Overcoming Deflation and Moving Forward Yoshio Okubo Vice-Chairman, Japan Securities Dealers Association (JSDA) ive years have passed since the global financial monetary policy, as part of the three-pronged ap- crisis, but the risk of deflation is still present proach of “Abenomics”, an economic policy strate- Fin the global economy. Japan’s recent signs of gy of the new government headed by Prime Minis- economic recovery and improved market senti- ter Shinzo Abe. This three-pronged policy consists ments provide an excellent opportunity to recon- of bold monetary easing, flexible fiscal policy, and sider the challenges of overcoming deflationary a growth strategy to promote private investment. expectations. This article argues that overcoming entrenched deflationary expectations rests pri- Markets have so far responded favorably to this marily on monetary policy and that its success new policy initiative. The Nikkei 225 stock mar- will depend on credible fiscal policies to reduce ket index rose by 38 percent in the first six months public deficits. The overall long-term policy goal since Prime Minister Abe took office. The develop- is to encourage entrepreneurship and foster inno- ments in currency markets have helped ease de- vation, which proves difficult under a deflationary flationary pressures caused earlier by larger scale environment. Such policies should be supported monetary easing in the U.S. and Europe. The opti- by a regulatory framework that can ensure fair and mism in Japan’s stock markets has also been helped transparent functioning of capital markets, there- by the buoyancy of U.S. stock markets, where in- by enabling efficient pricing of risks in allocating vestors have become more sanguine about the re- scarce risk-taking capital. covery of the U.S. economy. There are now more signs that the recovery in Japan is gaining momen- Bold Monetary Policy tum, gradually spreading the optimism that the prolonged period of deflation will be finally over Monetary policy in major countries has played a in the near future. predominant role in responding to the global fi- nancial crisis. In the wake of the failures of many Lingering Nervousness large financial institutions, major central banks provided liquidity to the financial systems under In Japan, given the prolonged and entrenched de- unprecedented stress. They also assumed a deci- flationary expectations, it is not easy to completely sive role in macroeconomic management, resort- reverse such expectations. Nervousness and skep- ing to nontraditional policies both in terms of in- ticism still remain about “Abenomics” and these struments used and in terms of the scale in which new policies in the mind of some critics. These they implemented them. feelings seem to have been heightened by the recent volatility in the stock and currency markets, which The Bank of Japan (BoJ) had pursued a strategy, have been driven primarily by the concern that now being followed by other major central banks the program of large-scale bond purchases in the after the crisis, centered on very low interest rates U.S. will be tapered off much earlier than had been and quantitative easing (QE). With an aim of dis- expected. This nervousness has spread around the pelling prolonged deflationary expectations, the world, but it has been most pronounced in Japan, BoJ recently embarked on a significantly bolder where it is thought that a rise in long-term interest THINK TANK 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 55 rates would have an adverse impact on the health interest rates above 2 percent from the current level of the banks that have been the major holders of of slightly below 1 percent. The key to the success government bonds. With the level of outstanding of a bold monetary policy lies in ensuring the sta- government debt extremely high, there are also bility of long-term real interest rates, and will de- worries that the impact on the government’s bor- pend crucially on the ability of the government to rowing costs might further enlarge fiscal deficit. set its deficits on a sustainable path toward reduc- This concern seems to be amplified by the signs tion. If the ability of the government to ensure the of a stronger recovery that may edge up long-term sustainability of debt were to be seen as fragile, the interest rates, adversely affecting a long-term re- perceived risk of the premature increase in interest covery prematurely. rates would be heightened, jeopardizing the favor- able impact of the bold monetary policy to sustain While uncertainties are inherent in markets, the and support real economic activity. The effective- nervousness in the Japanese markets may be exag- ness of the bold monetary policy therefore cannot gerated for several reasons. Compared with other be separated from the credibility of fiscal policy in countries, the level of long-term interest rates is controlling deficits over the medium term. In this still the lowest in Japan. At the same time, the stock environment, the “exit” policy of the central banks and bond markets are in the process