between the government in a strict sense and the BOJ would provide means to put the "government" in that broader scope.)

c. Are there no examples? [No examples]

It is not true that there are no examples for the implementation of inflation targeting. Sweden used to implement inflation targeting in the past, while New Zealand and Canada use it as a measure to cope with temporary falls in prices today. The cases of Sweden and New Zealand are introduced in explanatory material(Japanese only, PDF: 198KB), which was submitted to the Cabinet in January along with the government's Monthly Economic Report.

These countries, thanks to the implementation of an inflation targeting policy, avoided falling into deflation.

d. Will inflation be uncontrollable and turn into hyperinflation? [Fear of hyperinflation]

Contrary to the arguments described in a., this criticism in d. is based on the idea that inflation may eventually turn into hyperinflation. To begin with, it should be noted that hyperinflation is normally defined as inflation that exceeds 13,000 percent per year, a very extreme situation that would be destructive to any country. However, the inflation target proposed by those advocating for the scheme is 3 percent or so and thus it is hard to imagine a situation in which the inflation rate would constantly surpass the 3 percent level. Still, in the event that Japan suffers such a problem, the central bank could shift its policy and tighten its monetary grip. In fact, not a single country among those adopting inflation targeting has slid into hyperinflation during the past 10 years. Furthermore, by utilizing information concerning "expected inflation" derived from index-linked Japanese government bonds (JGBs), a sort of "price feature", the monetary authorities will be able to catch signs of inflation at an earlier stage and implement monetary policy based on a more accurate anticipation of future events. (Index-linked JGBs, whose principal amount moves up and down in line with changes in the inflation rate, have not been issued in Japan but the government plans to issue such bonds beginning fiscal 2003.)

e. Will nominal interest rates rise and damage the balance sheets of the BOJ and private-sector financial institutions? [Rise in interest rates]

Some critics say that inflation expectation will push up nominal interest rates. Indeed, according to the Fisher equation (Nominal interest rate = Real interest rate + Expected inflation rate), a rise in expected inflation rate brings an equivalent rise in nominal interest rates. However, this equation is based on the premise of full employment and therefore it is unlikely that the Fisher effect will occur anytime soon amid the ongoing deflation of Japan. In a liquidity trap, where preference of cash over other types of assets is extremely strong, the market is flooded with money. And even if some inflationary expectations begin to emerge, the most likely result is that part of the overflowing money will be invested in bonds thereby supporting bond prices and suppressing a rise in interest rates.

This view is corroborated by the results of some empirical studies which found asymmetries in the Fisher effect between economies in recovery and decline. No rises in nominal interest rates were observed in either the U.S. or Japan during the Great Depression of the 1930s. (See charts.)

Of course, the possibility of a temporary rise cannot be totally ruled out, that is, if market players believe that nominal interest rates will go up without good reason. Yet, given the massive amount of cash hoarded away, any rise in nominal interest rates would be quickly corrected. At the same time, however, it must be remembered that nominal long-term interest rates will eventually move upward in line with economic revival.

Some critics are concerned that the balance sheet of the BOJ may be impaired. However, the BOJ, though independent, is part of the government when broadly defined and thus does not have to worry about its balance sheets in the same way as private-sector banks do. For the BOJ to fail to implement appropriate monetary policy measures out of concern for potential damage to its balance sheet, would be to fail to see the wood for the trees.

f. Will fiscal discipline be loosened? [Fiscal indiscipline]

European countries, including those adopting inflation targeting, generally maintain stricter fiscal discipline than Japan because they have well-established budget rules to control fiscal deficits and the amount of outstanding debt. Cross national studies point to the absence of such established budget rules and the weak authority of the finance minister as problems for Japan's budget system. Concerns over fiscal indiscipline can and should be dealt with by creating budget rules, a common practice among other developed countries.

Some critics contend that reduction of government debts must be the true purpose of those advocating inflation targeting. But an annual inflation rate of between 1 and 3 percent would effectively make no contribution to the reduction of government debt.

Certainly, incentives do exist for the government to take expansionary fiscal measures financed by currency issuance at a time of deflation and such measures are rational as a means to solve deflation. However, whilst people identify inflation bias in government policy, there is a danger that such policy will produce inflation without a corresponding increase in GDP. Inflation targeting can help curb inflation bias by setting binding rules for government policy.

g. Will structural reform efforts be hampered? [Impediment to reform]

Some of those who oppose to inflation targeting insist that the government, instead of pursuing inflation targeting, should take more steps to accelerate the disposal of loans and proceed more vigorously with regulatory reforms and the privatization of special administrative corporations.

But inflation targeting is not an alternative to these policies. The government can pursue and implement inflation targeting at the same tine as other policies. I have testified before court that managers of financial institutions would be violating the Commercial Code if they fail to properly report accounting losses associated with the disposal of bad loans, regardless of the state of economy. Neither do I have any objection to privatizing special administrative corporations and promoting regulatory reform.

Other critics say that continuation of the zero interest rate policy slows the progress of structural reforms. But under the ongoing deflation, a nominal interest rate of zero translates into a substantial interest rate in real terms, which is being imposed equally on all economic entities. Therefore, the transfer of resources from stagnant industries to growth industries, as called for in structural reform, is not hampered.