Bank of Japan: A Good Strategic Revision but Tactics Still Lag

September 22, 2016 11:30 AM

The Bank of Japan (BOJ) made an important and promising adjustment to its monetary policy strategy this week. But the central bank is still behind the curve in correctly adjusting the level of monetary support to Japan’s economic needs. The good news is that the new strategy places more power in the hands of the government to help Japan achieve its goal of 2 percent inflation. Let us hope the government plays its part well.

The most useful element of the new plan is a promise to keep expanding the monetary base until the inflation rate “exceeds the price stability target of 2 percent and stays above the target in a stable manner” [emphasis added]. The BOJ understands that a commitment to allow a significant and sustained overshoot actually helps to raise inflation faster than otherwise by helping to raise expectations of inflation. Higher inflation expectations increase the stimulative power of monetary expansion. Moreover, markets previously feared a premature tightening of policy as soon as inflation approached 2 percent. Now they know the BOJ will not be in a rush to tighten.

The other key element is the decision to cap 10-year government bond yields at zero.  This announcement essentially commits the BOJ to maintaining its zero interest rate policy for the better part of a decade. Any rise in the short-term policy rate sooner than that would cause large losses on the BOJ’s bond portfolio, which is already the largest of any central bank in the world and growing rapidly. (However, it would be a mistake to judge the BOJ’s success or failure from its net income.)

The government could capitalize on the BOJ’s commitment through a major fiscal expansion. Especially useful now would be significant rises in wages of government workers and the minimum wages of private workers. It is also a good time to jawbone large companies to joining the government in boosting wages. These raises would be financed by more bonds to be purchased by the BOJ so that interest rates stay low. The goal is to establish a self-perpetuating cycle of positive wage and price increases while reducing the real (inflation-adjusted) rate of interest to encourage private spending.

Time will tell how markets view the BOJ’s new strategy. Initially, Japanese equities rose but the yen appreciated, providing a mixed overall reaction. The BOJ leaves open the possibility of more asset purchases and further cuts below zero in its short-term policy rate. It should have been doing more months ago, as core inflation and inflation expectations have slid away from their 2 percent goal. Perhaps the most effective avenue for further easing is through large-scale purchases of stocks, which may provide more upside to the BOJ’s portfolio in the event its policy succeeds. The BOJ is currently buying equities worth just 1 percent of gross domestic product per year. It could usefully buy ten times as much.

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Joseph E. Gagnon Senior Research Staff

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