From Deflation to Reflation? Japanís New Monetary Policy Framework, Effectiveness, and Broad Lessonsby David Lipton
First Deputy Managing Director, IMF
At the Bank of Japan
May 28, 2014
Good afternoon. I’m delighted to be with you for this conference on “Monetary Policy in a Post-Financial Crisis Era”.
I think we can agree this is an apt topic for discussion at this Bank of Japan conference. And one that is helpful to the rest of the world.
Other major central banks find themselves newcomers to the challenge the BoJ has been grappling with for nearly two decades now: that of guiding their economies through the aftermath of a major financial collapse. We can all learn a great deal from the efforts of the BoJ to stimulate demand and combat deflation in the aftermath of the banking crisis of the 1990s, with its policy rate stuck close to the zero lower bound for the major part of the last two decades.
The latest innovation to the BoJ’s policy framework, Quantitative and Qualitative Monetary Easing (QQE) represents a clear break from the past in its scale, decisiveness, and ambition. My aim today is to consider the progress to date in exiting deflation under QQE and the lessons we can draw both for central banks elsewhere facing deflation risk as well as for the BoJ’s next steps.
But in order to gain perspective on these issues, I will first touch upon the developments preceding the adoption of QQE in April 2013 with a view toward understanding how changes during the lost decades have set the stage for what the BoJ is now trying to accomplish.
Ominously for Europe, Japan's experience demonstrates that deflation can become entrenched for years, despite repeated efforts at demand management. And it shows that low inflation and a sustained—even if gentle—decline in prices can have major impacts on economic performance and dynamism, implying that decisive early action to pre-empt the slide is essential.
Macroeconomic changes during 15 years of mild deflation
Back in 2000, John Taylor speaking at this conference, touched upon the theme of relative macroeconomic performance in Japan and the US under different inflation regimes.
As an aside, he ventured that 13 years out a future session of the conference might look at updated versions of his charts and possibly “see another reversal”.
Seemingly on cue, John’s conjecture on Japan appears to have come to pass following the introduction of QQE. Last year, core-core (as the BOJ defines it) inflation turned positive for the first time in years and has since been in positive territory for the longest spell since 1998. While that is substantial progress, a decisive reversal on prices is not yet assured. The deflationary period has been one of profound economic changes which make the task of durably exiting from deflation increasingly difficult.
Indeed, I would say that the headline number familiar to everyone here today—that nominal GDP is 8½ percent lower now than in 1997—masks the extent to which the macroeconomic picture has changed in the past decade and a half, as well as what the BoJ finds itself up against now.
What accounts for this decline in nominal output? While there are several factors at play, It seems clear that the collapse of the bubble in the early 1990s followed, a few years later, by the shock from the Asia crisis, set in motion interacting forces in asset, goods and labor markets that created the propensity for moderate deflation.
Balance sheet repair in the banking system, corporate deleveraging, and household attempts to rebuild net worth all combined to suppress demand. Then, the Asian crisis further contributed to the deficiency of demand, pushing the economy from low inflation to deflation in 1998.
Our usual understanding of how deflation works its way through the economy starts with the notion that in an environment of falling prices, firms will hold off on purchasing capital goods and households will step back from refurbishing existing homes and building new ones. In Japan’s case, we saw evidence of both. Barring the brief run up prior to the global financial crisis, private non-residential investment has been a declining share of GDP. Residential investment has been on a steady downward trend from 1997 until last year.
Of course, price declines are not the only reason why investment fell - there was some needed adjustment after the real estate bubble of the 1980s, and certainly the aging of the population contributed as well. But it is interesting to note that residential investment actually picked up in real terms in the low inflation period from 1990 to 1997 and only after that did it steadily decline until last year – covering the entire period of deflation.
This decline in private investment was also associated with less risk-taking in the financial sector. Investment strategies across most major investor groups in Japan appear to have broadly adjusted to an environment with mild deflation and low nominal interest rates, in which safe and liquid assets have delivered steady, albeit low, real returns. Portfolio allocations across households, banks, pension funds, and insurance companies, in particular, remain heavily weighted toward currency, deposits, and government securities.
Risk aversion is manifest in changes in the labor market as well – faced with diminished growth prospects, firms have been reluctant to hire workers on contracts that lock them into high wages and costly benefits. As a result, the share of regular workers among salaried employees has been falling over this period, and is associated with a loss of permanent income for workers (lower basic wages), less job security, and lower benefits.
