FRBSF Economic Letter
2000-11 | April 7, 2000
Pacific Basin Notes. This series appears on an occasional basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies within the FRBSF’s Economic Research Department.
The Japanese government and the Bank of Japan (BOJ) are both considering the merits of conducting that nation’s monetary policy by pursuing an explicit inflation target. However, they seem to view inflation targeting as a means to quite different ends, which leads them to different conclusions about the proper timetable for a move towards such a regime.
The government’s motivation for promoting inflation targeting appears to stem from countercyclical concerns. This interest is no doubt linked to the fact that Japan’s current “zero interest rate” policy has not led to much of an increase in real activity in the Japanese economy. A panel from the government’s Liberal Democratic Party recently came out in favor of inflation targeting as a measure to provide further easing of monetary policy to stimulate aggregate demand (Nihon Keizai Shimbun, February 24, 2000).
In contrast, those members of the BOJ’s policy-setting board who have entertained the possibility of inflation targeting publicly, such as Kazuo Ueda (Nihon Keizai Shimbun, February 26, 2000), have stressed the potential benefits of inflation targeting in terms of the credibility, accountability, and transparency of the monetary regime. In particular, BOJ members have argued that a switch to an inflation-targeting regime is not a proper policy for combating low aggregate demand in the current environment.
In this Economic Letter, I explore the implications of an explicit inflation target for Japan. I first examine the potential for the immediate adoption of inflation targeting to facilitate Japan’s economic recovery. I then turn to the arguments for a permanent move to inflation targeting unrelated to the pursuit of current countercyclical policy.
Countercyclical arguments for the adoption of an inflation targeting regime center on the desirability of moderate price increases to magnify the expansionary effect of the BOJ’s “zero interest rate” policy. For the past year, the BOJ has brought nominal interest rates on short-term debt effectively close to zero. Under a zero nominal interest rate, the real rate of interest is equal to minus the rate of inflation. Consequently, at a zero nominal rate, an increase in the level of inflation can reduce the real interest rate.
Holding all else equal, it is believed that such a reduction in the real rate of interest would increase current investment and consumption. A sufficient increase in inflation could then stimulate aggregate demand and promote overall economic activity.
However, some members of the BOJ urge caution towards adopting an explicit inflation target as a short-term policy instrument. They stress that announcing an inflation target does not guarantee the achievement of that target, particularly in the absence of current inflation. This position finds some support in a large body of literature, going all the way back to Keynes, that addresses the constraints on expansionary monetary policy in the neighborhood of a zero nominal interest rate. Specifically, once nominal rates are zero, they can be driven down no further. The primary reason is that holding a short-term asset yielding a negative nominal rate would be dominated by holding cash. As a result, a monetary expansion at a zero short-term interest rate would be merely an exercise in swapping one asset with zero nominal return for another. The expansion would change the composition of the central bank’s balance sheet, as it issued currency and acquired reserves, but it would have no impact on the nominal rate of interest or the domestic price level.
Even though the interest rate channel is shut down at zero nominal overnight rates, there are arguments that other channels exist for real short-term effects of the adoption of a positive inflation target. These arguments are of two types. First, the expansion of the money supply may have real effects in the neighborhood of a zero nominal short-term rate. Second, the adoption of an explicit positive inflation target may affect the expectations of agents concerning the magnitude of future monetary expansion. These changes in expectations may then have real effects. I examine each in turn.
In their analysis of monetary policy in a low-inflation environment, Orphanides and Wieland (1999) discuss a number of ways that imperfect asset substitutability can allow monetary expansions to have real effects under a zero nominal interest rate. First, monetary policy can “flatten the yield curve,” i.e., drive the yield on long-term debt closer to the short-term yield. The BOJ could attempt to influence the term structure directly by purchasing long-term securities. Typically (and this is currently true in Japan), long-term assets still yield a positive nominal interest rate when short-term rates are zero. Even though short-term rates remain unchanged, such a change in the yield curve may have a real impact on investment rates by reducing the cost of obtaining long-term finance.
Second, a monetary expansion may lead to exchange rate depreciation. If foreign and domestic assets are imperfect substitutes, the BOJ could put downward pressure on the yen through large sales of yen assets. Once this exchange rate depreciation occurs, there are a variety of potential sources of upward pressure on the general price level. The exchange rate depreciation will raise the price of tradable goods domestically. The depreciation also may increase a nation’s competitiveness, raising the level of exports. The latter effect would increase aggregate demand, raise real activity, and ultimately put additional upward pressure on the price level.
