On March 20, former Bank of Japan Deputy Gov. Toshihiko Fukui will replace current BOJ Gov. Masaru Hayami as head of Japan’s central bank. Mr. Fukui, now director of the Fujitsu Research Institute, will be assisted by two new deputies: Mr. Toshiro Muto, former vice minister of finance, and Mr. Kazumasa Iwata, a senior official of the Cabinet Office and an economics professor at the University of Tokyo.
The biggest challenge for the new BOJ triumvirate — which was selected by Prime Minister Junichiro Koizumi on Monday, subject to parliamentary approval — is to maintain independence in the conduct of monetary policy. That is easier said than done, however, given persistent pressure from the government and politicians. The current policy tug-of-war over inflation targeting is a case in point.
The central bank acquired greater independence as a result of a 1998 revision to the Bank of Japan Law. The governor’s five-year tenure is guaranteed, meaning, among other things, that the government cannot dismiss him or her on grounds of policy disagreement. Still, the need for the bank to draw a line in the sand, so to speak, cannot be overemphasized. The BOJ is already beleaguered on all sides amid mounting calls, both here and abroad, for a more aggressive easing of its monetary policy.
Japan’s worst economic problem today is deflation. Prices have continued to fall across a broad spectrum of industries for the past four years. Inflation targeting aims to reverse this trend and get prices back on a ladder. Proponents say this should be done by setting a specific rate of increase, perhaps a few percent a year, for consumer prices.
Some politicians, academics and economists are urging the central bank to set an inflation target. The idea may sound attractive, but it is fraught with risks. It is hardly the right thing to do in a time of deflation. Inflation targeting has been tried in other countries, such as Britain, Sweden and New Zealand. But its objective was the opposite: reducing inflation, not fighting deflation.
Monetary policy, it is said, is effective in preventing an overheating of the economy through tight-credit steps such as interest rate increases. But the opposite is not necessarily true; the effect of easy-credit policy, such as cutting interest rates, is said to be indirect and limited. In fact, the BOJ’s zero-interest rate policy has not been effective in turning around the stagnant economy.
Advocates of inflation targeting say that rising prices boost sales in nominal value (excluding the effect of inflation), and that rising wages stimulate consumer spending, which in turns spurs business investment in new factories and equipment. In other words, they see mild inflation as a necessary condition for a virtual cycle of economic expansion. The catch is that inflation does not necessarily bring about real, or quantitative, increases in sales and spending. More likely it will cause “stagflation” — inflation without growth.
The proinflation school argues that the Bank of Japan should supply plenty of credit by buying not only more government bonds but also stocks and real estate — something the central bank has never done before. Gov. Hayami has rejected such an inflationary policy, and for good reasons. First, with the economy already awash in money, there is no guarantee that inflation could be kept under control at a specified rate.
Second, doubt remains as to whether it is really possible to create inflation artificially. There is no precedent to guide this new monetary experiment. Will massive bond purchases, either from the government or the market, not erode fiscal discipline and create runaway budget deficits? Will stocks and land purchased by the BOJ not turn into bad assets and deteriorate its balance sheet if their market prices drop? In the end, will this not undermine confidence in the central bank and reduce the monetary value of the yen?
The bottom line is that inflation targeting is a risky venture that the Bank of Japan should stay clear of. The risks are compounded by the fact that no country has ever tried to combat deflation by introducing an inflation target. The BOJ under the new governor will face an acid test of independence in dealing with this issue. The right choice for Mr. Fukui is to reject an inflationary policy, as outgoing Gov. Hayami has done.
People outside the BOJ should know that there are limits to what the central bank can do. Indeed, it is unrealistic to make excessive demands on the already overstretched monetary policy. Some argue that the government and the central bank should use every policy tool available to overcome deflation. They are right, but only up to a point. Conducting a potentially dangerous experiment with inflation is not the way to deal with the real economy.
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