The 2 percent inflation target set by the government and the Bank of Japan (BOJ) is an appropriate level. The BOJ’s major shift in its monetary policy is a great step toward overcoming deflation.
The new government of Prime Minister Shinzo Abe has asked the BOJ to adopt an inflation target of 2 percent and the bank has accepted it, underscoring a significant change in its policy as it had previously held to a goal of “1 percent for the time being.” I have estimated that the most appropriate level of inflation is 1 percent to 2 percent, based on the following grounds.
First, considering the risk of provoking deflation, a minimum of 1 percent inflation is required as the margin of safety. The second point is to consider how much the existing adopted consumer prices deviate from the actual cost-of-living index (or upward bias). But there is a difference in views regarding the upward bias of consumer prices – 1 percent on the one hand and 0 percent on the other. I have, therefore, taken the mean and assumed the bias is 0.5 percent.
A recent study by Professor Tsutomu Watanabe of the University of Tokyo using large-scale data revealed that the consumer price index using the U.S. calculation method and the index using the Ministry of Public Management, Home Affairs, Posts and Telecommunications differs. The research team has reported there is a possibility of a 1 percent upward bias or more in the Japanese index.
When asking Donald Khon, former vice chairman of the U.S. Federal Reserve Board, at the time of his visit to Japan at the end of last November about the upward bias of consumer prices in the United States, he mentioned that there is 1 percent upward bias in the U.S. estimation, which signifies that if his view is correct Japanese consumer prices would have a 2 percent upward bias.
In other words, we can say that the Japanese consumer price index has at least a 1 percent upward bias. The appropriate inflation target will be 2 percent with the addition of a 1 percent upward bias and a 1 percent safety margin to avoid deflation.
The Abe administration has set an economic growth goal of 2 percent in real terms and 3 percent in nominal terms. The difference in nominal and real growth rates means a 1 percent increase in the gross domestic product (GDP) deflator (nominal GDP ÷ real GDP), which is the value-added price index with respect to the system of national accounts. However, the historical data for the GDP deflator change rate show that it falls about 1 percent below the change rate of the consumer price index. If the BOJ targets the inflation rate at 1 percent for consumer prices, the growth of the GDP deflator would be close to 0 percent and to realize the 3 percent nominal growth would be difficult. If the government and the BOJ cooperate in implementing macroeconomic policy, the 2 percent inflation target as measured by consumer prices will be required as called for.
The main reason for the failure of the BOJ’s quantitative monetary easing conducted during the period from March 2001 to June 2006 to overcome deflation by continuing “a quantitative easing policy until prices reach above 0 percent” is that the initial price goal was too low.
When the inflation rate reached over 0 percent, the BOJ terminated the policy in March 2006 as it had committed itself to doing when the policy was adopted. At the time, I was in the position of deputy BOJ governor, and in terminating the policy I asserted that “You don’t drive the car without deciding the destination,” which made the policy board members of the monetary policy meeting announce the preferred inflation rate. When abolishing the quantitative policy, the bank issued a statement on “an understanding of medium- to long-term price stability” which noted that the preferred level is in the range of 0 percent to 2 percent but the medium level is 1 percent. I took it as the same as adopting a “flexible inflation target” but it was a minority view among board members at that time in March 2006.
One other reason why the Japanese economy easily deflated after the Lehman Shock was because of the large differences in interpretation of “understanding of medium- to long-term price stability” among the policy board members. Furthermore, the 1 percent goal was too low to deal with the occurrence of the big shock. The Swiss National Bank sets its (price-stability) target at 0 percent to 2 percent in consumer prices and is carrying out monetary measures with an effective inflation goal of 1 percent. One of the Swiss bank’s board members mentioned confidently that a 1 percent margin is adequate to avoid the risks of deflation. However, the country fell into deflation as the result of the euro crisis.
For Japan to overcome deflation, it is first of all necessary to correct the strong yen. Secondly, through the improvement of labor supply-demand conditions, stable growth in nominal wages is required.
Since 1970, the yen has played the role of control valve for the rapidly falling dollar, euro and other major currencies, showing dramatic appreciation. When corporate managers forecast a stronger yen as the underlying market tone or an overly strong yen, their overriding imperative is to lower sales prices in order to survive international competition. This forces corporations to implement large-scale cost reductions, including the wages of their employees.
It can be said that “self-induced deflation caused by corporate managers’ strong-yen projections” began with the excessively strong yen in 1995. If the main reason behind deflation lies in an overly strong yen or forecasts of a stronger yen as the underlying market tone, taking initiatives to solve the root cause will be the fastest way to bail the nation out of deflation. Rectification of the strong yen will boost exports, leading to expansion of capital investment, as exports and capital outlays are intimately related in Japan. More importantly, correction of the strong yen may prompt corporate managers to change their view on exchange rate trends ahead and shift their pricing actions.
