WASHINGTON – Japan could have avoided deflation if the Bank of Japan had cut short-term interest rates by a further 2 percentage points at any time between 1991 and early 1995, the U.S. Federal Reserve said in a recent report.
“With the benefit of hindsight . . . Japanese policymakers . . . did not take out sufficient insurance against downside risks through a precautionary further loosening of monetary policy,” the Fed said in the report titled “Preventing Deflation: Lessons from Japan’s Experience in the 1990s.”
The report says an economic model used by the Fed indicates that loosening after the second quarter of 1995 would have been too late to avoid deflation, as by that time inflation had already fallen below zero.
The BOJ trimmed short-term interest rates nearly to zero by late 1995 to jump-start the faltering economy in the wake of the collapse of the asset-price bubble in the early 1990s.
For its part, the Fed has cut the target for the federal funds rate by 4.75 points to 1.75 percent since the beginning of 2001 in an aggressive, unprecedented move to keep the economy from sliding into recession.
With the Fed funds rate now at the lowest level since 1955, concerns have arisen that, were a substantial further loosening of monetary conditions required, monetary policy would be limited.
The report discusses challenges the Fed may face in such circumstances by looking into the situation experienced by Japan in the mid-1990s.
The Fed report says deflation can be very difficult to predict in advance, showing sympathy toward the BOJ’s failure to recognize the significance of deflationary implications.
“With interest rates at historically low levels by late 1993, and with the experience of the asset price bubble of the 1980s fresh in policymakers’ minds, it is understandable that the BOJ did not loosen monetary policy more rapidly in the early 1990s,” it said.
In turn, the report says, Japanese fiscal policy should have become even more aggressive in an effort to prevent a deflationary slump, although it became relatively stimulative in the early 1990s by conventional standards.
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