On the other hand, announcing the adoption of an explicit positive inflation target also may have real effects by changing expectations about future monetary expansions. If the adoption of an explicit positive inflation target leads people to expect a higher rate of inflation in the future, then it will have implications for the price level today. In this manner, the adoption of an explicit positive inflation target may influence the price level today independent of its impact on the current monetary base.
The expectations channel also may apply to the exchange rate. If the announcement of an explicit inflation target changes people’s expectations about future monetary policy, it will influence their current relative demand for the domestic currency. In particular, if people expect higher inflation levels in the future, then, holding interest rates constant, the current exchange rate must depreciate. This exchange rate depreciation may influence current real activity, as described above.
Explicit inflation targeting will have such an impact on people’s expectations only if the inflation-targeting policy is credible. However, the optimal method of credibly committing to a positive inflation target in a zero or negative inflation environment is unclear. Krugman (1998), for example, argues for legislation mandating an aggressive explicit inflation target for a long period of time.
The permanent arguments for and against an explicit BOJ inflation-targeting policy do not differ much from those that apply to other developed nations. For example, Rudebusch and Walsh (1998) reviewed the merits of pursuing an inflation target for the United States. On the positive side, they argued that explicit inflation targeting would provide greater transparency concerning the goals of monetary policy. This enhanced transparency would diminish the pressure sometimes placed on central banks to pursue goals other than price stability. It also would increase the accountability of the monetary authority, in that its success in achieving its inflation target could be easily monitored. In addition, it would help reduce uncertainty in the economy about monetary policy. Rudebusch and Walsh argue that in the absence of an explicit policy target, monetary policy is too dependent on the individuals currently holding office in the monetary authority.
On the negative side, the authors acknowledge that pure inflation targeting precludes the pursuit of other policy goals, such as the stability of the financial system and full employment. While monetary policy can only deliver price stability in the long run, it can be used to address these other concerns through short-run policies, such as the provision of liquidity to the financial sector during episodes of turmoil. Discretionary policy allows the monetary authority to weigh these short-term concerns against its long-term price stability goal. In addition, because inflation responds to monetary policy with a lag, any pursuit of an inflation-targeting policy must rely on forecasts of future inflation. These forecasts will certainly contain errors. Of course, similar problems might arise with other policies, such as targeting the level of nominal income.
These arguments, both pro and con, appear to apply equally well to Japan. In addition, the BOJ recently has experienced an increase in its formal independence. In that sense, it shares with the European Central Bank (ECB) the desire to establish credibility as a monetary authority that places a strong emphasis on the pursuit of price stability. The ECB, which has an explicit inflation target as one of its policy targets, stressed the desire to build institutional credibility as one of the reasons for adopting an explicit inflation target.
While the BOJ and the Japanese government are both considering inflation targeting, they have different opinions about the merits of the immediate adoption of an inflation-targeting policy. Many in the Japanese government currently advocate adopting an explicit inflation target as a countercyclical policy tool. They argue that doing so will act to stimulate aggregate demand through the various monetary policy channels described above. Moreover, they argue that easing monetary policy in Japan is preferable to greater fiscal injections, given the large deficits the country has accrued in its attempts to stimulate demand.
BOJ officials have expressed caution about adopting an explicit inflation target as a vehicle for countercyclical policy. First, because monetary policy affects the economy with a lag, they argue that a large monetary stimulus in an environment where recovery is incipient runs the risk of leading to higher than desirable inflation rates. Second, because nominal interest rates are close to zero, further expansion would have to come through non-standard methods, such as expanded purchases of long-term Japanese government debt. BOJ officials have expressed some reluctance about pursuing such a strategy in an environment of high budget deficits. With BOJ independence still relatively new, some officials are reluctant to give even the appearance of a willingness to monetize fiscal deficits.
Instead, some officials at the BOJ have held out the possibility of a move to inflation targeting after a Japanese recovery. This timing will not address Japan’s current economic difficulties. However, it may enhance the credibility, accountability, and transparency of Japan’s monetary regime over the long term, as discussed above. Nevertheless, the permanent advantages of an explicit inflation target are also controversial. Other developed nations have made different choices; while the European Central Bank has chosen an explicit inflation target as one of its monetary policy targets, the Federal Reserve Bank of the United States does not have an explicit inflation target.
Mark M. Spiegel
Krugman, Paul R. 1998. “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap.” Brookings Papers on Economic Activity 2, pp. 137-206.
Orphanides, Athanasios, and Volker Wieland. 1999. “Efficient Monetary Policy Design Near Price Stability.” Board of Governors, Federal Reserve System, Finance and Economics Discussion Series Working Paper No. 1999-67.
Rudebusch, Glenn D., and Carl E. Walsh. 1998. “U.S. Inflation Targeting: Pro and Con.” FRBSF Economic Letter 1998-18 (May 22).
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