In March 2001, the Bank of Japan set short-term interest rates at near zero, declaring that the nation’s economy had entered a period of deflation. That extra-loose monetary policy, which is said to have had few parallels in the world, is likely to change next spring, because an upturn in consumer prices — an essential condition for lifting the “zero-interest-rate” policy — is considered almost certain.
According to the central bank’s “Outlook on the Economy and Prices” for November, the Consumer Price Index (excluding prices for perishable food) will rise by 0.1 percent in fiscal 2005 (ending March 31, 2006) from the year before, for the first time in eight years. The report also predicts the CPI for fiscal 2006 will register a further increase of 0.5 percent.
The BOJ has said time and again that it will reverse its ultra-easy money policy — aimed at expanding the money supply while overnight interbank lending rates are kept near zero — if and when the CPI begins to follow a positive trend “on a stable basis.” It now appears certain that this condition for a policy reversal will be more or less met if, as seems likely, the economy continues to expand steadily.
The question is when to shift the target of monetary policy from “quantity” (money supply) to “quality” (interest rate). With the economy apparently poised for a long-term expansion, it can be safely said that the moment of decision is approaching. The central bank, it is hoped, will make the right decision at the right time. Policy failures of the past should provide lessons.
In its November report, the BOJ has revised upward its April forecast for consumer prices, taking a more positive stand on future price trends. The revision seems to underscore a belief that the Japanese economy, buoyed by higher corporate earnings, has emerged from a “soft patch” and is now on track to sustainable growth. In fact, there is a growing sense that the economy is getting out of the “structural stagnation” that followed the collapse of the asset-price bubble in 1990.
True, economic prospects are clouded by high oil prices and other uncertainties. Still, demand from major export markets, notably the United States and China, remains fairly strong. Many Japanese companies, having freed themselves from the crushing burdens of the “three excesses” (capacity, debt and employment), are investing increasingly in new machinery and equipment. This is leading to a gradual recovery in consumer spending through increased household income.
The “quantitative monetary easing” now in place can be described as an “abnormal policy designed to deal with an abnormal situation” — namely, deflation (decline in the prices of goods and services). The test for the central bank is to get the economy out of this anomaly without disruptions. The present policy was introduced as an “emergency measure” to save troubled financial institutions even if individual deposit-interest rates were sacrificed.
As things stand now, a policy reversal is expected around next March. The question, of course, is when to raise interest rates after that. The timing needs to be chosen carefully. The central bank says only that the level of interest rates will be “adjusted in accordance with economic and price conditions.” Experience tells us that hasty action can spell trouble.
In August 2000, the BOJ, then headed by Mr. Masaru Hayami, lifted the “zero-interest-rate” policy amid signs of an improving economy, but about half a year later it was forced to not only revive that policy but also introduce a new policy of quantitative easing as the economy deteriorated due to the collapse of the information-technology bubble.
A reversal of the “zero-interest-rate” policy will also require a great deal of coordination between the government and the central bank. Of crucial importance will be coordination with the Finance Ministry, which wants to avoid increases in debt service — because higher interest rates would push up interest rates on government bonds as well.
Another lesson is that the BOJ could miss the opportunity to raise interest rates if it pays too much attention to consumer-price trends and overlooks vital signs in other key areas. That’s what happened on the eve of the bubble. The bank failed to grasp the gravity of the situation: Inflation in asset prices was creeping up amid soaring prices for real estate, stocks, paintings and so on.
Now there is talk of a “minibubble” as surplus money flows again into stock markets and urban real estate. Although a full-blown bubble is unlikely, the central bank needs to stay on guard. Making a policy change at the right time is always a big challenge for the central bank. Making it too soon, or too late, could make things worse.
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