FRBSF Economic Letter
2000-11; April 7, 2000
 Economic
Letter Index
Inflation Targeting for the Bank of Japan?
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.
Inflation targeting as
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.
Real effects of monetary policy at zero
nominal rates
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.
Permanent benefits of inflation targeting
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.
Conclusion
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
Research Officer
References
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
98-18 (May 22).
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
