BOJ Deploys U.S. World War II Tactics That Failed to Spur Pricesby
Targeting long-term yields on its own didn’t work, study shows
Only with a fiscal ramp-up did sustained inflation emerge
In deciding to target bond yields, Japan is deploying a monetary strategy to combat deflation used by its former enemy in World War II. The trouble is that America’s experience back then suggests that the tactics probably won’t work on their own.
Economists who have studied that period say that it was increased government spending, along with heightened inflation expectations, that eventually led to a stepped-up pace of U.S. price increases more than a half century ago.
Once inflation was humming along, the Federal Reserve’s strategy of pegging long-term interest rates did nothing to put a lid on it, which is why the central bank pushed for a 1951 agreement with the Treasury to abandon the long-term yield fix.
If inflation expectations are contained, simply targeting yields won’t necessarily spur price pressures, according to Barry Eichengreen, a professor at the University of California at Berkeley who co-wrote a paper on U.S. monetary and financial policy from 1945 to 1951. But if people already expect faster inflation, then the tool can help promote it.
That’s not a helpful conclusion for Bank of Japan Governor Haruhiko Kuroda and his colleagues, who last month switched the focus of their monetary stimulus to controlling yields across a range of maturities, after simply expanding the monetary base through debt purchases. It set the target for the yield on the 10-year Japanese government bond at around zero percent.
Another piece of their new framework: trying to shock inflation expectations higher by pledging to keep stimulus in place until prices are rising even faster than their 2 percent target. Their struggle is to overturn subdued household and corporate expectations that have been set hard by decades of deflation.
For the Fed in World War II and its aftermath, capping long-term yields at 2.5 percent had nothing to do with inflation per se. Its goal was to limit the government’s borrowing costs and so support the war effort.
Inflation was held down by price controls during the war, then spiked higher after hostilities ended, hitting a high of 19.7 percent in 1947. The surge proved short-lived, as an economic recession that began late the following year produced a return of the deflation that had plagued the country during the Great Depression.
It took mounting budget deficits, driven by the 1950-53 Korean War, to convince Americans that rising price pressures were becoming a more permanent feature of the economy. That’s because the fiscal profligacy was seen as break from the post-World War I pattern of budget surpluses and deflation.
“The public had grown concerned over inflation,” Eichengreen wrote with his co-author Peter Garber in their review of the period.
For Kuroda, who is now more than halfway through his five-year term after taking office in 2013, changing expectations has been a particular bugbear.
While he argues that the BOJ has overcome deflation, he admits that the central bank has been unable to convince companies and workers that its 2 percent inflation goal is realistic.
That means their inflation beliefs are influenced more by what’s happened to prices in the past than what the BOJ commits to achieving in the future. In the words of Kuroda, inflation expectations are “adaptive” rather than being anchored to the central bank’s target, as is the case in the U.S.
That’s a problem because price pressures recently have been ebbing in response to the strength of the yen and the weakness in gross domestic product. Excluding fresh food, prices in August were 0.5 percent lower than a year earlier.
“The BOJ’s challenge will be to hold inflation above 1 percent,” said David Stockton, a former Fed official and chief economist at consultants LH Meyer Inc.
A big boost to the budget deficit probably would help lift inflation in Japan, according to Allan Meltzer, a professor at Carnegie Mellon University in Pittsburgh and author of a two volume history of the Fed.
After all, that’s what happened in the U.S. as it ramped up spending on the Korean War.
Former U.S. Treasury Secretary Lawrence Summers, speaking at a BOJ conference in Tokyo Friday, said that, generally, a successful yield-curve targeting strategy “operates in a positive way with respect to the government’s budget constraint, and therefore should enable more expansionary fiscal policies.”
The BOJ’s yield target -- and its pledge to keep expanding the monetary base until inflation is sustainably above 2 percent -- is a clear enticement to the government to loosen the fiscal reins, said former Fed official Roberto Perli.
“Japan is fully in helicopter money territory,” Perli, now a partner at Cornerstone Macro LLC in Washington, wrote in a Sept. 29 note to clients.
Under so-called helicopter money, the central bank directly finances deficit spending by the government. While Kuroda has championed record government-debt purchases, he has repeatedly said that direct financing isn’t allowed in Japan.
In August, Japan announced 4.6 trillion ($45 billion) in extra spending for the current fiscal year ending March 31. It is part of what Prime Minister Shinzo Abe flagged as a 28 trillion yen stimulus package. And with the country due to host the Olympics in 2020, the pressure to spend more may increase.
“Japan is going to be stimulating at least a half percent of GDP over the next couple of years,” said Adam Posen, president of the Peterson Institute for International Economics in Washington and a former Bank of England policy maker.
Still, Finance Minister Taro Aso has said the government is sticking with its plan to eliminate its primary budget deficit in 2020. And it still has a two percentage point increase in the consumption tax penciled in for 2019.
“Both reviving the economy and pursuing fiscal consolidation are important,” Aso told a meeting at the Ministry of Finance on Sept. 7.
The BOJ’s shift in its monetary regime means that it won’t stand in the way if inflation and inflation expectations increase, said Vincent Reinhart, chief economist at Standish Mellon Asset Management Co. in Boston and a former senior Fed official.
“If inflation starts rising, you have foamed the airstrip and are ready to let it happen,” he said. “That’s what you saw in the U.S.”
What’s got investors worried though is that Kuroda told them “how he’d accommodate rising inflation because he didn’t know how to get inflation to start going up,” Reinhart said.
“That’s the concern.”