Gangnam-Gu, Seoul -- (SBWIRE) -- 12/02/2010 -- Japanese Finance Minister Naoto Kan has recently exerted pressure on the Bank of Japan (BOJ) to act more quickly to defeat deflation, saying he wants the falling price trend to end this year. “Two or three years is too long. If possible, I hope that the consumer price index turns positive by the end of this year” Kan told a parliamentary session.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. The finance minister also said that the BOJ may have to set an inflation target aimed at dragging the economy out of grinding deflation … a policy where a central bank declares a target for inflation and guides actual price levels toward that goal through monetary policy such as interest rate changes. BOJ Governor Masaaki Shirakawa made it clear he had no intention of taking such a step, and explained in detail why he considers it inappropriate. “There is a mood to reconsider the use of the framework of inflation targeting following the recent financial crisis," Mr. Shirakawa said at a recent news conference. “If a central bank concentrates only on achieving a short-term price goal, that could have an adverse effect on sustainable economic growth, which is the final goal of monetary policy”, Shirakawa said. Moreover, “such a mechanism would reduce the BOJ’s flexibility on policy”. Inflation targeting has become a favoured policy among many central banks worldwide, but since the start of Japan’s deflationary era in 1999, the BOJ has stoutly resisted calls to set an inflation target against which it can be judged, and by which it can be embarrassed if it misses it.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. Instead it has relied on softer price guidance in determining policy. Its inflation objective is defined in the loosest terms, as a rate between zero and 2% for the core consumer price index, as one that meets its “understanding of medium- to long-term price stability”, with no time-frame to achieve it and no penalty for failure. Still, core consumer price index, which excludes volatile fresh food prices, fell 1.3% on year in December, dropping for the 10th straight month. Shirakawa’s comments suggest the central bank will not embark on any further easing for now to put a stop to deflation. However the BOJ might be forced to loosen policy toward the middle of the year if the domestic economy loses momentum from its recent strong performance … recent data showed the economy grew at a 4.6% annualized pace in the final quarter of 2009. And with a key upper house election coming up in the summer, at which the ruling Democratic Party of Japan hopes to win a majority in the chamber, political pressure on the BOJ to do more to improve the economic picture could rise.

Can the introduction of inflation targeting under deflation and zero interest rates contribute to the Japanese economic recovery? Generally, inflation targeting has been increasingly viewed as a good monetary policy framework and widely applauded by economists and policymakers. In the literature, there are benefits of inflation targeting for both inflation and output behaviour. Inflation targeting should stabilise the level of inflation, reduce its variability and persistence, and also decrease the variability of output.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. A recent study by Daniel Leigh, an economist at the IMF, shows that had Japan introduced inflation target in the 90’s its economy’s performance would have substantially improved and the BOJ would have avoided the zero lower bound on nominal interest rates. But the essence of the question is to what extent the introduction of inflation targeting will enhance credibility of the BOJ’s reflation policy in a deflationary phase and help economic recovery. More importantly, whether or not the BOJ monetary policy is credible enough for inflation expectations to be anchored to an inflation target. Takehiro Sato of Morgan Stanley says that, unlike the Federal Reserve, which has won a high degree of respect for its handling of monetary policy, Japan’s central bank is not yet trusted by markets because of its past moves. “The BOJ’s policy track record is bad.

A target for inflation helps to anchor future expectations of monetary policy, but BOJ lacks credibility. The mere announcement of an inflation target would not change expectations”, he said. Indeed, the introduction of inflation targets among advanced countries tends to be accompanied by an institutional framework that makes inflation targeting credible and accountable. In several countries, including New Zealand and Australia, inflation targeting is an agreement between the government and the central bank, and both are committed to policy that is consistent with the inflation target.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. In several countries, including New Zealand and the UK, when inflation exceeds the target by a wide margin, the Governor is required to provide an explanation to the parliament. With accountability and commitment, inflation targeting does become credible.

A central bank in a deflationary environment is subject to a time-inconsistency problem: it cannot credibly commit to “being irresponsible” and so continue to shoot for high inflation.

Furthermore, there is a concern that once the Japanese economy has emerged from a deflationary spiral and starts to recover, the central bank will be tempted to renege on its commitment to a high inflation target, because it would like the economy to return to an inflation rate consistent with price stability. Thus a central bank in a deflationary environment is subject to a time-inconsistency problem: it cannot credibly commit to “being irresponsible” and so continue to shoot for high inflation. The result of the time-inconsistency problem is that the markets would not be convinced that inflation would remain high, and inflation expectations would not be high enough to lower real rates sufficiently to stimulate the economy out of the deflation trap. To overcome deflation and restore economic activity Japanese policymakers may not need to adopt an inflation target. They could simply use unconventional instruments, such as purchases of riskier assets and foreign assets, more aggressively so to persuade the markets and the public that there will be higher inflation.