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Unformatted text preview: he economy slumped again in 2001 and it went into another recession in 2002. The extent of deflation increased from 2000 to 2003. The rate of CPI deflation reached around 1 per cent and the GDP deflator declined even more rapidly, at a rate of 3.5 per cent at one point. How to fight deflation became the top priority of monetary policy. Since many economists believe that inflation and deflation are ultimately a monetary phenomenon, there was increased attention on the Bank of Japan. The Bank of Japan Act was revised in 1997 after an intense debate in public and in the parliament, and the new law became effective in April 1998.4 The legal and institutional independence of the Bank of Japan was enhanced: the Governor
3. For a discussion of the failure of bank supervision and crisis management in the 1990s, see Cargill, Hutchison and Ito (1997). Ito and Harada (2000) showed that the Japanese premium, the spread charged by the western banks on the interbank lending rate to Japanese banks, virtually disappeared after April 1999. 4. See Cargill, Hutchison and Ito (2000) for a comparison of the language of the old and new Bank of Japan laws, an assessment of the change in the Banks independence, and an analysis of experiences of the Banks operations during the early years. 222 Takatoshi Ito and Board members could not be dismissed for differences of opinion with the government, or any other reason other than physical and mental incapacitation. The newly enhanced Monetary Policy Board, consisting of the Governor, two Deputy Governors, and six full-time members who must be recruited from outside the Bank, became fully responsible for setting monetary policy. Mr Hayami, aged 72 and longretired from the Bank, was appointed as Governor. Some Board members from the old regime were retained, to be replaced at the expiration of their respective terms, and some vacancies were filled by new appointments with the new qualifications for Board members in mind. For example, Mr Yamaguchi, a long-time Bank economist, and Mr Fujiwara, a journalist, were appointed as Board members. Previously, the Board members represented different kinds of businesses agriculture, large financial and regional financial institutions, and trade and industry but under the new law, Board members had to have expertise in finance and banking. Two professors were also appointed as Board members: Professor Ueda of the University of Tokyo and Professor Shinotsuka of Ochanomizu University.5 Minutes of discussions (without names) and voting records (with names) were to be disclosed with a delay of about one month, as a part of enhanced transparency. The mandate of the new Bank of Japan was clearly price stability, while the mandate of the Bank under the old law was to help maximise the potential growth of the economy.6 With independence, the Bank of Japan became accountable to the public for its actions and their consequences. Deflation, many critics argued, was the proof of its failure. As deflation became worse, critics argued that there was a danger of a deflationary cycle: deflation generates deflationary expectations, which raises the real interest rate and depresses investment and consumption; and lower aggregate demand results in more deflation. The Bank should have done everything it could to prevent deflation from worsening. The Bank both Board members and staff economists initially argued that deflation was not so serious and, moreover, deflation that resulted from technological innovation and cheaper imports could be desirable. The Bank lowered the policy interest rate (the call rate) to virtually zero in February 1999. As the nominal interest rate cannot become negative, the zero interest rate policy (ZIRP) was the ultimate conventional monetary policy instrument available to the Bank. However, from mid 1999 to 2000, calls for additional action to fight deflation increased among policy-makers and academics. The list of additional or unconventional policies (from the perspective of standard textbook central banking) included: quantitative easing (expanding the monetary base); an increase in the purchase of long-term government bonds; the purchase of riskier assets including commercial paper, corporate bonds, equities, and foreign bonds; and the adoption of inflation targeting. The arguments raised by proponents of inflation targeting included greater accountability, instrument independence, better communication with the market, and an influence on inflation expectations to break the deflationary cycle.
5. These professors had to resign from their respective universities, as the Board member position required full-time employment at the Bank of Japan. 6. The word potential was probably meant to refer to the potential of the economy to support the war effort as the old law was enacted in 1942. Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting? 223 In fact, inflation targeting became somewhat symbolic of the additional unconventional steps that many argued the Bank of Japan should take to achieve a positive inflation rate. Most of the Banks Bo...
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