The quantitative monetary easing from 2001 to 2006 and large-scale intervention in the currency market resulted in the rise of the consumer price index from minus 1 percent to above 0 percent. It largely depended on the effects of the strong yen’s correction.
In this connection, during the period from September 2001 to July 2007, including the term of implementation of quantitative monetary easing, the yen’s nominal effective exchange rate weakened by 40 percent and the real effective exchange rate by 60 percent. On the other hand, the dollar showed a trend of moderate depreciation since the spring of 2002, and the euro played the role of control valve on the heels of the eurozone’s economic bubble.
Regarding desirable levels of exchange rates, I think that more weight should be placed on the terms of trade (proportions of export and import prices). Suppose all goods and services can be exported, the real effective exchange rate should be equal to the inverse number of the terms of trade. If the terms are variables that indicate the fundamentals of the goods and services market, the margin of deviation in real effective exchange rates from the inverse of the terms of trade will signify the degree of excess in a strong or weak yen.
Furthermore, if consumer prices are the proxy variables of wages and if “the law of one price” (one price for all identical goods) prevails in the market, the difference between the real effective exchange rate using the consumer price index and the inverse of the terms of trade will signify the degree of impact on corporate earnings, or the international competitive power of a nation. (Koichi Hamada-Yasushi Okada hypothesis).
In terms of the economy, needless to say, there are goods and services that cannot be traded. To understand and recognize the existence of non-trade goods, the difference in prices between domestic and foreign markets is required to be in addition to the inverse of the terms of trade (Ballasa-Samuelson effect). Japan trades with various countries at different economic development stages and therefore the impact of the Ballasa-Samuelson effect on real effective exchange rates is limited.
The yen’s real effective exchange rate has maintained the underlying tone of a strong yen since 1970, distinctively as compared to other countries. The currency has shown a steep appreciation at a time when the dollar and the euro declined sharply.
The Deutsche mark had also assumed the role of control valve at the time of the dollar’s downswing. However, Germany’s real effective exchange rate, surprisingly, has maintained almost the same level as in 1970. This means that there are fewer occasions on which Germany’s exchange rate deviates from “purchasing power parity” which is determined by reflecting the gap between rises in domestic and foreign prices. The terms of trade in Germany also show small fluctuations around the same level. The real effective exchange rate has been moving almost neutrally in line with the level of international competitiveness, partly owing to the effects of joining the euro.
In Japan’s case, according to the calculation, the yen’s strength was 30 percent in excess of the equilibrium exchange rate measured with the inverse of the terms of trade in the latter half of 2012, and 15 percent when excluding energy-related items from import prices in the terms of trade. The assumption of a case excluding energy-related goods was made in recognition of the crude oil and commodity markets becoming utilized for financial assets investment since 2005.
Direct conversion to a nominal dollar-to-yen rate lacks accuracy, but given the dollar-to-yen rate in 2012 was 78 yen, an exchange rate in the range of 90 yen to about 100 yen (if the median is taken, 95 yen) can be considered as a recovery to the equilibrium rate.
Nominal wages per capita, which are the second factor crucial to overcoming deflation, have shown a descending trend since 1997. From 2005 to 2006, nominal wages rose temporarily. Coupled with the weaker-yen trend, I was then convinced that Japan could defeat deflation. However, nominal wages ceased rising in December 2006 and eventually returned to negative growth. Although the root cause was the mass retirement of the baby boomer generation, it can be said that the rise in nominal wages was not sufficiently stable.
As nominal wages faltered into negative growth in December 2006, I firmly believed the Japanese economy would fall back into deflation and opposed credit tightening in February 2007. This was a moment when they lost the opportunity to defeat the dragon of deflation, just as in the saying, “Ryusei kotei chodao issu” (the sword flashed in a moment but failed to get the big target) warns. From historical data, a decrease to about 3.5 percent in the unemployment rate is demanded and necessary for wages to rise stably.
Although the desired inflation target is 2 percent, the view that it is impossible to realize is deeply rooted among private economists. For prices to rise, excess supply must shift to excess demand in terms of the GDP gap, which is the difference between aggregate demand (real GDP) and supply (potential GDP) in the economy.
What is the volatility rate of consumer prices against a 1 percent alteration in the GDP gap? The degree of sensitivity largely varies depending on the duration of its measurement. Long term would be 0.4 and short term 0.1. If the assumption is made of 0.2 in sensitivity, a 10 percent GDP gap movement would be required to raise consumer prices from about 0 percent to 2 percent. Suppose the potential growth rate is 0.5 percent, a 2.5 percent (five-year average) growth rate of aggregate demand would be required.
