The Bank of Japan’s New Price Stability Goal

At its monetary policy meeting on February 14, 2012, the Policy Board of the Bank of Japan unveiled a “price stability goal in the medium to long term.” The inflation rate consistent with stable prices is, the BOJ has decided, a year-on-year increase in the consumer price index of 2% or less. For the time being, it has set its goal at 1%.

How should we evaluate this switch to an explicitly stated consumer price inflation rate of 1%? In the following I discuss the new framework, comparing it with both formal inflation targeting as practiced in such countries as Britain and the monetary policy of the US Federal Reserve Board and its Federal Open Market Committee.

Seven Elements of Inflation Targeting

True inflation targeting may be described as a setup consisting of the following seven elements.

1. Obligation to attain a numerical inflation target: The central bank commits itself to realizing and sustaining an inflation target over the medium term, making this a goal of its monetary policy, and it makes public an explicit numerical value as the inflation rate it seeks to achieve.

2. Authority for determining the numerical target: The government or the government and the central bank together determine the target. However, the government alone holds the final authority for target setting.

3. Means for attaining the numerical target: The central bank decides on the means for target attainment.

4. Time period for target attainment: A public commitment is made to attaining the target over the medium term, which is often defined as about a year and a half or two years.

5. Reconciliation of the target with stable production and employment: While seeking to attain the desired inflation rate, the central bank aims also to stabilize production and employment.

6. Duty to explain or correct for missed targets: When inflation is above or below the target, the authorities are responsible for making a clear public explanation of why the policy failed or taking action to correct the failure.

7. Commitment to dynamic consistency: The authorities pledge not to break their promise after the policy has been set in motion.

Speaking at a press conference on February 14, BOJ Governor Shirakawa Masaaki explained why the Policy Board has introduced the “price stability goal in the medium to long term.” Previously, he noted, the bank had made public what it called its “understanding of medium- to long-term price stability,” which it defined as the level of inflation that each member of the Policy Board understood as being consistent with price stability over the medium to long term. During deliberations in the National Diet, however, this approach was criticized as being hard to understand compared with the US policy of the Fed, which in January set a “longer-run long-term numerical goal for inflation.” Under the circumstances, he said, the Policy Board decided to revise its approach. (Photo: Sankei Shimbun)

Evaluating the BOJ’s Price Stability Goal

To get a grasp of the BOJ’s new price stability goal, we can evaluate it in terms of the elements of inflation targeting I listed above.

With respect to the first element, the obligation to attain a numerical target, the fact is that Japan’s central bank has made no official commitment to realizing and sustaining the desired inflation rate. From this perspective, neither the talk of achieving a year-on-year increase in the consumer price index of 2% or less nor the goal of 1% for the time being can be considered a true inflation target. Even if the CPI rate of increase continues to be less than 1%, the BOJ has no obligation to take responsibility for failing to achieve its goal. The market is unlikely to put much faith in a price stability goal for the medium to long run when the BOJ bears no responsibility to achieve it or even to explain why it was not achieved. Accordingly, the new goal will be of limited effectiveness in putting an end to deflation.

The consumer price index used by the BOJ for its goal is the overall CPI, which includes all items. Judging from CPI statistics released by the Ministry of Internal Affairs and Communications, we find that year-on-year increases in the overall CPI are above the increases in real consumer prices by 0.6 percentage point on average. In this light, setting the goal “for the time being” at 1% amounts to setting a 0.4% goal. At that rate, there will be a serious risk of falling into deflation.

The annual rate of increase in the overall CPI could easily exceed 1% were energy prices to rise sharply. During 2008, for instance, the overall CPI was boosted by a surge in the price of crude oil imports. On a year-on-year basis, the increase rate moved above 1% in March and reached the 2.1%–2.3% range from July through September. Oil prices fell rapidly in 2009, however, causing the overall CPI to plummet into negative figures. From this perspective, a monetary policy that targets year-on-year change in a measure of consumer prices that includes energy goods is unlikely to achieve price stability.

Authority for Determining the Numerical Target

In a departure from the second of the inflation-targeting elements, it was the BOJ’s Policy Board that decided on the medium- to long-term price stability goal. The government was not involved. Having the institution that is responsible for managing monetary policy set its own target is akin to allowing a salesperson to decide on what volume of sales he or she needs to achieve. For a private enterprise, such a practice would be inconsistent with achieving targets set by management. As the central bank is an institution that only implements monetary policy, having it set its own price stability goal is inconsistent with achieving the government’s policy goals.

