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Japan’s war against deflation: progress and risks

More than a year after its launch, the impact of “quantitative and qualitative easing” seems pervasive. The Bank of Japan asserts that the output gap has closed, that inflation expectations have increased, and that the conquest of deflation would be in sight. The policy board has maintained its commitment to the 2% inflation target through forward guidance and large-scale JGB purchases. However, without successful fiscal consolidation and supply side reforms this policy poses new serious risks.

The below are quotes based on Bank of Japan board member presentations and speeches, as well as two IMF publications. Emphasis and cursive text has been added. Links to the sources are at the bottom of the post.

The objectives of QQE
“QQE [quantitative and qualitative monetary easing, introduced in April 2013] has two major pillars. The first pillar is a commitment to achieve the 2 percent price stability target as swiftly as possible. Specifically… the Bank provided a time frame, pledging that it would achieve the price stability target…with a time horizon of about two years. The second pillar consists of underpinning the first pillar — the commitment — with specific actions. The main action is to double the monetary base in two years through massive purchases of government bonds, including those with longer remaining maturities.” [Iwata, June 2014]
“The Bank of Japan [means] to achieve the price stability target of 2 percent…by bringing about an improvement in the output gap and encouraging a rise in inflation expectations with large-scale asset purchases and a clear commitment.…In Japan, with deflation continuing for nearly 15 years, the expectation that prices will not rise had taken hold. Breaking out of the status quo…means that firms’ and households’ behavior is based on the expectation of continued inflation of around 2 percent.” [Nakaso, July 2014]
“What the price stability target aims to achieve is not a situation in which only prices will rise. Rather, it aims to achieve an environment in which the improvement of the overall economy results in higher wages and then higher prices.” [Sato, March 2014]
“QQE does not rely on an increase in import prices due to depreciation of the yen.” [Iwata, June 2014]
The operating target
“The main feature of QQE was a shift in the main operating target for money market operations from the uncollateralized overnight call rate to the monetary base…It was thought it would be intuitively easier for the public to grasp the essence of monetary easing: an increase in the ‘quantity’ could easily be connected to a large-scale supply of cash, creating an image of inflation…there was general agreement among the Policy Board members that changing the main operating target would…enable the Bank to wipe away its image as a reluctant monetary accommodator… it was then decided that the size of the monetary base would rise at an annual pace of about 60-70 trillion yen, to be doubled in two calendar years (2013-14). Under this monetary base target, the Bank currently purchases JGBs of approximately 50 trillion yen (on an outstanding basis) each year to double the amount outstanding in two years” [Shirai, February 2014]
Forward guidance
QQE entails forward guidance as one of its most important elements [including a statement of the] intention to continue with QQE as long as it was necessary for maintaining the 2% target in a stable manner. [This is] state-contingent guidance. The Bank applies forward guidance to QQE as a package. Once the pace of the annual increase in the monetary base is set, the approximate pace of increase in JGB purchases is determined accordingly. In this sense, the pace of increase in the monetary base and that in asset purchases are treated as ‘non-separable’… Then the Bank uses forward guidance to inform the public of its intention to maintain an increase in the monetary base and thus in asset purchases in the future. In other words, the Bank attempts to exert downward pressure on the entire yield curve by influencing the expectations of the markets and the public about the low level of the yield curve in the future.” [Shirai, February 2014]
“The QQE thus relies on the mechanism in which the combination of the forward guidance and asset purchases will maintain nominal long-term interest rates at low levels. That is not different from what happens at other central banks, such as the Federal Reserve and the Bank of England, which also depend on similar unconventional monetary policy.” [Sato, March 2014]
“CPI inflation is expected to approach the price stability target of 2 percent. However, if the outlook changes due to the manifestation of some risk factors and it is judged necessary for achieving the price stability target, the Bank will make adjustments without hesitation. I would like to emphasize that, under QQE…it is a matter of course that the Bank will make adjustments if necessary to ensure the target is achieved.” [Kuroda, August 2014]
Progress in meeting’s QQE’s objectives
“Under the Bank’s large-scale purchases of government bonds, long-term interest rates have been stable. At the same time, inflation expectations have been rising on the whole, so that real interest rates — that is, nominal long-term interest rates minus the expected rate of inflation — have declined, thereby stimulating private demand. As a result, the output gap has improved and inflation has accelerated…Therefore, the conquest of deflation in Japan is now in sight.” [Nakaso, July 2014]
“One clear achievement of QQE (and of the anticipated greater monetary easing from the end of 2012) is that long-term real interest rates turned negative and have remained in negative territory”  [Shirai, February 2014]
Risks and limitations
 “There is a limit to the extent to which a central bank can control the nominal long-term interest rates. Therefore, the government’s efforts for fiscal consolidation are vital….If growth expectations do not rise materially due to the aging, the fiscal structure will remain vulnerable… even after we manage to overcome deflation.” [Sato, March 2014]
Asset purchases are already unprecedented: each year that the QQE program is maintained, the BoJ will add approximately 5 percent of the outstanding stock of JGBs to its existing holdings, estimated at 23 percent at end 2014. Continuing with QQE in its current form for too long could impair market liquidity or give rise to financial stability risks as asset prices could become disconnected from fundamentals.” [IMF country report, 2014]
“Deflation has led to excess savings in the private sector [decreasing in the household sector and increasing in the corporate sector], and that has enabled the government to finance its debts with subdued borrowing costs. Thus, ‘deflationary equilibrium’ has prevailed. The equilibrium is subject to change once the QQE succeeds and Japan’s economy overcomes deflation…the propensity to import will rise by stimulating investment and spending. That will lead to an outflow of income overseas. Under such circumstances, domestic excess savings in the private sector are likely to shrink, if not a reversal from excess savings to excess investment…In light of the decline in excess savings, if the fiscal deficit does not change, the current account balance will register a deficit. We might no longer be able to finance all government debts with domestic savings. Then, overseas investors will ask for a higher premium, possibly driving the government’s borrowing costs even higher.” [Sato, March 2014]
“Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We…find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need.” [Anderson, Botman, and Hunt, August 2014]
Anderson, Derek; Dennis Botman ; and Ben Hunt, “Is Japan’s Population Aging Deflationary?”, IMF Working Paper, 14/139
Iwata, Kikuo, “Japan’s Growth Potential and Quantitative and Qualitative Monetary Easing’, Remarks at a Panel Discussion at the Bank of Korea International Conference, June 3, 2014
Kuroda, Haruhiko, “Japan’s Economy – Achieving 2 Percent Inflation”, speech at a meeting, held by the Naigai Josei Chosa Kai (Research Institute of Japan), Tokyo, 1 August 2014
Nakaso, Hiroshi, “Japan’s Economy and Monetary Policy”, speech at a Meeting with Business Leaders in Shizuoka, July 23, 2014
Sato, Takehiro, “Quantitative and Qualitative Monetary Easing: Importance of Fiscal Consolidation”, speech at the Japan Society in New York, March 19, 2014.
Shirai, Sayuri, “Communication and Forward Guidance in a World of Unconventional Monetary Policy: The Case of the Bank of Japan”, February 2014

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