Shinzo Abe’s (Mostly) Sensible Plan for the Bank of Japan

Japan’s new prime minister, Shinzo Abe, has promised to force the Bank of Japan to change its monetary policy, and he seems likely to get his way. Though Abe’s approach isn’t risk-free, he is mostly right.

Critics see Abe’s plan as a dangerous assault on the BOJ’s independence. These fears are overblown. The more pressing issue is Japan’s stagnant economy. Consumer prices have flatlined or fallen, which has held real interest rates above zero and made monetary policy too tight. Prices fell by 0.3 percent in 2011, were unchanged in 2012 and are expected by the International Monetary Fund to fall again in 2013.

Digging out of deflation isn’t easy, but the U.S. Federal Reserve, the Bank of England and other central banks have shown that unorthodox measures can work even when interest rates have been cut to nothing.

In principle, the Bank of Japan agrees. It has done some quantitative easing through its asset-purchase program and has kept interest rates near zero, but it has been timid in two main ways.

First, it bought mostly short-term securities. Because these are close substitutes for cash, issuing money to acquire them does little to ease monetary conditions. QE on a bigger scale and directed at longer-term securities, in the style of the Fed and the Bank of England, would be more effective.

Talking Down

Second, the BOJ has undermined its own modest efforts by talking them down. In monetary policy, “forward guidance” about the central bank’s intentions is a powerful instrument in its own right. The Fed has put increasing stress on this, for instance by promising to keep monetary conditions loose even after growth picks up. The BOJ has usually done the opposite, which is tantamount to telling markets its efforts will fall short.

Last October, in an unusual joint statement with the government, the BOJ said it thought price stability in the medium term was consistent with inflation of 2 percent or less. Yet at the same time it affirmed an inflation goal of 1 percent “for the time being” -- then semi-retracted even this by announcing that easing would continue until the 1 percent goal was “in sight,” not until it was achieved. This excess of caution is self-defeating.

Under mounting from Abe and others, the BOJ announced new asset purchases in December and said it would review its medium-term price-stability goal at its next policy meeting later this month. Abe is calling for a 2 percent inflation target and threatening legislation. A new governor is due to be appointed in April in any event. One way or another, a long-overdue loosening of policy and a stronger commitment to see the new policy through look likely.

What about the risk that attacking the BOJ’s independence in this way will shatter confidence in Japan’s financial system -- maybe causing a collapse in the yen and a spike in long-term interest rates, enough to push the economy into an even deeper hole?

Abe’s critics have a point. With enormous public debts, Japan is already fiscally stretched, and Abe is promising a big new stimulus program as well as demanding easier monetary policy. If the BOJ were simply put at the government’s command and instructed to finance ever-bigger deficits, the critics’ fears could come true.

Abe invoked this possibility when he called for the central bank to buy construction bonds in support of public-works spending. He has since withdrawn that suggestion, which is wise. Outright monetization of government spending at the finance ministry’s direction would reduce the central bank to a printing press -- a reckless notion, to put it mildly.

Yet this doesn’t have to happen. A democratically sanctioned inflation target of 2 percent to 3 percent, together with operational independence and proper accountability for the central bank in achieving that goal, is the right approach, tried and tested elsewhere.

In aiming merely to get inflation of 1 percent “in sight,” the BOJ settled on a bad target and failed to achieve even that. The government is right to complain, to press for a better inflation target and to hold the BOJ accountable for hitting it. So long as it draws the line there, it will not compromise vital principles of prudent central banking, but uphold them.

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