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Unformatted text preview: s or real estate. Thus, what started as a proposal aiming at a moderate inflation rate of 2 to 3 per cent under the disguise of inflation targeting for price stability has ended up being the same as inflation policy in that inflation should be artificially created at any cost [emphasis added by the author]. It is not clear from Hayamis speech what prevents the Bank of Japan from stopping inflation at around 2 to 3 per cent, and why it is technically impossible or politically impossible. Hayami (2000a) argued that inflation is most likely uncontrollable once triggered. Many argued at that time that it would be possible to pursue a policy aiming at a moderate inflation rate of 1 to 3 per cent. However, in response, Hayami commented: if we tried to contain inflation after it had gained momentum, we would need very strong monetary tightening, which might result in a substantial deterioration of economic activity and a steep climb in unemployment. He seems to be arguing that the optimal and stable inflation rate is zero, and any deviation from it, even a modest amount, would end up in an inflationary spiral that would need strong restraint to end. This might be a reflection of the literature of the early1980s. Indeed, Hayami cited the experiences of the 1970s, where tolerating a small inflation rate triggered a further round of wage and price increases, which spiralled into a higher inflation rate. It was unfortunate that, in the early stage of deflation in Japan, the argument for moderate inflation targeting was dismissed on the grounds of a quite dated argument. The experience in the 1990s proved that inflation targeting could anchor expectations, so that it is possible to avoid a wage-price spiral. 3.4.2 No good price indicator
Inflation targeting is not possible if there is no agreement on which price index should be used to define inflation/deflation. Some form of the CPI is commonly used by inflation targeters. The menu of choices includes the headline CPI, core CPI excluding fresh food and energy prices, CPI excluding fresh food, or CPI excluding fresh food and rents. In most cases, the difference between the choices is not great, and a reasonably wide band would make the differences among these indices a secondary issue. A possible alternative for a price indicator is the GDP deflator. But it suffers from delayed and infrequent reporting (quarterly, instead of monthly) and constant revisions. No inflation targeter has used the GDP deflator. Some form of the CPI would be an appropriate price indicator. However, it took until March 2001 for the Bank of Japan to recognise that point. 248 Takatoshi Ito The Bank of Japan was hesitant to name a price indicator for judging deflation/inflation. Okina (1999a, p 164) argued that [p]rice indicators such as the GDP deflator, CPI, and Wholesale Price Index (WPI) often move differently. Even when these indicators exhibit the same movement, the extent to which the sound development of the national economy will be achieved may depend on such factors as whether property prices are stable or rising sharply. Similarly, the On price stability document, issued in October 2000, did not identify any price indicator as a possible price index. However, the debate was over on 19 March 2001, when the Bank of Japan decided to use the CPI excluding fresh food as an indicator for a necessary condition to terminate the ZIRP. 3.4.3 No optimal inflation rate can be identified
When deflation is caused by supply-side factors, such as technological innovation and cheap imports, then deflation may be desirable and can be tolerated. This argument was commonplace in 1999 and 2000 (recall the earlier discussion in Section 2.1). Advocates of inflation targeting have pointed out that this argument confuses the relative price phenomenon prices of goods subject to technological innovation would fall relative to other goods and services, but the average price level would remain predominantly a monetary phenomenon. In addition, a combination of low growth with declining prices is better explained by demand factors than supply factors. Advocates of inflation targeting insist that price stability can be defined as a reasonable range, such as a medium-term range of 1 to 3 per cent, which allows for sufficient flexibility if prices are influenced by supply-side factors and temporary shocks. The 1 to 3 per cent target has been popular among inflation targeters, such as Canada and Sweden. The United Kingdom now has a target of 2 per cent for CPI inflation with a tolerance range of plus/minus 1 per cent.33 The floor of the target, 1 per cent, is designed to allow for the upward bias of the price index and to provide a buffer against deflation. The buffer also helps to ensure that the economy would not instantly fall into deflation if it was hit by negative demand shocks, and thereby exhaust the conventional instrument (the interest rate) too quickly. Economists at the Bank of Japan have argued for a long time that it is difficult to identify a specific number as a target inflation rate (or range). In short, they a...
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This note was uploaded on 05/12/2010 for the course COMMERCE finc at University of Sydney.