- May 25, 2017
- May 24, 2017
- May 22, 2017
Member of the Policy Board
March 28, 2017
First of all, I thank Senior Fellow Stephen Roach for giving me the opportunity to talk to this esteemed audience at Yale. I understand that he teaches macroeconomic policy issues, focusing on the lessons Japan learned from deflation. The Bank of Japan is the frontrunner in combating deflation. As one of its board members, I hope that my remarks today will help stimulate academic discussion.
Deflation has prevailed for almost a quarter century in Japan. To overcome deflation, theory and practice were introduced and tested, and the policy effects were examined. As a result, a range of knowledge and wisdom has been acquired. The Bank, on its part, conducted a comprehensive assessment of quantitative and qualitative monetary easing -- or QQE for short -- in September last year, and learned some important lessons. Among these, I will today focus on the issues regarding long-term inflation expectations. This is because they are the key factor in overcoming deflation. I admit that conceiving such expectations is a somewhat elusive task, but it is worth discussing.
Japan's experience refutes the premise for monetary policy that long-term inflation expectations are determined by a central bank (Chart 1).1 This is because monetary policy effects are asymmetric when a central bank decreases long-term inflation expectations toward the target and when it raises them toward the target.
In other words, once long-term inflation expectations -- the norm of prices -- are de-anchored, a central bank's ability to influence inflation is constrained significantly due to the zero interest rate bound. Those in academia might feel that this is somewhat troublesome. In fact, however, when a central bank re-anchors long-term inflation expectations toward the target, there will be a limit if monetary policy is the only game in town. What is needed, in addition to continued powerful monetary easing, is a raise in the potential growth rate, which roughly equals the natural rate of interest. This should be achieved through structural policies including labor market reform.2
Academic discussion is seriously needed on this point. This is because Japan is not the only country that has learned lessons on deflation. Namely, simultaneous declines in the potential growth rate and long-term inflation expectations have been observed in many countries since the latest global financial crisis (Chart 2).
Let me elaborate. The more fundamental lesson we learned was that central banks should not allow long-term inflation expectations to decline to excessively low levels.
Central banks can lower excessively high long-term inflation expectations because of the credibility they have earned through the past achievements. The fight against inflation is easier and the strategy can be simpler compared with combating deflation. There is a premise for economic theory that holds true with the fight against inflation; namely, long-term inflation expectations are determined by inflation targets set by central banks.
By contrast, an inflation target will not be the basis for an economic model when set by a central bank that has lost credibility due to excessively low inflation. For example, the declines in the potential growth rate and long-term inflation expectations occurred simultaneously in Japan. However, the academic side of economics has yet to provide an answer as to whether it is possible to raise excessively low long-term inflation expectations through monetary policy. This is because of the present unique situation in Japan -- as I will touch on later -- that long-term inflation expectations are at virtually 0 percent and the potential growth rate is at slightly above 0 percent, while there is a zero nominal interest rate bound to usual economic transactions.
In reality, even under a large-scale unconventional monetary policy, both the mechanism of Friedman's quantity theory of money and the New Keynesian model of a jump in expectations have operated insufficiently so far. In terms of re-anchoring long-term inflation expectations, the glass is both half full and half empty. If the potential growth rate and long-term inflation expectations had not declined to the current low levels, monetary policy would have been more effective.
Next, I will discuss long-term inflation expectations in the following aspects: (1) their formation mechanism; (2) reasons for low expectations in Japan; (3) the relationship with Japan's financial crisis; and (4) the relationship with labor market reform.
In economics theory, long-term inflation expectations are irrelevant to the potential growth rate. However, I doubt that this holds true in reality, in light of what is happening in Japan. Rather, I think that long-term inflation expectations and the potential growth rate do have a correlation, although it may not be strong (Chart 3).
Long-term inflation expectations declined sharply in Japan, before and after the financial crisis in the late 1990s. Economic fundamentals already had been weak before the crisis because of the negative interaction between demand and supply conditions; specifically, (1) a negative financial accelerator on the demand side due to the dire asset price deflation, and (2) the impairment of the financial intermediary function, as well as the distortion of economic resource allocation caused by the bubble economy on the supply side. The financial crisis triggered further weakening of economic fundamentals (Chart 4). In this situation, pessimism about the future led to a decline in people's expectations for medium- to long-term growth, and the potential growth rate remained low over a long period of time. As a result, people's perception of prices became excessively conservative. In other words, long-term inflation expectations turned downward.
Next, let us take a look at developments in survey-based measures of expected long-term inflation in Japan. A survey-based rate marked a sharp decline during the period of the financial crisis in the late 1990s, and then leveled out at around 1 percent. Since then, even throughout the period of the global financial crisis and the European sovereign debt crisis, it has been more or less unchanged at around 1 percent (Chart 5). However, I am somewhat doubtful about this figure.3 I believe that it is more persuasive to say that long-term inflation expectations in Japan have actually declined to around 0 percent, for the following four reasons.4
First, the frequency of micro-level price changes suggests that the mode value remains zero. In other words, the year-on-year rate of increase in the prices of sample items concentrated on 0 percent. Therefore, people are likely to consider that zero inflation is a steady and constant state. It is helpful to see the comparison with the U.S. situation (Chart 6).5
Second, administered prices are excessively sticky (Chart 7).6,7 For example, the starting subway fare in Tokyo has been unchanged for over 20 years since 1995 -- disregarding the effects of the consumption tax hikes.
