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Empty Mind after Ten Thousand Reasons

Monetary policy needs a new guideline

Kazumasa IWATA


 Japan’s monetary policy freezes. COVID-19 and Russia’s invasion of Ukraine add to stagflation pressures, which increase inflation and recession risks at the same time. Monetary policy cannot follow the two rabbits of stopping inflation and avoiding recession.

 Looking at current price trends, import prices for energy and food have skyrocketed, and the rate of increase in consumer prices, excluding fresh food, has exceeded the target of 2%. On the other hand, the GDP deflator, which shows price movements in the domestic value-added, is still in the deflationary region (minus 0.5% from the previous year in the first quarter of 2022). “Output gap”, which shows the difference between demand and potential supply capacity, exceeds minus 3%, Thus, the tightening is not possible.

 The Bank of Japan is trying to eliminate domestic deflation by import inflation arising from the depreciation of the yen, and is keeping the upper limit of the long-term rate (0.25%) with a limit order operation to buy unlimited amount of government bonds.

 However, this strategy has pitfall of worsening terms of trade.When the effect of the depreciation of the yen is measured by the rate of change in the import / export price ratio of denominated in foreign-currency and in yen, one-fourth of the deterioration of the terms of trade is due to the depreciation of the yen (1st quarter of 2022). The outflow of real income from the country arising from the deterioration of the terms of trade exceeds 11 trillion yen (annualized). Even if production (real GDP) increases due to the depreciation of the yen, Japan has fallen into “immiserating growth”, where real per capita consumption of households decreases due to the outflow of income and imported inflation.

 The average nominal growth rate from 2013 to 2021 is 1%, and the average real growth rate is a little under 0.5%, but the real consumption per capita is the same level as before the financial crisis. The policy goal should be the per capita real consumption level, which indicates the affluence of people’s lives.

 Like the fixed exchange rate, the long-term rate becomes difficult to control if the basic economic conditions change. The Reserve Bank of Australia provided forward guidance (future guidelines) to keep the policy interest rate unchanged and set a yield target policy for 3-year government bonds, but was forced to abandon the target. The BOJ’s upper limit setting of long-term rate can be interpreted as a similar guideline, but it will not work if the economy changes significantly. Switching to guidelines associated with economic indicators is desirable.

 The reason why the domestic inflation rate is unlikely to rise is that it faced the effective lower limit of the nominal interest rate (zero interest rate constraint) after the deflationary mindset was embedded in the economy. US economist Paul Krugman argued that in 1998 the equilibrium real interest rate (natural rate of interest) went negative and deflation returned to Japan. The Japanese government recognized deflation in March 2001, when I was in charge of the Monthly Economic Report. The delay in cognition during this period has established a deflationary mindset, making it extremely difficult for the Bank of Japan to overcome deflation.

 Since the plague outbreak in the 14th century, the real long-term rate has been on a downward trend, dropping to near zero. Super-secular stagnation suggests that there are limits to the economic activity of humankind that the Earth’s ecosystem tolerates. Developed countries on a “growth path of the bubble economy “have low interest rates and growth rates, and the growth rate is higher than interest rates. Required future guideline must be based on the long-term structural changes.

(English translation of Morning Edition of the Nikkei with 2022/7/15)