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Japanese Economy Update

Are the views of the Government and the BOJ consistent?

Jun SAITO
  Senior Research Fellow

2016/09/02

Division of labor between the Government and the BOJ

Responsibilities for macroeconomic policies belong to the Government and the central bank. More specifically, in the case of Japan, the Bank of Japan is responsible for the monetary policy which aims for price stability, and the Government is responsible for fiscal policy which aims for sustainable growth and full employment.

It is a natural division of labor between the two bodies which can be derived from the so–called principle of effective market classification. The principle, which is often paired with the name of the founder Robert Mundell, says that policies should be assigned to objectives on which they have comparative advantage. Since monetary policy is considered to be better at controlling prices than fiscal policy, assigning monetary policy to price stability is a natural assignment.

What is more important about the Mundell’s principle is that the Government and the Bank of Japan can achieve both of the objectives without taking into account what the other is doing: each of them should only monitor the assigned objective, and act in order to close the gap between the reality and the objective. That is the reason why providing independence to central banks from the government can work.

Differences in their views of the economy

The division of labor between the government and the Bank of Japan, as just described, should work well when there is an agreement on how they view the current economic situation. However, there exists at present a non-negligible difference in the views between the government and the Bank of Japan.

The differences in views are in the following areas.

First is in the area of the inflationary trend. Since the outset of the Quantitative and Qualitative Monetary Easing (later reinforced with the Negative Interest Rate Policy), the Bank of Japan has committed itself to achieve 2 percent inflation rate in terms of headline CPI. However, it is subject to temporary fluctuations, such as oil price changes, so that some auxiliary index became necessary. The Bureau of Statistics provides such index as CPI excluding fresh food, and CPI excluding foods and energy. However, both the government and the Bank of Japan relies on CPI index of their own to assess the inflationary trend: The Cabinet Office has being watching CPI excluding foods, oil products, and other extraordinary factors, while the Bank of Japan has recently started to publish their own favorite CPI excluding fresh food and energy. While the two indices currently show a relatively similar movement (the former being 0.6 percent in June 2016 and the latter showing 0.7 percent in the same month), they showed somewhat larger difference in the past: As the average for CY2015, the former was 1.4 percent, while that for the latter was 0.9 percent.

Second is in the area of GDP gap. GDP gaps, and the estimate of potential GDP from which it is derived, can differ due to the difference in approach, and thus they are subject to considerable margin of error. Nevertheless, the Cabinet Office has been providing an estimate for some time, and the Bank of Japan has also started to publish its own estimate. The concern is that there is a difference between the two estimates. For the most recent quarter for which both estimates are available, 1st quarter of 2016, the Cabinet Office number is minus 1.1 percent of GDP, while the BOJ number is minus 0.1 percent. It suggests that that from the Government’s point of view, there is still a considerable deflationary gap to be filled, but from the BOJ’s point of view, additional stimulus measure may do more harm than otherwise.

Third is in the area of GDP itself. The System of National Accounts (SNA), including the GDP, is compiled and published by the Economic and Social Research Institute of the Cabinet Office (by the way, the current SNA, which is based on the 1993 manual published by the United Nations, is scheduled to be revised to the 2008 manual basis late this year). In their most recent working paper, economists in the Bank of Japan estimated an income-side GDP based on tax collection data. It suggests that the level of GDP could be revised significantly upwards: For example, the GDP for FY2014 could be revised upwards by 6 percent, and the real GDP growth rate for the year may change to positive from negative as the official number showed.

Iron out the differences before they become serious

At the moment, there are differences in the views between the Government and the Bank of Japan, but they are currently not so large. Also, discussions on how to assess the economic situation should not be denied if they are to lead to a deeper understanding of the economy.

However, the difference may diverge in the future if left untouched, and may lead to a serious disagreement in policy action: for instance, the timing of the exit from the QQE with negative interest rate. It is still fresh in our memories that, in 2006, when the Bank of Japan tried to withdraw the Quantitative Easing Policy then in place, the government expressed strong doubt about the action because of the difference in views.

The differences in the views between the Government and the Bank of Japan need to iron out the differences as soon as possible, before they become serious.