Third, the rate of increase in wages resulting from the wage negotiations between labor and management continued to be 0 percent for a long time. Even after the recent resumption of base pay increases, the rate is less than 1 percent (Chart 8).8
Fourth, Japan's deflation equilibrium cannot be theoretically explained on the basis of the 1 percent long-term inflation expectations (Chart 9).
I will elaborate on the fourth point. Let us assume that there is a zero nominal interest rate bound. Even if that is the case, as long as long-term inflation expectations are meaningfully positive, the real interest rate will fall below the natural rate of interest, which is around 0 percent, by making the real interest rate negative. In this case, monetary policy should be effective, and Japan's economy should be able to get out of deflation equilibrium. This suggests that, if long-term inflation expectations are at least around 1 percent, monetary policy can be more effective.
Looking back, if Japan's financial crisis in the late 1990s had been settled more promptly with ample liquidity provision and capital injection, the large-scale credit crunch could have been avoided, and thus the subsequent path of Japan's economy might have been different. This widely shared lesson was put to good use at the time of the global financial crisis afterwards. I note that it is important to address the private sector's solvency problem through provision of a massive scale of liquidity and through credit enhancement by means of swift capital injection.
In Japan, the bailout of financial institutions with taxpayers' money experienced a strong backlash from the public. It took a considerable amount of time before public funds were actually injected into financial institutions. In the aftermath of the financial crisis, the injection of public funds was carried out several times. However, it actually took several years before concern about the stability of the financial system subsided (Chart 10).
It was only after the introduction of the zero interest rate policy in 1999 and the introduction of quantitative monetary easing in 2001 that the market's liquidity concern was alleviated through the Bank's provision of ample funds (Charts 11-1 and 11-2).9
Quantitative monetary easing was a pioneering attempt in increasing the predictability of monetary policy. It was conducted both by lowering market interest rates to virtually 0 percent through the provision of ample funds surpassing the required reserves and by introducing forward guidance. Nevertheless, I have a feeling that the Bank could have addressed liquidity concern in the late 1990s at a much earlier stage. In that regard, I somewhat have understanding toward the criticism that the Bank's monetary easing was insufficient at that time, and as a result the financial crisis was prolonged and the economy fell into a deflationary trap.10
I also note that the Bank paid particular attention to the negative feedback loop between asset price deflation and the real economy. It did not pay due attention to mild deflation for a long period. In fact, the Bank repeatedly explained that the deflation was mild and the economy was not falling into a deflationary spiral, unlike at the time of the Great Depression in the 1930s.11
It is true that the Bank's provision of ample funds and the government's capital injection helped avoid a deflationary spiral, although these were somewhat delayed. Long-term inflation expectations were declining, but not much attention was paid by the Bank or those in academia to their potential effects on monetary policy.
With hindsight, the Bank at least should have clarified its firm determination not to allow the decline in long-term inflation expectations, as was done by the Federal Reserve after the global financial crisis and by the European Central Bank after the sovereign debt crisis.
In my view, as a measure to raise long-term inflation expectations that already have declined to a low level, it is important to have structural policies, particularly labor market reform.
If long-term inflation expectations have some kind of relevance to the potential growth rate, it is necessary to raise both at the same time. To this end, one important measure is labor market reform. If such reform leads to rises in labor productivity and the labor force participation rate, the potential growth rate will increase from a longer-term perspective and firms' expected rates of return and households' permanent income also will increase. This will strengthen monetary easing effects and the inflation rate will increase. Then, the adaptive formation mechanism of inflation expectations, which is unique to Japan, will bring about a positive influence on long-term inflation expectations.
In Japan, some labor market practices could be constraints on raising long-term inflation expectations. Therefore, labor market reform should be actively pursued. Given that there is an increasing sense of labor shortage caused by the population decline, now is an ideal time to take a step forward in labor market reform. I will next focus on three possible reform measures.
First, a more flexible adjustment mechanism should be implemented in Japan's labor market. Let me elaborate on this point. The way people form their expectations could be affected by how labor market adjustments are made during periods of recession -- i.e., whether to have quantity adjustments in terms of headcount or price adjustments in terms of wages. For example, in the U.S. labor market, quantity adjustments are mainly made in the form of layoffs. Japan's labor market mostly makes price adjustments and layoffs tend to be avoided (Chart 12).
