Japan's Central Bank Is Pressed to Boost Money Supply

The Bank of Japan may lose its independence if it doesn’t crank up the money supply
Photo illustration by 731; Samurai: Bridgeman Art Library(2); Architecture: Getty Images

Shinzo Abe and the Liberal Democratic Party swept back into power in mid-December by promising a high-octane mix of monetary and fiscal policies to pull Japan out of its two-decade run of economic misery. To get there, Prime Minister Abe is threatening a hostile takeover of the Bank of Japan, the nation’s central bank. The terms of surrender may go something like this: Unless the BOJ agrees to a 2 percent inflation target and expands its current government bond-buying operation, the ruling LDP might push a new central bank charter through the Japanese Diet. That charter would greatly diminish the BOJ’s independence to set monetary policy and allow the prime minister to sack its governor.

Central bankers the world over know what it’s like to feel the heat from political leaders in a bad economy. Republican presidential candidate and Texas Governor Rick Perry in 2011 called Federal Reserve Chairman Ben Bernanke’s ultra-loose monetary policies “treasonous.” What’s taking place in Tokyo right now is far more threatening than a verbal jab. Abe ran against BOJ Governor Masaaki Shirakawa’s economic record as much as he did against former Prime Minister Yoshihiko Noda. The tactic worked: Abe’s LDP-led coalition won a two-thirds majority in the Diet’s lower house. “The LDP’s landslide election victory gives it a virtually free hand in policy,” Robert Feldman, Morgan Stanley chief economist for Japan, wrote in a Dec. 17 note to clients. “The macro stance will shift to ‘print and spend.’ ”

The markets have started to account for the impact of a 2 percent annual inflation target for consumer prices. That would be a big jump in an economy as depressed as Japan’s, creating public expectations about price increases and, in theory, getting households spending and businesses investing. Abe also wants the BOJ to expand its quantitative easing program, an effort that involves printing money to purchase government bonds and other assets to give the government more leeway to spend. On the fiscal side, the LDP is considering a possible 10 trillion yen ($116 billion) spending package.

The superstrong yen, which crushed Japanese export earnings through most of 2012, started to weaken in December on expectations that the new monetary moves will hit the currency. Prices of Japanese government bonds (JGBs) are also falling, because of concerns that a new fiscal expansion will add to the country’s debt, the largest among rich economies and equal to about 220 percent of gross domestic product. On the flip side, 2012’s last day of trading saw the Nikkei 225 finish 23 percent higher for the year on the hope that Abenomics will deliver an adrenaline shot to profits.

The BOJ on Dec. 20 agreed to expand an existing program to buy government bonds and other financial assets for the third time in four months and reconsider its current inflation target of 1 percent. Yet Abe is likely to demand that Shirakawa, whose five-year term expires in April, sign an agreement with the government declaring the new inflation target, says Masaaki Kanno, a former BOJ official and chief economist at JPMorgan Securities Japan. To come close to hitting that mark will require “open-ended JGB purchases of, say, 5 trillion yen every month,” Kanno says, and would expand the BOJ’s balance sheet at a faster rate than that of the U.S. Federal Reserve. Even then, the monetary expansion must be coupled with fiscal measures to generate 2 percent inflation annually, he says.

In the past, the BOJ has bent to the political needs of the day. It was commandeered by Hideki Tojo’s government in the early 1940s to fund the war effort and kept interest rates low to help underwrite a bridge and highway spending bonanza in the early 1970s under Prime Minister Kakuei Tanaka. Loose credit conditions contributed to the late 1980s stock and real estate bubbles, while weak bank supervision set the stage for the 1990s bank crisis. In 1998 the BOJ won its independence under a new charter that freed it from government meddling. That same year Tokyo prosecutors uncovered a bribery scandal at the Finance Ministry implicating nearly 100 staff members: A top central bank official leading an in-house probe hanged himself, and then-Governor Yasuo Matsushita resigned in disgrace. The next governor, Masaru Hayami, raised interest rates in mid-2000, which contributed to a recession the following year. The Japanese economy is 7 percent smaller since the BOJ gained full control over monetary policy 15 years ago. “For Japan, central bank independence has turned out very detrimental to the economy,” says Koichi Hamada, a professor emeritus at Yale University who taught Shirakawa at the University of Tokyo in the 1970s.

Shirakawa warned in an early 2011 speech after Japan’s devastating earthquake that unrestrained central bank purchases of government debt, a process known as monetization, would lead to “a limitless expansion of currency issuance, spur sharp inflation, and yield a big blow to people’s lives.” His warnings have fallen on deaf ears. With Japan in its second recession since the quake, and deflation still a worry, “the market may be disappointed unless more aggressive policies are taken,” says Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management.

By some measures, the BOJ has been fairly aggressive. Since the start of a quantitative easing program in 2001, government bond purchases by the BOJ have swollen its balance sheet so much that it’s worth more than all the yen banknotes and coins in circulation. Under Shirakawa, the central bank is on track to buy the equivalent of all new Japanese government bonds issued this year.

Stoking inflation expectations is unprecedented for a central bank, says ex-BOJ official Kanno. “If they can do this, I think they’ll get the Nobel prize.” Abe is expected to choose a more dovish BOJ governor when Shirakawa departs in April. His successor might want to talk with Bernanke, who as a Princeton University economist in the 1990s criticized the BOJ for not lighting a fire under the economy. Mark Gertler, a New York University economics professor who co-authored a paper with Bernanke on central banking and asset bubbles, thinks the BOJ can stay independent if Japan pulls decisively out of its torpor. “The best way for a central bank to be independent is for things to go well,” he says.

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