Make them believe.

Photographer: Haruyoshi Yamaguchi/Bloomberg

A Possible Cure for Japan's Low Inflation

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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Japan’s central bank has long been battling an ailment that now afflicts much of the developed world: unduly low inflation, which tends to go together with lackluster economic growth. If it wants to succeed in its efforts, it may have to aim to overshoot its inflation goal.

The Bank of Japan announced an inflation target of 2 percent in March 2013. Since then, it has made some progress: The consumer price index has risen at an average annual rate of 1.3 percent, up from negative 0.3 percent over the previous three years. That’s better than the Federal Reserve has done in the U.S., where prices have risen at an average annual rate of only 0.8 percent since March 2013.

Still, the Japanese central bank has fallen short of its goals. In April 2013, it announced that it expected to reach the 2 percent target in “about two years” -- yet even now there’s a long way to go.

The lack of success might stem from an inadequately ambitious strategy. One key to achieving higher inflation is convincing people and companies that prices will start rising faster. The Bank of Japan wants to get those inflation expectations up to 2 percent -- but in doing so, it doesn’t want them ever to rise above 2 percent. That limitation could be self-defeating, according to a recent paper by professors Kinda Hachem and Jing Cynthia Wu of the Chicago Booth School of Business.

Hachem and Wu posit that many people forecast inflation simply by looking at how fast prices have recently been rising. The central bank wants them to pay attention instead to what it says inflation will be -- a task that would be much easier if actual inflation proved to be a lot different than what they had seen in the past. Hence, the central bank can be more effective if it initially aims above its longer-term inflation target. 

Suppose, for example, that the Bank of Japan had announced a target of 4 percent in March 2013. Actual inflation over the past three years would probably have been higher -- teaching wage-setters and price-setters that if they want to avoid costly mistakes, they’d better pay attention to what the central bank says will happen. Having built up that credibility, the central bank could then more easily guide expectations to its long-run goal of 2 percent.

Here’s an analogy that I find helpful. Imagine tossing your keys onto a table from about a yard away. It’s not that hard to do. But now imagine that the keys can’t rise above the level of the table top. Now it’s impossible to achieve your goal of landing the keys on the table.

I have faith that the Bank of Japan will eventually reach its inflation goal. I suspect, though, that it would get there sooner if it first tried to overshoot.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net