How should Japan respond to inflation?

In the fall of 2021, monetary economists in the United States were sharply divided between those who believed that high inflation would be short-lived (Team Transitory) and those who insisted it was here to stay (Team Persistent). Today, a similar clash can be seen in Japan, though there are very different considerations at play.

America’s Team Transitory based its stance on the benign inflation projections that were being shared among members of the Federal Open Market Committee. As recently as December 2021, projected personal consumption expenditure inflation — the US Federal Reserve’s preferred measure — for 2022 was just 2.6 per cent. Such figures, Team Transitory concluded, called for a slow, gradual increase in the policy rate over 2022.

 

Team Persistent, however, warned that this would not be enough to curb US inflation, and urged the Fed to undertake sharp increases in the policy rate —  starting immediately. The Fed ultimately embraced this recommendation, hiking the policy rate seven times in 2022, for a cumulative increase of 4.25 percentage points. But it did so only after inflation proved to be much higher than Team Transitory’s projections.

Though US inflation now seems to have cooled, the Fed’s slow start likely resulted in larger interest-rate hikes than would otherwise have been needed. The Fed, it seems, was behind the curve. Is the Bank of Japan (BOJ) making the same mistake?

Japan’s headline inflation rate in June —  the most recent figure available — was 3.3 per cent, meaning that it has remained above the 2 per cent target for more than a year. The “core-core” inflation rate —  which tracks the prices consumers pay for a basket of goods, excluding fresh food and energy — was even higher, at 4.2 per cent. This shows that the main driver of inflation is not energy or fresh food prices, which tend to be volatile, but rather a wide range of other items. For Japan’s Team Persistent, this is enough reason for the BOJ to consider tightening monetary policy.

Japan has maintained ultra-easy monetary policy for years. Since launching its quantitative and qualitative easing (QQE) policy in 2013, the BOJ has purchased more than 50 per cent of outstanding government bonds. This has undermined the bond market’s functioning and encouraged a lack of fiscal discipline.

Moreover, the widening interest-rate gap between the US and Japan has caused the yen’s exchange rate against the US dollar to depreciate sharply, from ¥115 in January 2022 to ¥150 in October 2022. The dollar exchange rate has remained in the ¥135-150 range ever since. One might hope that this would stimulate Japan’s economy by boosting export competitiveness, but no such thing has occurred, at least not to any significant extent.

Japan’s Team Transitory, however, sees no reason to worry about a sharp, let alone persistent, rise in inflation. They might point out, for example, that the BOJ’s board members anticipated in April a core inflation rate (which excludes fresh food but not energy) of 1.8 per cent for fiscal year (FY) 2023, 2 per cent for FY 2024, and 1.6 per cent for FY 2025; and a core-core inflation rate of 2.5 per cent for FY 2023, 1.7 per cent for FY 2024, and 1.8 per cent for FY 2025. The inflation forecasts are still undershooting the target in the medium run. 

There is no reason to believe the BOJ’s projections are biased. A recent survey by the Japan Center for Economic Research shows that while private forecasters predict slightly higher price growth (2.6 per cent) for FY 2023, they also expect inflation to fall back below target — to 1.7 per cent — in 2024. The break-even rate of 10-year government bonds — which stood at 1.16 per cent at the end of June —reinforces the view that inflation will decline in the medium to long run.

Team Transitory would also emphasise that this is the first time Japanese inflation has surpassed 2 per cent since soon after the BOJ adopted its inflation-targeting framework in 2013. In fact, whereas inflation expectations are more or less anchored around 2 per cent in the US, Japan has been in a deflation trap for decades; inflation expectations never came close to 2 per cent.

This has had serious consequences for Japan’s economy. With the inflation rate stuck at (or below) zero, firms were unable to raise prices, even when costs rose, which prevented them from raising wages and left consumers extremely sensitive to any price changes. But recent price growth has gone some way towards changing that, spurring wage increases of 3 per cent. For Team Transitory, the conclusion is clear: Japan should view today’s inflation as an opportunity to break its deflationary equilibrium and raise inflation expectations to 2 per cent.

It is worth noting that, far from fearing a wage-price spiral, Japan would have to hope for 2-3 per cent annual wage increases for years to come to reach 2 per cent inflation. Moreover, given that inflation expectations tend to lag behind actual inflation, Japan must be willing to overshoot the target for some time, as former BOJ Governor Haruhiko Kuroda pledged to do back in 2016. By this logic, the last thing Japan needs is inflation-suppressing monetary-policy tightening.

But Team Persistent would warn that another risk is looming.  If the BOJ does not raise its yield curve control (YCC) ceiling in line with the new inflation projections, investors could begin short-selling government bonds, just as they did last October and November.

One compromise would be to widen the YCC band from 50 basis points to, say, 75 basis points, but insist that the goal is to maintain the functioning of the Japanese government bond market and not a step toward monetary tightening, just as Kuroda explained in January.

The BOJ undoubtedly faces hard choices. 

(The column was written before the BoJ meeting)

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The writer, a former Japanese deputy vice-minister of finance, is a professor at the School of International and Public Affairs at Columbia University, and a senior professor at the National Graduate Institute for Policy Studies in Tokyo. ©Project Syndicate