April 26, 2019 / 6:41 AM / in 3 months

Breakingviews - Guest view: Halve Bank of Japan’s inflation target

Japan's Prime Minister Shinzo Abe speaks during a debate session with seven other party leaders in Tokyo December 1, 2014. REUTERS/Toru Hanai

NEW HAVEN, Connecticut (Reuters Breakingviews) - For all the successes of Japanese Prime Minister Shinzo Abe’s economic policies, consumer prices are rising more slowly than the central bank’s 2 percent target. Aiming for a lower inflation rate is acceptable in a country where unemployment is low, especially since asset purchases will remain a lever at monetary policymakers’ disposal.

In 2012, when Abe returned to power for a second term, Japanese college graduates were struggling to find meaningful work. Seven years into “Abenomics”, they have few such difficulties. In fact, there is such a shortage of labour that there are more than 1.6 effective job offers for each applicant. And in the economy as a whole, there is a shift away from the excess supply that Abe inherited from the previous administration.

However, investors, particularly in the debt market, are worried by low, or even negative, interest rates since they consider this to be an “exceptional” phenomenon, which deprives bond traders and bankers of profit opportunities. They are concerned that the situation will persist for some time. Japan’s inflation rate is around 1 percent and may struggle to rise much higher even if employment rates stay high. New technology, such as artificial intelligence, is replacing labour, which means the middle classes are less able to demand higher wages.

That is not necessarily a problem. Inflation is undesirable, other things being equal, because it erodes households’ disposable income. Granted, unemployment declines more easily when there is mild inflation rather than none. But for Japan, where the jobless rate is low, halving the inflation target does not raise any serious concerns. 

One possible objection might be that in a world where the United States and the euro zone stick to inflation targets of around 2 percent, the yen’s exchange rate would in theory appreciate by around 1 percent per year. This might have some short-term effect on the competitiveness of Japanese exporters.

Such currency moves would, however, be relatively small compared with typical swings. For example, the dollar/yen exchange rate has fluctuated in range of slightly less than 10 percent so far in 2019. Also, while the yen may appreciate in nominal terms, its inflation-adjusted exchange rate against the dollar and the euro would stay broadly unchanged and would not therefore interfere with real resource allocation. As a result, changing Japan’s inflation target can be viewed as just a technical matter.

That does not mean policymakers should overlook the effectiveness of quantitative easing when interest rates are close to, or below, zero. Asset purchases influence the economy through the outstanding stock of money. The price of oranges relative to apples goes down if more oranges are suddenly available relative to the number of apples. Similarly, monetary expansion in a country tends to weaken its currency against that of others. If countries went back to using interest rates as their only policy lever rather than relying on QE when needed, the world economy would lose a safety valve against financial crises. But this is unlikely to be the case. Better then to focus on the labour market and human capital formation, for example by improving the pre-school education of young children, instead of worrying too much about a 2 percent inflation target.

-The author is an economic adviser to Japanese Prime Minister Shinzo Abe and a professor emeritus at Yale University. The opinions expressed are his own.


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