The degree of sensitivity for consumer prices against GDP gap also relies on corporate pricing actions and expected inflation rates. Should sensitivity against an alteration in GPD gaps heighten in line with changes in corporate pricing actions and expected inflation rates, the required growth of aggregate demand can be smaller. Presuming the sensitivity of consumer prices rises from 0.2 to 0.3 due to a change in corporate actions triggered by the rectification of the strong yen and movements in inflation rates, the required expansion of aggregate demand will be 2 percent. If 2 percent real economic growth is realized by the Abe administration, the inflation target of 2 percent will also be achieved at the same time.
Fiscal stimulus is needed to achieve the extrication of the economy from deflation “as soon as possible” because Japan has approximately 3 percent of demand shortage (deflation gap) against GDP. There are two conflicting views on fiscal measures. Professor Paul Krugman of Princeton University highly regards the use of fiscal action but Professor Martin Feldstein of Harvard University points out the risk of the increase in government debts and sharp rise in long-term interest rates. Observing the (recent) market reaction, fiscal measures have led to stability in long-term interest rates, higher stock prices and a weaker yen occurring at the same time. This signifies that fiscal stimulus has been working to empower the vitality of the private sector. However, fiscal spending does not last forever. There is a limit to the amount of newly issued government bonds the private sector can soak up. While promoting transition toward economic growth led by private demand, mid- and long-term targets for fiscal soundness should be clearly presented at the same time.
There are two ways of approaching to 2 percent economic growth led by private demand.
The first is drastic reform of the tax and social security systems. The Japan Economic Research Center has twice announced results of its simulations that lowering the unemployment rate to 3 percent or below is possible with the expansion of personal consumption and capital investment through the combination of reform of the public pension system (shift to a tax-based basic pension scheme, and income-proportionate and defined-contribution pension plan) and a tax overhaul (1 percent step-by-step increase in consumption tax and decrease in corporate tax). As nominal wages increase, consumer prices will rise about 1.5 percent, excluding the impact of the consumption tax hike.
These reforms will have an effect similar to those proposed by Professor Feldstein to overcome persistent deflation in Japan: “reduction of payroll tax and increase of corporate tax.” The combination of reducing payroll and investment taxes and hiking the consumption tax will have the same economic effect as a reduction of interest rates even under the current key policy 0 percent interest rate.
The second method is to set a national target toward which people can expect the Japanese economy to take an equilibrium route for long-term expansion.
In China, it is said that a middle income trap or “wall of 10,000 dollars GDP per capita” exists. In Japan, a pessimistic view prevails that the “50,000 dollar wall” cannot be wiped out in regard to national gross income per capita. The national gross income per person reached 40,000 dollars in 1995 and ranked in the top class among developed countries. Income growth fell into stagnation after that year and the level as of 2011 was still about 40,000 dollars, dropping out of the top-class rankings. It is possible, however, to break the “50,000 dollar wall in national gross income per capita” if 3 percent growth can be achieved for eight consecutive years.
Furthermore to counter the anticipation that the Japanese economy will contract due to a population decrease in the future, Japan must set a long-term goal of maintaining population size (at a little below 100 million) until 2050. In order to get closer to the goal of 2.1 from 1.39 in fertility rate (the average number of children a woman will have over her lifetime), all policy resources should be used. It is also essential to improve the female workforce participation rate to the same level as the Netherlands. This will necessitate creating an environment to allow “child care by dual working parents.” To realize this, a flexible employment and salary system based on the importance of the job and responsibility must be put in place. To achieve stability in the working age population ratio, a goal must be set to create a society that enables the labor force to work until the age of 70. Should the above measures prove insufficient in stabilizing the size of the population, the government must be prepared to accept 200,000 immigrants in 2050.
In addition to the maintenance of population size, the promotion of innovation is essential to break the “50,000 dollar wall.” South Korea breached the “10,000 dollar wall” by focusing on enriching the quality of secondary and higher education. It is desirable for Japan to break through the “50,000 dollar wall” by improving the quality of higher education centered on universities. Positioning universities as the center of “the best and highest training sites for capable human resources,” the number of “university ventures” (venture businesses initiated by universities or their research achievements) must be increased from the existing 79 per year to 800, which is half the number in the United States.
Japan must set a national target to maintain its position as a country with a top-class economy. Maintaining such a position will lead to affluent living standards for each individual, and at the same time have a positive influence on other countries through the provision of public goods, such as sustaining a stable international currency system and strengthening the free trade framework.
Translation of an article (pages 76-79) from the weekly magazine Economist Feb. 26, 2013 issue (The Mainichi Newspapers)
Kazumasa Iwata was born in 1946. He graduated from the University of Tokyo and joined the Economic Planning Agency (current Cabinet Office) in 1970. After serving as professor at the College of Arts and Sciences at the University of Tokyo from 1991 and director general in charge of economic assessment and policy analysis at the Cabinet Office from 2001, he assumed the post of deputy governor of the Bank of Japan in 2003. He assumed his current post in 2010. Iwata received the “Economist Prize” in 1981 for a book titled “Banks’ Behavior and Monetary Policy” which he jointly authored with Koichi Hamada.