Japan's policy shift needs anchor to normality

Economics:Shinzo Abe, Japan’s prime minister, continues to astonish. He could hardly have chosen a more radical team than the one he has appointed to run the Bank of Japan. Haruhiko Kuroda, a critic of the BoJ’s past passivity, is now in charge of monetary policy.

Kuroda not only wants to deliver 2 per cent annual inflation but considers this to be within the power of the central bank. He can expect to have the backing of the government and the new deputy governors, Kikuo Iwata and Hiroshi Nakaso. The BoJ may grumble. But a shift in policy seems sure. The question is: will it work? Indeed, what might “work” mean?

One must start by noting Japan’s peculiar position. Expectations of deflation are well entrenched, in bond markets, if not in surveys, with yields on government 10-year bonds now at 66 basis points. Real rates of interest have remained positive, even at the short end. Deflation has also been very sticky. Finally, the distribution of debt has shifted from the private to the public sectors: according to economic advisers Smithers Co, net debt of non-financial companies has fallen from 150 per cent of equity in 1995 to 30 per cent. But government net debt has jumped from 29 per cent of gross domestic product at the end of 1996 to 135 per cent at the end of 2012.

These facts have deep implications. First, ending deflation is going to be far harder than it would have been in the late 1990s. Second, it would be helpful if higher inflation also made real interest rates negative, which would encourage people to spend. Third, negative real rates would also redistribute wealth from the state’s creditors towards future taxpayers.

Risk of political backlash

Such negative real rates can be achieved either by making inflation higher than expected or by capping interest rates. It is not, in fact, clear whether the Japanese authorities want to create strongly negative real rates of interest. But they should, even though this would also create the risk of a political backlash.

How should this be done and how transparently? The BoJ could insist that it is aiming at 2 per cent inflation, but follow policies likely to bring higher inflation than this. That would be risky deceit. Alternatively, it could announce the aim of higher inflation while announcing a lengthy period of low nominal interest rates. This would be an open inflation tax.

Either way, policy could be buttressed by a temporary move to a target for price or nominal GDP levels. The argument for this is that bygones should not, in this extreme case, be bygones. The current price level is 30 per cent below where it would have been if annual inflation had been 2 per cent since 1997.

Similarly, nominal GDP is 40 per cent lower than it would have been if it had grown at 3 per cent a year. If the BoJ sought to return to the level of nominal GDP implied by 3 per cent annual growth from 1997, it would be committing itself to an annual increase of close to 9 per cent a year over the next decade. That could surely reduce the real burden of debt! Thereafter, policy makers might return to a 2 per cent inflation target. This is illustrative, not a recommendation. But the case for such radicalism is that it could change economic prospects quickly. Normal targets may not be enough.