All of this reinforced the contracting spirals of lower nominal spending over time.
Monetary and fiscal policy responses over the long deflation
Against this difficult backdrop compounded by recurrent external shocks, demand management tools were deployed, but failed to break the disinflation.
On the monetary side, starting in the late 1990s and through the aftermath of the global crisis, the BoJ provided policy support through various means: cutting the policy rate to the zero lower bound and experimenting with quantitative easing and asset purchases.
In hindsight, the experience points to the need for clear communication regarding the end objective and consistent implementation of policy easing toward that goal. But it also spotlights how difficult it is for a central bank to stimulate demand when confronted with powerful private sector imperatives to deleverage, repair balance sheets, and restore net worth.
Many have argued that balance sheet problems and deleveraging also blunted the effectiveness of an activist fiscal policy response to the onset of deflation. In this view, fiscal stimulus was tried and failed, proving to be a Sisyphean waste, with only the huge increase in sovereign debt left to show for it.
The proposition, however, doesn’t hold up to closer scrutiny.
Japan’s run-up of public debt was primarily driven by rising social security spending, and not excessive stimulus. Beginning in 1990, demographic changes started to weigh on public finances and were the main reason for the large average deficits of 5 percent of GDP during the decade.
Expansionary policy did at times deliver a positive fiscal impulse, but it was neither forceful nor sustained:
- Once the demographic effects were stripped out, fiscal stimulus was moderate. Between 1994 and 1998 fiscal impulses were 0.5 percent of GDP.
- Moreover, fiscal policy was implemented in a stop-go manner. Stimulus in 1995 and 1996 was followed by the consumption tax increase in 1997. A similar stop-go pattern continued in the early 2000s. Medium-term fiscal planning was limited, expansions announced for a year-at-a-time, and extended via supplementary budgets. As a result, fiscal policy had only a limited effect on consumer or business sentiment.
- Finally, the share of public investment spending was much smaller than the large headline numbers on expenditure suggest. Public investment rose only temporarily during the 1990s by 1 percent of GDP and declined thereafter (from 8 percent in 1997 down to 5 percent in 2013). In real terms, by 2013, public investment was half the level it had been in 1997.
Tracking exit from deflation under QQE
So how is QQE different from what was tried before in Japan?
The big difference is a bolder commitment aimed at shifting expectations (the latter being an important transmission channel at the zero bound).
Another difference is a clearer articulation that the effectiveness of monetary policy depends on complementary fiscal and structural reforms to lift growth expectations and generate the increases in nominal spending needed to support price momentum.
QQE has taken the lessons of the preceding gradualism to heart with a higher inflation target, more aggressive purchases of longer-dated JGBs and risk assets, and enhanced forward guidance. More broadly, the “three arrow” approach of Abenomics correctly emphasizes complementary fiscal and structural policies to bolster the monetary effort in the fight against deflation.
Concerted and aggressive policy action had a pronounced immediate effect last year. The turnaround on inflation and expectations fronts has been remarkable, owing in part to the announcement effects and forward guidance under the QQE framework, which specifies a target of 2 percent inflation while emphasizing that policy accommodation will be maintained until it is achieved in a stable manner.
Inflation has indeed been making steady progress toward this target and is becoming increasingly more broad-based over time.
But it is too soon to declare success, as some conditions still exist that could presage a tipping back into deflation.
Specifically, a large part of the rise in inflation has been due to the 20 percent depreciation of the yen that took place in early-2013. Our analysis suggests that within a sub-basket of non-tradable goods less sensitive to the exchange rate, inflation is currently running at less than 0.5 percent, well below the headline of around 1.5 percent inflation.
In addition, key capital goods prices continue to decline and labor earnings have so far been sluggish. Inflation expectations reflect this tentativeness: looking out past the 1-3 year horizons, where the recent hike in the consumption tax rate and the second one expected in October 2015 have their strongest impact, long run expectations are still well below the 2 percent target.
Finally, portfolio rebalancing of domestic investors has been somewhat limited so far – and this will be essential for generating wealth effects to support consumption and for the provision of risk capital to promote investment.
In sum, the 15-year-long grip of deflation appears to have created widespread passivity and a low appetite for risk taking. Sustaining further price rises will increasingly depend on overcoming these entrenched obstacles.