of digesting will not be an easy road back to the normal conduct the policy changes and it will take some time for of monetary policy, but will involve pressing the a new steady-state to emerge. No signs have yet government to proceed with fiscal consolidation. emerged that would encourage inflationary ex- pectations to rise. In fact, an interesting analysis Preventing Deflation by the IMF’s World Economic Outlook1 argues that over the past decade or so, inflation in advanced Following the global financial crisis, prevent- economies has become less responsive to changes ing deflation has become a main policy agenda in economic slack and that long-term inflation in many countries. The bold monetary policies expectations have become more firmly anchored. pursued by major central banks reflect the sense This suggests that ongoing monetary policy ac- of urgency with which they aim to prevent defla- commodation is unlikely to have significant infla- tion and a return to recession, having in mind the tionary consequences as long as inflation expecta- prolonged deflation which has persisted after the tions remain anchored. This analysis is particularly bubble burst in Japan. Five years after the crisis, valid for Japan, where deflationary expectations however, the fight against deflation and recession are deeply entrenched. In addition, while the po- is not yet over in many countries. tential impact of the rise in long-term interest rates may have an adverse impact on the profitability of Deflation can be very dangerous. It threatens the banks, it is believed that the effect would be limit- stability of the economy and the society in the ed. In fact, encouraging banks to increase lending long-run. Deflation makes firms and households in order to support investment by borrowers, and excessively risk-averse, due to the devaluation of discouraging them from sitting on investments assets held by households and firms. Inability to in government bonds, is an important part of the lower real interest rates toward zero hampers overall economic policy strategy. monetary policy. Households and firms who have outstanding debt suffer from the real increase in Obviously, it is premature to prescribe an “exit” the debt burden. With the prospect of decreasing from the unconventional monetary policy in Japan. prices, household consumption is postponed and Deflationary expectations will have to be dispelled businesses become cautious in making investment and replaced by expectations of “price stability”, decisions given the perceived high real interest defined as an inflation rate of 2 percent. This pro- rate. Business sentiment is also adversely affected cess will certainly entail a rise in nominal long-term by greater uncertainties about the future of the THINK TANK 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 56 economy and the undervaluation of the market safety net should not be underestimated. In the capitalization of firms in the stock market. Risk- immediate aftermath of the financial crisis, pri- taking activities, necessary for innovation, are gen- vate sector net savings spiked as households and erally suppressed and the economy starts shrink- firms cut investment, and households saved more, ing, depriving the youth of job opportunities and resulting in a huge increase in budget deficit. Tax on-the-job learning—an impact that could last a revenues fell sharply while expenditures adjusted generation. Investments are likely to shift abroad slowly, serving as an automatic stabilizer in the due to high real exchange rates, further depriving economy. Fiscal policies have also been used more job opportunities at home. proactively to fight deflation and reduce unem- ployment. Expenditures on the social safety net When deflation is mild, however, such danger may have helped alleviate the burden that falls on the not be fully recognized by political leaders or by socially vulnerable, including the young and the the public. The danger of prolonged mild deflation unemployed. Fiscal expenditures on infrastructure is likely to be underestimated and fighting defla- projects helped upgrade the quality of public ser- tion might not gain policy priority. In fact, there vices, which may have been needed regardless of are some segments of society, such as pensioners, the economic situation. who may benefit from prolonged mild deflation. The public begins to accept a zero increase or mild Overall, however, the effects of fiscal policy on decrease in the consumer price index as price reversing deflationary expectations seem to have stability, not recognizing the real dangers. Defla- been limited. The ballooning deficits have raised tionary expectations become entrenched, leaving concerns about debt sustainability, and eventually the long-term real interest rate at a high level and eroded confidence in the ability of government to slowly depriving the economy of entrepreneur- sustain the level of public services and social safety ship and the risk-taking that is necessary to move nets including public pensions and medical in- the economy forward.