## Time for Change

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**Canonical URL:** [Time for Change](https://www.imf.org/-/media/files/publications/fandd/article/2023/march/shirakawa-time-change.pdf)

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### Central critique of the prevailing model
- Central banks missed the recent high inflation—levels "not seen in 40 years"—despite earlier focus on low inflation.
- Triggering events (pandemic, war in Ukraine) were supply-side, yet their inflationary impact depended on preexisting financial conditions shaped by monetary policy.
- Central bankers are "not entirely blameless" for failing to restrain inflation even after deeming it transitory.

### Unfounded fear: zero lower bound and deflation
- Jay Powell (August 2020 Jackson Hole) argued that falling inflation expectations below the 2 percent objective reduces scope to cut rates, risking inability to stabilize employment.
- Japan reached the zero lower bound long before other economies, yet:
  - Growth of Japanese GDP per person was in line with the G7 average from 2000 to 2012.
  - Growth of Japan’s GDP per working-age person was the highest among the G7 during the same period.
- The Bank of Japan’s balance sheet expanded from 30 percent to 120 percent of GDP after 2013; the impacts on inflation and growth were "modest."
- Unconventional monetary policy can be potent depending on timing; forward guidance can be ineffective in weak economies but suddenly "too expansionary and inflationary" after surprise shocks.

### Political naïveté and flexible average inflation targeting
- Adoption of flexible average inflation targeting, which allowed inflation to overshoot, contributed to delayed tightening.
- Central bankers underestimated the political difficulty of reversing stimulus—the "difficulty of taking away the monetary punch bowl" in democratic societies.
- The "Great Moderation" (about 20 years beginning in the mid-1980s) may have led to complacency: success of independent central banks could reflect favorable supply-side factors (entry of developing/former socialist economies, rapid IT advances, stable geopolitical environment) rather than purely policy skill.
- Unwinding unconventional policy is now harder amid heightened geopolitical risk, rising populism, and pandemic-induced supply disruptions; central banks face a trade-off between inflation and employment.

### Reconsidering the monetary policy framework — three issues highlighted
1. Reassess focus on deflation and the zero lower bound
   - Some economists advocate a higher inflation target to create "additional room for interest rate cuts" and avoid deflation risk.
   - Author is skeptical: argues that entering the 2008 crisis with a higher inflation target would not have materially changed outcomes.
   - Cites Paul Volcker: "deflation is a threat posed by a critical breakdown of the financial system."
   - Central banks must monitor financial imbalances (debt-fueled asset bubbles, financial crises) in addition to macro indicators like inflation and the output gap.

2. Reflect on prolonged monetary easing and its consequences
   - Example: Japan’s stagnant growth from structural factors (notably a "rapidly aging and shrinking population") was misconstrued as cyclical weakness, leading to decades of easing.
   - If monetary easing persists "over a longer period of, say, 10 years or more," adverse effects on productivity through resource misallocation become serious.
   - Monetary policy should not ignore supply-side considerations even if it primarily targets demand.

3. Attend to national differences in policy framework design
   - Employment practices (e.g., Japan’s "long-term employment" implicit contract) alter wage dynamics and inflation dynamics; Japanese consumer inflation is accelerating but "at a much slower pace" than in other advanced economies.
   - Differences in social contract and economic structure undermine a "one-number-fits-all inflation-targeting strategy."
   - A currency anchor requires a firm central bank commitment to restrain inflation and act as lender of last resort—not merely setting an inflation target.

### Key observations and policy implications
- Inflation targeting emerged in response to stagflation of the 1970s and early 1980s and is not immutable; its limitations are now clearer after recent events.
- Central banks should:
  - Incorporate financial stability considerations into monetary policy decision-making.
  - Avoid treating prolonged monetary easing as a benign, reversible tool; recognize potential long-run supply-side distortions.
  - Customize frameworks to national institutional and structural features rather than applying uniform targets.
- The intellectual foundation of monetary policy used for the past 30 years needs reconsideration and renewal.

*Masaaki Shirakawa, "Time for Change," Finance & Development, March 2023.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/shirakawa-time-change.pdf_