15 in addition to the costs of lost output deflation

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Unformatted text preview: zero, monetary policy loses its potency, because the nominal interest rate is bound at zero. With a zero nominal interest rate, the real interest rate increases 14. Cargill et al (1997, 2000) and Hoshi and Kashyap (2001) discuss the structural problems in the corporate-bank relationship and bank and corporate governance in Japan. 15. Irving Fischer (1933) was the first to note the debt deflation process. The Great Depression is often used as an example of very negative consequences of debt deflation. See Bernanke (1983) and Mishkin (1978, 1991, 1997, 1998) for application to Japan. 230 Takatoshi Ito as the expected inflation rate becomes lower. A high real interest rate in a stagnant economy reduces corporations incentives to invest to expand production. In a sense, companies burned once by unexpected disinflation will not invest, say in additional plant and machinery, until the inflation rate is stabilised at a positive level. Deflation will therefore cause more deflation by generating deflationary expectations. This is the mechanism of a deflationary spiral. Although Bank of Japan economists tended to argue that deflation was mild, and a deflationary spiral never happened, there is some evidence that deflation and deflationary expectations deteriorated from 1999 to 2002. The Bank of Japan Monetary Policy Board has published a semi-annual Outlook since October 2000. In the Outlook, Board members express their expected inflation rate for the fiscal year (where fiscal year t runs from April of year t to March of year t+1). In October 2000, the Board members inflation expectations, taking out the most optimistic and most pessimistic forecasts, for FY 2000 (note that the time of the poll was already in the middle of the FY) ranged from 0.4 to 0.2 per cent. The expectation for FY 2001, at the beginning of that FY (April 2001) ranged from 0.8 to 0.4 per cent. One year later, in April 2002, the expectation was for further deflation in FY 2002, ranging from 1.0 to 0.8 per cent. It would therefore seem that deflationary expectations increased from 2000 to 2002. In Japan, one additional consideration is the impact of deflation on fiscal settings. One of the largest borrowers at fixed interest rates is the Japanese government, with outstanding long-term debts of 550 trillion yen, more than 100 per cent of GDP. The Japanese government has regularly issued long-term government bonds with fixed interest rates. (Only in 2003 did the Japanese government start to issue inflationindexed bonds, where the principal is protected from deflation.) Unexpected deflation during the 1990s meant that the Japanese government had an increased real debt burden that is, more taxes in real terms have to be collected than otherwise to repay debt. In addition, since tax brackets are not adjusted for inflation, deflation meant that the government had less tax revenues due to the reverse of the wellknown bracket creep phenomenon. 2.3 Chronology of policy responses As the economic slump continued, the Bank of Japan has changed its position on whether and how to fight deflation. This sub-section examines the Bank of Japans actions to fight deflation from 1998 (the birth of the new Bank of Japan) to mid 2004. I identify four stages of action in the period from 1998 to 2004: Stage 1. Cautiously lowering interest rates to the zero interest rate policy (ZIRP) April 1998February 1999. Stage 2. ZIRP, lifting ZIRP and return to ZIRP: February 1999March 2001. ZIRP until deflationary concerns are dispelled. Stage 3. Quantitative easing (QE), phase 1: March 2001March 2003. QE until CPI inflation rate becomes stably above zero. Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting? 231 Stage 4. QE, phase 2: March 2003present. QE until CPI (excluding fresh food) is positive for a few months and is expected to remain positive in the future. Stage 1. Lowering of interest rates to the ZIRP: April 1998February 1999 When a new team took over the newly-independent Bank of Japan, there was high hope that pro-active actions would be taken and that the Bank would take accountability for its actions. Price stability became the stated mandate, rather than the de facto mandate. The Bank does not have to listen to, or try to guess the judgement of, the government on how monetary policy should be conducted, so that price stability should be genuinely pursued. However, in retrospect, the timing of independence was less than perfect or even unfortunate. The economic outlook was quickly deteriorating, due to the banking crisis and the lingering aftershocks of the Asian currency crisis. The yen was depreciating, reflecting a pessimistic mood towards prospects for the Japanese economy and the financial sector. Additional policy measures, both monetary and fiscal, had to be prepared. In many monetary policy meetings (MPMs), Mr Nakahara proposed to lower the call rate. For example, in July, he proposed that the Bank lower the interest rate to 0.35 per cent, and at the 11 Au...
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