In the United States, the Fed reaches its own decision on an inflation rate that it judges to be consistent with price stability. At first glance, this seems to be much the same as what the BOJ is doing. But as is evident from the Fed’s annual reports, the testimony of its chairman before Congress, and speeches by the chairman, the Fed and its Federal Open Market Committee take responsibility for stabilizing inflation over the medium run at a level that is consistent with maximizing employment. This applies to the long-term inflation goal they have now specified, which is an inflation rate of 2% as measured by the annual change in the price index for personal consumption expenditures. (See, for instance, Federal Reserve Board Chairman Ben Bernanke’s October 18, 2011, speech at the Federal Reserve Bank of Boston on “The Effects of the Great Recession on Central Bank Doctrine and Practice.”)

This point was clearly stated in the January 25, 2012, FOMC press release  on the Fed’s new policy. It says: “The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates.” In the sense that the rate of 2% for the price index of personal consumption expenditures is a longer-run inflation goal to which the FOMC has committed itself, the target is fundamentally different from the BOJ’s medium- to long-term price stability goal.

Achieving Stable Production and Employment

With respect to the specification of a time period for target attainment, the fourth of the inflation-targeting elements, the BOJ has made no mention of any period for its price stability goal. This also saves the bank from having to take any responsibility for not attaining the goal or assuring that the inflation rate remains at the desired level.

How should we rate the goal in terms of the fifth element, maintaining inflation at a rate that will stabilize production and employment? The fact of the matter is that as long as monetary policy is aligned with the overall CPI, including energy and foods, production and employment will not be held stable. The year-on-year overall CPI will easily rise above 1% whenever there is a surge in energy prices, and it will also be likely to shoot up if, as expected, the consumption tax is hiked. In that event, with inflation moving faster than the 1% figure set by the BOJ for the time being, we may expect to see moves to tighten the monetary reins. Such policy switches would invite contractions in production and increases in unemployment.

At times when consumer prices are rising at a rate above 1% because of changes in energy prices and the consumption tax, will Japan be able to pursue a flexible monetary policy of the kind practiced in the countries that have a formal system of inflation targeting? That seems too much to expect in the light of the past record of what happened when the monetary authorities tried to terminate their zero-interest policy and put a stop to their quantitative easing.

Other Essentials of an Inflation-Targeting Setup

The BOJ and the government believe that bringing deflation to an end cannot be accomplished by monetary policy alone, that at the same time, the government must pursue a growth strategy and companies must strive to increase productivity. Most of the Japanese public and media agree. This way of thinking has a bearing on the duty to explain or correct for missed inflation targets, the sixth of the inflation-targeting elements. At times when the BOJ persistently fails to achieve and sustain the 1% inflation goal, people are likely to place the blame on inadequacies in the government’s growth strategy or insufficient efforts by companies to improve productivity. In such a situation, it would not be possible to demand that the central bank explain why its policy failed, much less take corrective action.

The countries that have adopted inflation targeting see things differently, and so do the Fed and the FOMC. In its January 25 press release, the FOMC made a clear statement of its thinking: “The inflation rate over the longer run is primarily determined by monetary policy.” As long as people in Japan fail to share this common understanding, they cannot hold the central bank accountable for explaining or rectifying an inflation rate that differs from whatever the desired rate is, whether it is called a goal or a target. And if the BOJ bears no responsibility for either explanation or corrective action following such a policy failure, we can hardly expect it to achieve the medium-term inflation goal or target, or the average rate of inflation over a period of roughly a year and a half or two years.

If a central bank has not made a commitment to achieving a goal or target, naturally it cannot be asked to make a commitment to dynamic consistency, the seventh of the inflation-targeting elements. Only after a firm promise has been made to attain a target is it possible to raise questions of responsibility when the promise is broken.

Overall, it is fair to say that the BOJ’s new price stability goal represents a step forward from its past monetary policy. But compared with true inflation targeting or the policy now being pursued in the United States, the bank’s policy remains inadequate in the area of making a commitment to goal achievement. For this reason, the BOJ is still a long way from having a policy that could put an end to Japan’s deflationary woes.

(Originally written in Japanese on March 13, 2012.)