Bank of Japan's Inflation Avoidance

Macquarie Securities Japan chief Richard Jerram says the BOJ shouldn't be so hasty about pulling the trigger on an interest rate hike

Inspired by Japan, some of the best minds in economics have looked at the question of deflation in recent years and have come to two conclusions. The first: There are various measures financial authorities can take to pull an economy out of the sort of corrosive slide in consumer prices that has hurt Japan over the past decade. The second: It makes sense to avoid succumbing to deflation in the first place. Countries should run monetary policy with enough of a cushion to prevent suffering from falling prices.

Japan has isolated itself from this discussion. Having fallen into deflation a decade ago, the Bank of Japan (BOJ) rejected the more-radical and imaginative solutions, apparently because the outcomes were unpredictable (unlike the predictable damage of deflation). Instead, from 2001, the central bank pushed short-term rates to zero and flooded the money markets with liquidity that no one wanted.

This was never likely to be effective, and it took an export boom, driven largely by China, to put the economy back on stable footing. Five years on, Japan is finally seeing small price increases.

Now the BOJ seems to reject the possibility of having a too-low inflation rate. In the 1980s, we were told that Japanese snow and intestines were different, as a justification for trade barriers to imported skis and beef. Now we are told that Japanese inflation is different, too.


 Most inflation-targeting central banks around the world aim for consumer price rises of around 2%. The reasoning is there are no particular merits to inflation of much less than 2%, but there are potential costs because of the risk of deflation. However, the BOJ's view is that price stability means inflation averaging just 1%. It is preparing to raise interest rates now, when it's running at 0.6%. And if you take out the effect of fuel prices, inflation amounts to just 0.1%. The central bank seems ready to raise rates for the first time since 2000 as early as July 14, at the end of a two-day BOJ policy board meeting.

The longest serving Federal Reserve governor, William McChesney Martin, famously said his job was to "take away the punch bowl just as the party gets going." In Japan, the BOJ is searching the guests for alcohol at the door and then serving them green tea.

This makes for perverse behavior after a decade when falling prices meant that real interest rates were too high, due to the inability to cut nominal interest rates below zero. This "liquidity trap" contributed to a decade of poor performance by the Japanese economy, but the BOJ is taking the risk of a recurrence.


 Excessive inflation tends to distort resource allocation across an economy and damage growth. Deflation benefits savers at the cost of borrowers. And excessively high real interest rates discourage investment. In defense of its position, the BOJ argues that moderate deflation would not be such a major problem despite historic evidence to the contrary.

BOJ officials are suggesting interest rates will rise only slowly, but that is not a great reassurance. Over the past year, they also suggested they would be in no hurry to end their excess liquidity policy, or to drain out the liquidity once that policy ended, but they ended up moving as quickly as they could.

Why does the BOJ feel so afraid of inflation? The most persuasive explanation: that the bank's officials are still suffering nightmares from the real estate bubble of the late 1980s, and fear a repeat. The current policy framework gives them the freedom to raise interest rates even when no inflation exists—if they believe that asset price increases are potentially destabilizing. No matter that land prices in major cities fell by three-quarters from the bubble peak and have since risen by just 4%.


 Moreover, the development of a market for real estate investment trusts, or REITs, should allow investors to see when returns on real estate threaten to go out of line with those on other assets, and thereby prevent a bubble. Contrast that with the Federal Reserve's view that it is impossible to judge when a bubble exists.

Despite its regrets about the late-1980s bubble, the BOJ appears to accept no responsibility for the damage to the economy from the persistent deflation of the past decade. Meanwhile, the politicians don't seem to care too much. We are seeing criticism of the BOJ, but this may be politicians shifting accountability, so if anything goes wrong over the coming year, they can escape the blame. Appointments to the BOJ board show that the government does not have a problem with its hawkish bias.

That is not to say the outlook for Japan appears particularly worrisome. One of the benefits of holding down the economy for such a long time is that when it bounces, it produces impressive growth for an unusually extended period. Japan is in the second year of a normalization of domestic activity that I think can run into the next decade.


 What is worrying is that the BOJ is unnecessarily increasing the downside risks. There are plenty of external candidates to deliver a shock to demand at the moment—the U.S. housing market, policy tightening in China, commodity prices, global epidemics—bringing the danger of temporary recession and return to deflation in Japan. In that light, prudent policy would argue for a pro-growth stand with a positive inflation bias.

The downside risks are all the greater because in the event that external factors turn bad, it's going to be very hard for the BOJ to admit it made a mistake. Self-preservation would probably lead the BOJ to hope for the best and enter a state of denial. As a result, any policy reversal would be delayed, with further costs to the economy. Even a return to zero interest rates would prove less effective the third time around.

In a world where central banks of most major economies are tightening policy, it is overly dramatic to lay the blame for financial market weakness at the door of the BOJ. Moreover, the conservative stance of the BOJ does not come as a great surprise, considering its behavior over the past decade. Nevertheless, there is the unnecessary risk of periods of renewed deflation in the future because of the decision to try to stabilize the inflation rate at such a low level.