Let me add a few things about wage adjustments in Japan. In the face of the past shocks, including oil crises during early 1970s and 1980s, Japan's labor unions had a practice of prioritizing the job security of regular workers and accepting management's proposal to set lower wages. Under such coordination between labor and management, restraining wage increases of regular workers was effective in controlling inflation. Afterwards, the base pay of regular workers significantly shifted downward following Japan's financial crisis, and then became sticky at low levels. Since then, non-regular workers have acted as a buffer against wage adjustments as they are outside the protection of labor unions.
As illustrated, Japanese-style employment and wage practices of prioritizing the job security of regular workers and restraining wage increases may have influenced long-term inflation expectations to shift downward. If that is the case, the solution is to implement dynamic U.S.-style employment practices and allow the compensation of regular workers to reflect risk premiums.
I note that, in Japan's labor market, job mobility and a social safety net are not necessarily sufficient. In this situation, the U.S.-style employment system is unlikely to be socially acceptable. In fact, it has been difficult to reach a consensus between labor and management, and thus progress in labor market reform has been moderate.
I believe that a key to success in labor market reform is to implement dynamic U.S.-style employment practices while modifying them to fit Japan's own circumstances. For example, it is important to gain the understanding of labor unions by establishing a social safety net that leads to economic growth. One option is to build a framework for employment and reemployment assistance in coordination with the government, labor, and management.
Second, a forward-looking wage negotiation system should be established. Let me elaborate on this point. In Japan's wage negotiations, the observed rate of increase in the consumer price index (CPI) of the previous year is used as a benchmark in determining the rate of increase in wages for the following year (Chart 13). For this reason, even when a decline in the CPI is attributed to external factors, including a decline in crude oil prices, the low inflation rate tends to be referred to in wage negotiations. That said, such a price decline is a positive factor in corporate profits with an improvement in the terms of trade at a macroeconomic level.12
In my view, it is necessary to replace the existing practice of referring to the observed CPI in the past and negotiating the wage increases for only one year in an adaptive manner. Instead, it is necessary to implement the practice of negotiating wage increases for several years in a forward-looking manner by sharing the outlook on the path of price changes over several years, or over the medium to long term.13
Third, there should be a change in the practice of applying the result of labor-management wage negotiations at large manufacturers to other industries. In Japan, the result of wage negotiations at large manufacturers -- especially automobile, steel, and other major manufacturers -- tends to be used as a benchmark for such negotiations in other industries, including non-manufacturing. Therefore, even when the terms of trade at a macroeconomic level improve due to the yen's appreciation, if a higher yen causes major manufacturers to have lower profits and depress the rate of wage increases, such a rate for non-manufacturers also tends to be depressed accordingly.
In Japan, the share of manufacturing in gross output is less than 20 percent. Therefore, it is not suitable at this time to use wages at major manufacturers as a benchmark for wage negotiations in other industries. I believe that wage increases should reflect individual firms' profits with forward-looking inflation expectations being used as a basis.
The roles of fiscal policy measures have regained attention in Japan recently, following the insufficient increase in expectations even with the large-scale unconventional monetary policy. "Helicopter money" and the Fiscal Theory of the Price Level (FTPL) are examples of this (Chart 14).
The issue they have in common is whether or not additional fiscal expenditure will exert positive effects on the way people form their positive expectations in a sustainable manner. Households do not act as rationally as Ricardian equivalence assumes. Meanwhile, it also is plausible to assume that their concerns over possible tax hikes and an increase in social security tax burden provide a reason for their cautious outlook. These arguments might have given rise to the idea that it is desirable to have permanent fiscal policy expansion without an accompanying future tax hike.
Even if government debts are assumed to be financed in the future through inflation that will be triggered by fiscal expansion, empirical research on related theoretical models is still insufficient. Therefore, the models cannot be applied to the actual policy formulation, nor used as the basis for macroeconomic forecast for such formulation.
Economic policy is implemented based on a critical decision that takes account of more than just gains and losses for various economic entities. This is because it is difficult to obtain the consent of stakeholders based on an economic model that considers future inflation to be inevitable but cannot predict when it will occur. Let me also note that actual policy management cannot help being prudent. The reason for this is that the policy authorities have to strongly recognize various constraints. In fact, macroeconomic policy is managed under various constraints -- such as those in terms of legal, accounting, and practical affairs, as well as the need for parliamentary consent.
I will close by noting the lesson learned from the 4-year experience since the introduction of QQE. Once long-term inflation expectations decline, it is not easy to raise them, even through the large-scale unconventional monetary policy. Given that monetary policy on its own has limited effects, it is vital to make steady efforts, such as through the labor market reform that I discussed earlier, in order to change conservative inflation expectations that are deeply rooted in people's mindsets. In particular, I consider it important to produce a change in the wage determination mechanism.
In the process of wage determination, it is desired that inflation targets set by central banks be the basis for the medium- to long-term path of inflation. For this purpose, central banks' inflation targets should gain sufficient credibility with the public. To this end, it is necessary to see achievements that prove monetary policy is able to change the inflation trend. It is not easy to regain credibility. As the frontrunner in combating deflation, however, the Bank of Japan will continue to endeavor to do so, always deliberating on what can be accomplished through monetary policy.