For Japanese business people and policymakers, the biggest question of this year is whether Japan’s economy will be able to rid itself of deflation. Asking the question itself is right. The problem is that many continue to overestimate the impact of deflation, real or perceived. The result is a gridlock in policymaking. It’s as if the nation’s monetary and fiscal authorities are plagued by a deflationary trauma.
This gridlock stems from a policy of “quantitative monetary easing” that the Bank of Japan introduced in March 2001. At that time, the economy was suffering from serious credit shortages as financial institutions nationwide, including big banks, were struggling to sort out a massive level of nonperforming loans. Prices were continuing to fall, and economic growth was marking time. With interest rates already near zero, the central bank adopted a more direct policy of relaxing the monetary faucet.
That policy had two aims: getting rid of deflation and writing off bad loans. The second aim — “final disposal” of loans gone sour — was achieved at the end of March 2005, as the Bank of Japan continued to pump money freely into the banking sector under the “zero-interest-rate” policy. With volumes of bad debt returning to normal levels, particularly at major lenders, the specter of financial crisis had disappeared.
That was when the BOJ could have begun lifting the quantitative easing policy — leaving the “interest-free” world by gradually reducing the credit supply. But the bank did not move, saying the problem of deflation had yet to be resolved. So the gridlock has continued.
The monetary policy of the past five years — expanding the credit supply freely while keeping interest rates near zero — is in itself an aberration. In fact, the BOJ adopted the policy as an emergency measure on the assumption that it would be removed once its twin objectives (ending deflation and paring bad loans) had been achieved. It seems, however, that the bank’s freedom of action has been restricted by a rigid self-imposed condition for declaring deflation over: that consumer prices rise year on year for a reasonably long period.
That condition finally is materializing. The Consumer Price Index (CPI) climbed above zero from the year before in both October and November. With the economy expected to keep expanding in the months ahead, the BOJ predicts that consumer prices will keep up their upward momentum. It is likely, indeed, that the bank will lift the zero-interest-rate policy as early as this spring.
The difficulty is that the government and the ruling coalition are not of the same mind as the BOJ. The former are wary of declaring an end to deflation at this stage, believing that the recent reversal of price declines may be temporary. They seem to have an ax to grind: Higher interest rates would increase interest payments on government bonds and causing fiscal conditions to deteriorate further.
That argument, plausible as it is, can be ignored. Higher interest rates, of course, lead to higher borrowing costs. But a rise in the budget deficit can be avoided by reducing bond issues. Higher interest rates should make borrowers, including governments, more cautious. A continuation of the zero-interest-rate policy could send the wrong signal to the fiscal authorities, possibly reinforcing the past tendencies toward fiscal laxity and neglect.
The right course of action for the central bank is to move steadily and confidently with due respect for economic indicators and market signals. It needs to resist the temptation to listen to “outside noise.” Since price fluctuations of plus or minus 0.2 percent are within the margin of error, it would be meaningless to argue whether deflation is over in terms of these narrow price changes. The important thing is to grasp a broader, longer-term price trend.
The fact is that the rapid growth of China and India, fueled in part by the relatively low prices of their export products, is tending to depress prices worldwide, not just in Japan. Such deflationary pressures are likely to persist. It is unrealistic, therefore, to let mild deflation dismiss policy discussion.
The key point to consider is that interest rates in Japan have remained at near-zero levels over an extended period. The task for the BOJ is obvious: extricating the economy from this abnormal situation as soon as possible so that interest rates can start functioning again. That is essential for bringing monetary policy back to normal and putting the economy on a sounder footing.
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