There are lessons in all of this that pertain not just to QQE, but also to countries other than Japan currently facing deflation risks.
The euro area, for instance, has been slow to recover from the global financial crisis. Although proactive and aggressive action by the ECB has been instrumental for negating tail risks, consumer price inflation at 0.7 percent is still uncomfortably low.
Moreover, some economic conditions in the euro area mirror those of Japan at the onset of deflation. Domestic demand is weak, in part because debt levels remain high and deleveraging is continuing, and credit is contracting. And, similar to conditions during Japan’s post-financial crisis period, the euro area has ample slack amid low employment growth.
In this context, assessing the acuteness of deflationary risks requires a broad approach. Taking too much comfort in stable and positive long-term inflation expectations can be a mistake. Prior to Japan’s deflation period, inflation expectations were reassuringly positive, but declined gradually as deflation set in.
The key here is for the euro area to remain ahead-of-the-curve and consider forceful action before low inflation becomes entrenched and to guard against the risk of deflation. Japan’s gradual approach of ever increasing stimulus during the last decade was not effective enough to prevent deflation from taking root.
Let me turn to the question of the BoJ’s next steps.
What is next for the BoJ?
The BoJ’s new monetary framework and its policy commitment are, I think, well understood. But available indicators suggest the public and investors are yet to be fully persuaded that inflation will increase to and stabilize at 2 percent.
In part, this may reflect doubts about the timeline of reaching this mark in “about two years”, as expressed in the initial forward guidance under QQE. And it is of course difficult to know precisely how inflation expectations will evolve coming out of a long deflation episode such as the one Japan has experienced. We are perhaps still very early in the process: the historical experience of efforts at disinflation in other advanced economies shows that expectations are slow to adjust.
Nevertheless, I would suggest that the gap between the market’s medium-term inflation forecast and the forecast by the BoJ’s policy board members indicates that the communication strategy – already a strength of the bank’s top leadership team - may need to be refined further.
In this regard, the BoJ could draw on the experience of other inflation targeters and place more emphasis on explaining how 2 percent inflation will be achieved “in a stable manner”.
Enhancing the communication strategy will help anchor inflation expectations at the 2 percent level and, in turn, further lower real rates, encourage portfolio rebalancing toward higher yielding assets, generate wealth effects on consumption, and accelerate the provision of risk capital for boosting investment in new growth areas.
I should, however, point out that without complementary fiscal and structural policies, monetary policy alone may not be sufficient to decisively shift growth expectations and lift nominal spending in a manner that would stabilize inflation at the 2 percent target. During the lost decades in Japan, efforts to end deflation and revive growth were often criticized for lacking sufficient coordination between demand management and structural reforms. Concrete growth and fiscal strategies are now even more critical to support QQE in its efforts to place inflation on a secure upward path toward 2 percent.
The role of the IMF
Let me end by saying a few words about the role of the IMF in this matter. QQE has raised interesting issues about evenhandedness for us. Under our new integrated surveillance decision, we are mandated to take up the issue with members if their policy actions lead to spillovers that may have a significant impact on the global system, even when those actions are undertaken to pursue domestic objectives. So, what does this mean for the IMF's view of Japan's QQE?
We have been supportive of Japan's efforts to use QQE even though a by product of that approach has been to depreciate the yen. Our judgment has been based on this policy approach fulfilling three requirements. First, we have to judge whether Japan has any alternative to QQE to escape deflation and reach its inflation target--put differently, it is acting for domestic reasons. Second, while the weaker yen may have some adverse impact on neighboring countries and the rest of the world, the policy approach must be temporary in nature, with a commitment to allow the real exchange rate to adjust as reflation proceeds and the BOJ's inflation target is achieved. And third, Japan needs to accompany its QQE with other policies that are supportive of reflation -- the other arrows of Abenomics -- to avoid relying too much on QQE and its impact on the real exchange rate. More broadly, our judgment is that there is little doubt that successful QQE and escape from deflation will have meaningful positive spillovers to the global economy in the medium term. One need only imagine that Japan had quickly escaped deflation fifteen years ago and registered improved economic performance since then to see that point.
Clearly, much rests on Japan's success in escaping deflation. Not for the first time, the world has much to learn by studying Japan's experience.