Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target

Japanese Finance Minister Naoto Kan has recently exerted pressure
on the Bank of Japan (BOJ) to act more quickly to defeat deflation,
saying he wants the falling price trend to end this year. “Two or
three years is too long. If possible, I hope that the consumer price
index turns positive by the end of this year” Kan told a parliamentary
session.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. The finance minister also said that the BOJ may have to set an
inflation target aimed at dragging the economy out of grinding
deflation … a policy where a central bank declares a target for
inflation and guides actual price levels toward that goal through
monetary policy such as interest rate changes.
BOJ Governor Masaaki Shirakawa made it clear he had no intention
of taking such a step, and explained in detail why he considers it
inappropriate. “There is a mood to reconsider the use of the
framework of inflation targeting following the recent financial
crisis," Mr. Shirakawa said at a recent news conference.
“If a central bank concentrates only on achieving a short-term
price goal, that could have an adverse effect on sustainable economic
growth, which is the final goal of monetary policy”, Shirakawa said.
Moreover, “such a mechanism would reduce the BOJ’s flexibility
on policy”.
Inflation targeting has become a favoured policy among many
central banks worldwide, but since the start of Japan’s deflationary
era in 1999, the BOJ has stoutly resisted calls to set an inflation
target against which it can be judged, and by which it can be
embarrassed if it misses it.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. Instead it has relied on softer price guidance in determining policy.
Its inflation objective is defined in the loosest terms, as a rate
between zero and 2% for the core consumer price index, as one
that meets its “understanding of medium- to long-term price
stability”, with no time-frame to achieve it and no penalty for
failure.
Still, core consumer price index, which excludes volatile fresh food
prices, fell 1.3% on year in December, dropping for the 10th straight
month.
Shirakawa’s comments suggest the central bank will not embark
on any further easing for now to put a stop to deflation. However
the BOJ might be forced to loosen policy toward the middle of the
year if the domestic economy loses momentum from its recent
strong performance … recent data showed the economy grew at a
4.6% annualized pace in the final quarter of 2009.
And with a key upper house election coming up in the summer, at
which the ruling Democratic Party of Japan hopes to win a majority
in the chamber, political pressure on the BOJ to do more to improve
the economic picture could rise.

Can the introduction of inflation targeting under deflation and
zero interest rates contribute to the Japanese economic recovery?
Generally, inflation targeting has been increasingly viewed as a
good monetary policy framework and widely applauded by
economists and policymakers.
In the literature, there are benefits of inflation targeting for both
inflation and output behaviour.
Inflation targeting should stabilise the level of inflation, reduce its
variability and persistence, and also decrease the variability of
output.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. A recent study by Daniel Leigh, an economist at the IMF, shows
that had Japan introduced an inflation target in the 90’s its
economy’s performance would have substantially improved and
the BOJ would have avoided the zero lower bound on nominal
interest rates.
But the essence of the question is to what extent the introduction
of inflation targeting will enhance credibility of the BOJ’s reflation
policy in a deflationary phase and help economic recovery.
More importantly, whether or not the BOJ monetary policy is
credible enough for inflation expectations to be anchored to an
inflation target.
Takehiro Sato of Morgan Stanley says that, unlike the Federal
Reserve, which has won a high degree of respect for its handling
of monetary policy, Japan’s central bank is not yet trusted by
markets because of its past moves. “The BOJ’s policy track record
is bad.
A target for inflation helps to anchor future expectations of
monetary policy, but BOJ lacks credibility.
The mere announcement of an inflation target would not change
expectations”, he said.
Indeed, the introduction of inflation targets among advanced
countries tends to be accompanied by an institutional framework
that makes inflation targeting credible and accountable.
In several countries, including New Zealand and Australia, inflation
targeting is an agreement between the government and the central
bank, and both are committed to policy that is consistent with the
inflation target.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. In several countries, including New Zealand and the UK, when
inflation exceeds the target by a wide margin, the Governor is
required to provide an explanation to the parliament. With
accountability and commitment, inflation targeting does become
credible.

A central bank in a deflationary environment
is subject to a time-inconsistency problem: it
cannot credibly commit to “being
irresponsible” and so continue to shoot for
high inflation.

Furthermore, there is a concern that once the Japanese economy
has emerged from a deflationary spiral and starts to recover, the
central bank will be tempted to renege on its commitment to a
high inflation target, because it would like the economy to return
to an inflation rate consistent with price stability.
Thus a central bank in a deflationary environment is subject to a
time-inconsistency problem: it cannot credibly commit to “being
irresponsible” and so continue to shoot for high inflation.
The result of the time-inconsistency problem is that the markets
would not be convinced that inflation would remain high, and
inflation expectations would not be high enough to lower real rates
sufficiently to stimulate the economy out of the deflation trap.
To overcome deflation and restore economic activity Japanese
policymakers may not need to adopt an inflation target.
They could simply use unconventional instruments, such as
purchases of riskier assets and foreign assets, more aggressively
so to persuade the markets and the public that there will be higher
inflation.