Bank of Japan Governor Haruhiko Kuroda's bold program to get Japan out of deflation has made enormous progress, but it has fallen well short of its goal of 2 percent inflation within two years. Now is the time for a final big push to cross the goal line and prevent a slow slide back into deflation.
On January 29, the Bank of Japan (BOJ) announced a complicated program to pay different rates of interest on tranches of deposits that banks hold with the BOJ. Beyond a certain point, any additional money deposited at the BOJ will earn a negative rate of interest. Financial markets quickly reacted positively: Real bond yields fell, the yen fell, and stock prices rose. But much of these gains were erased in subsequent days, probably because markets came to believe the effects of the new policy would be small. Worryingly, the nominal bond yield fell further even as the real yield rose. Ten-year inflation compensation is now only 0.5 percent, a clear message that markets expect the BOJ to fail to deliver 2 percent inflation. Other measures of expected inflation are also turning down.
A shift from 0.1 to -0.1 percent on a small fraction of BOJ deposits is a tiny move. In Switzerland, where deflation also has been a problem, banks face a -0.75 percent interest rate on additional deposits at the central bank, and even larger negative rates may be possible. The BOJ should move to -0.75 percent on future increases in deposits, while paying 0 percent on the current stock of deposits.
The BOJ's program of asset purchases since 2013 moved the best measure of core inflation (consumer prices excluding energy and fresh food) from nearly -1 percent to more than 1 percent. This is about two-thirds of the way to its goal of 2 percent, a tremendous achievement. But the BOJ cannot afford to make only tiny adjustments to its policies at this time. The effects of past yen depreciation are diminishing, and wages are not accelerating enough to sustain the current rate of core inflation, let alone push it higher.
The government of Prime Minister Shinzo Abe could help by raising the salaries of public workers and taking other measures to increase wages recently recommended by Olivier Blanchard and Adam Posenin the Nikkei Asian Review. But the BOJ should not make inaction by the government an excuse for its own passivity. In the end, maintaining stable inflation is the job of the central bank.
It is absolutely critical to get a strong increase in this spring's wage negotiations. The BOJ needs to make a convincingly bold move now. In addition to lowering its deposit rate to -0.75 percent, the BOJ should step up purchases of equities to 50 trillion yen, about 10 percent of the market, for at least one year, and longer if needed to firmly anchor inflation at 2 percent.
Equity purchases should be directed toward all shares trading in Japan in proportion to their market capitalization. Alternatively, the BOJ may continue to buy exchange-traded funds (ETFs) based on the broadest available market indexes. ETFs are open-ended and thus grow automatically in response to market demand. The point of the program is not to pick winners and losers, but to raise equity values and household wealth broadly. This will encourage consumption and investment in Japan, putting upward pressure on inflation.
The paradox of quantitative easing in the past seven years is that central banks that were slowest to engage in it at first (the BOJ and the European Central Bank) are being forced to do more of it later than those central banks that embraced it earlier (the Bank of England and the Federal Reserve). If the BOJ does not move boldly now, it will have to do even more later.