Japanese Inflation Targeting
In the first Project Firefly Emerging Leaders Essay Competition in 2012, one of the questions asked, “Is monetary policy alone enough to stimulate an economic recovery?” Certainly, central banks are able to stimulate a recovery through conventional monetary policy during normal recessions. Nevertheless, the question focused on whether or not it is possible during a liquidity trap, when conventional monetary policy is no longer effective because interest rates are already at zero and cannot be lowered further. Economists have advanced various theories as to the answer, but there have not been any real world situations in a developed economy to test them. That is until now. Japan’s new prime minister, Shinzo Abe, and the head of the Bank of Japan, Haruhiko Kuroda, have taken the advice of the proponents of unconventional monetary policy and have promised higher inflation. The results of this monetary policy experiment are not only important to the Japanese economy, but they also will provide a lesson to the central banks of Europe and the United States trying to recover from their depressed economies.
While the economies of Europe and the United States have received more attention, the Japanese economy has been in a deflationary trap since the 1990s. To be sure, the Japanese economy has suffered less, with unemployment nowhere near the levels of the European Union or the United States. Still, the Japanese economy has performed below its potential for decades.
It is easy to blame this stagnation on Japanese culture, aging demographics, and other structural problems.
Nevertheless, prominent economists such as Ben Bernanke (before he was Chairman of the Federal Reserve) and Paul Krugman have argued since the late 1990s that there are still monetary policy options available to Japan that could help to stimulate a recovery.1 In 1998, Paul Krugman argued that the way to make monetary policy effective after interest rates have been lowered to zero is for the central bank to “credibly promise to be irresponsible--to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.”2
Fifteen years later, Japan has finally decided to try this. At the Monetary Policy Meeting that took place at the beginning of April of this year, the Bank of Japan (BOJ) announced a dramatic quantitative easing (QE) program with an inflation target of two percent. Japan has averaged negative 0.3 percent inflation since 2000. To achieve this target level, the BOJ announced that it will “enter a new phase of monetary easing in both terms of quantity and quality.” The BOJ will do a round of QE every year, which will consist of buying long-term bonds as well as stocks and real estate.3 Since the BOJ announced this, the Nikkei has risen sharply and the yen has been falling. The depreciated yen will give Japanese companies a competitive advantage in the global marketplace.4
There are, however, questions of the effectiveness of this inflation targeting. Since increasing the money supply is not inflationary during a liquidity trap, will the BOJ “promising” higher inflation be enough to achieve two percent inflation? And if it is, will that be effective in stimulating a recovery? Or are Japan’s problems structural, so that boosting demand through lower real interest rates will not be helpful? But as Ben Bernanke argued in 1999, sometimes it is necessary for leaders to show “Rooseveltian Resolve,” referring to Franklin D. Roosevelt’s willingness to be aggressive and “do whatever is necessary to get the country moving again” during the Great Depression.5
If this Japanese experiment works, it will provide a great lesson for monetary policy outside of Japan. Currently, the popular focus of many pundits and central bankers on both sides of the Atlantic is price stability. Even the slightest hint of higher than normal inflation causes the central bankers to back off easing even with very high unemployment. If Japan’s higher inflation targets are able to stimulate a recovery, it will show that slightly higher inflation can be beneficial and does not mean a country will turn into “a Zimbabwe.” This is important since in the United States Congress is unlikely to enact any fiscal stimulus as it focuses more on deficit reduction than unemployment. Lowering the real interest rate through higher inflation may be the only way to get people and businesses to start spending again and to stimulate a recovery. Furthermore, higher inflation in Europe may be the only option to save the euro. This would help countries on the periphery regain competitiveness since the current strategy of internal devaluation is not working.6
In conclusion, the BOJ’s recent pledge to allow higher inflation to end its long slump should answer the question of whether monetary policy alone is enough to stimulate an economic recovery. Certainly, aggressive monetary policy will not be enough to support a depressed economy that is undergoing harsh austerity measures. But with all other things being equal, if this Japanese experiment is not effective, it will show that in a liquidity trap, the central bankers may be out of options, and unconventional monetary stimulus is not as effective as many economists believe. But if it works, it will show that monetary policy even in a liquidity trap is still useful, and that central bankers should aggressively pursue it. Therefore, the BOJ’s aggressive unconventional monetary policy is an important natural experiment in macroeconomics that warrants particular attention.
- Ben S. Bernanke, “Japanese Monetary Policy: A Self-Induced Paralysis?” Princeton University. December 1999. http://www.princeton.edu/~pkrugman/bernanke_paralysis.pdf
- Paul Krugman, “Japan’s Trap.” May 1998. http://www.princeton.edu/~pkrugman/japans_trap.pdf. (Italics are in the original).
- Bank of Japan, “Introduction to the ‘Quantitative and Qualitative Monetary Easing.’” April 4, 2013. http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf
- Neil Irwin, “Why Japan is the most interesting story in global economics right now.” Wonkblog. Washingtonpost.com. April 8, 2013. http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/08/why-japan-is-...
- Ben S. Bernanke, “Japanese Monetary Policy: A Self-Induced Paralysis?”
- Paul Krugman, “Internal Devaluation, Inflation, and the Euro (Wonkish).” The Conscience of a Liberal. NYTimes.com. July 29, 2012, http://krugman.blogs.nytimes.com/2012/07/29/internal-devaluation-inflati...
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