Most of the banks board members and staff economists

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Unformatted text preview: ard members and staff economists were publicly dismissive of inflation targeting. Several reasons were mentioned. First, inflation targeting was a simple-minded reflation policy. Second, no country had adopted inflation targeting to move from deflation to inflation. Third, there were no available policy measures to lift the inflation rate to positive territory, given that the interest rate was zero, so the announcement of inflation targeting, without tools to achieve a positive inflation rate, would damage the Banks credibility. Fourth, the mere announcement of an inflation target would not change expectations. Fifth, if the public believes in the inflation target, the long-term interest rate would increase and this would damage the economy. The Bank not only rejected calls for additional ways of easing monetary policy but tightened monetary policy, by 0.25 percentage points, in August 2000, citing a brighter outlook for the economy. However, the inflation rate was still in negative territory. This turned out to be a costly mistake: the ICT stock bubble had already burst and the US economic outlook was deteriorating; the peak of the cycle was near in Japan too. Sure enough, the economy started to contract from October 2000. The economy deteriorated to such an extent that the Bank of Japan had to change course in March 2001, and return to the ZIRP. At the same time, the policy instrument was changed to the current account at the Bank of Japan (basically excess reserves at the Bank of Japan). By targeting excess reserves, a regime of quantitative easing had started. In March 2001, the target for current account balances was set at 5 trillion yen, at the time when required reserves were about 4 trillion yen. The target amount has since been raised in several steps, and reached the range of 3035 trillion yen in January 2004. The Bank also expanded its purchase of long-term bonds. The amount of monthly purchases was raised from 400 billion yen to 600 billion yen in August 2001, and in several steps to 1 200 billion yen in October 2002. Thus, since March 2001, the Bank has adopted some unconventional policy measures, but not inflation targeting. The term of Governor Hayami expired in March 2003. He was replaced by Mr Fukui, employed in the private sector for the five years prior to his appointment, but an earlier Deputy Governor of the Bank of Japan. The tone of statements and communication with the public became much better than under Governor Hayami. Under Governor Fukui, the confrontational style with the government has melted away, and the fixation on raising interest rates as soon as possible has also disappeared. However, Governor Fukui has not adopted inflation targeting. The economy started to recover in the second half of 2003 and the growth rate has climbed up to above 3 per cent in 2003, and is expected to remain around this level in 2004. The degree of CPI deflation has shrunk to near zero, and economic expansion is spreading from electronic machinery exports (particularly of electronic machinery) to consumption. As the economy continues to expand, some observers have started to speculate about when the ZIRP will be lifted. In October 2003, the Board refined the necessary conditions for lifting the ZIRP: the CPI inflation rate (excluding fresh food) has to 224 Takatoshi Ito be zero or above, on average, in the past few months; and the inflation rate has to be projected to stay above zero in the near future. Many private-sector forecasters predict that if economic growth remains strong in the second half of 2004 and the first half of 2005, the necessary conditions to end the ZIRP will be achieved sometime in 2005. There is a growing call for adopting inflation targeting as a part of the exit strategy from the zero interest rate regime. The rest of this paper is organised as follows. Section 2 reviews experiences of deflation and monetary policy actions from 1998 to 2004. Section 3 examines the pros and cons of inflation targeting and explains why the Bank of Japan did not adopt inflation targeting; a detailed discussion of inflation targeting in the Bank of Japans Monetary Policy Meetings is presented in the Appendix. Section 4 concludes the paper. 2. 2.1 Deflation and Monetary Policy Deflation: measurement and effects Measured by the CPI (excluding fresh food), Japan has experienced deflation for much of the period since July 1998, and measured by the GDP deflator, Japan has been in deflation for nearly all of the period since the third quarter of 1994.7 The level of the CPI in 2004:Q2 was 2.7 per cent lower than in 1998:Q4, and the GDP deflator in 2004:Q2 was 11.5 per cent lower than in 1993:Q4. This is deflation. The changes in the CPI and GDP deflator are shown in Figure 1. Prior to 1995, the series moved in parallel most of the time, but have since deviated. The CPI, calculated using the Laspeyres index formula, has an upward bias, while the GDP deflator, calculated using the Paasche index formula, has a downward bias. Quality changes that are n...
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