No. 32 — August 18, 2000


Weekly Review

--- by Douglas Ostrom

The Bank of Japan's extraordinary 18-month-long strategy of guiding short-term interest rates practically to zero — a policy begun at a time of widely acknowledged emergency for the world's second-largest economy — ended August 11. That day, BOJ posted a brief statement on its Web site that provided the unprecedented political context for its move:

At the Monetary Policy Meeting held today, the delegates of the Ministry of Finance and the Economic Planning Agency requested, pursuant to Article 19, Section 2 of the Bank of Japan Law, that the Policy Board postpone a vote on the proposed change of the guideline for money market operations until the next Monetary Policy Meeting. Pursuant to Section 3 of the same Article, the Policy Board took a vote on this request and rejected it by majority vote.

Until the Bank of Japan Law went into effect April 1, 1998 (see JEI Report No. 8B, February 28, 1997), the Ministry of Finance, especially, would have had little reason to ask for a postponed vote on a change in the government's monetary policy since it no doubt would have exerted decisive influence behind the scenes. Moreover, had MOF requested a delay, it certainly would not have tolerated the immediate publication of its plea for all to see. Least of all would the central bank have asserted its independence so boldly by noting that, by a majority vote, it had turned a deaf ear to two powerful government agencies.

The Finance Ministry and the Economic Planning Agency sought the delay because they knew what the decision would be. BOJ Governor Masaru Hayami had been signaling for days that he had the votes to end the central bank's zero interest-rate policy. MOF and EPA had many allies in their hope against hope that BOJ would reconsider, as it had at the July Policy Board meeting (see JEI Report No. 28B, July 21, 2000). Most prominent among them was Prime Minister Yoshiro Mori, who made further critical comments after the vote.

Arguably even more important, though, was the International Monetary Fund. Only a week before the BOJ decision, the Washington-based organization, in which Tokyo ranks second only to the United States in voting power, had completed its annual review of Japan and the government's monetary, fiscal and other economic policies. In a public information memorandum dated August 4, the IMF said:

Directors cautioned against moving away from the "zero interest rate" policy at this time. They noted that, notwithstanding the inherent difficulty of assessing the degree of output slack under current circumstances, a range of indicators suggests that a still significant degree of economic slack remains in Japan, with the prospect that deflationary pressures are likely to persist for some time.

This statement only seemed to stiffen the resolve of Mr. Hayami and his allies on the Policy Board to strike a blow for BOJ's independence. They noted that the 0.25 percent boost in the target overnight interbank lending rate, which is comparable to the Federal Reserve Board's key federal funds rate, left Japan's interest rates among the lowest in the world. Mr. Hayami and company also said that the emergency conditions that had prompted the Policy Board to vote in mid-February 1999 for the most economically accommodative policy possible had abated. Policy Board members seemed to have in mind the diminished likelihood of a deflationary spiral, in which output drops rapidly in the face of an impotent monetary policy. BOJ officials added that the central bank's zero interest-rate policy increasingly had distorted credit conditions and discouraged aggressive corporate restructuring.

Mr. Hayami, who between stints at BOJ had sandwiched in a career at Nissho Iwai Corp., the huge trading company, clearly recoils at the idea of a free ride for corporate Japan. Critics have two responses to this concern. First, businesses are not borrowing cost-free. At a time like the present, when prices — as measured by either the consumer price index or the gross domestic product deflator — are declining, loan repayments after adjustment for inflation are a larger burden than they were originally, zero interest rates notwithstanding. Second, even if companies need a cold shower in the form of nominal interest rates above zero, it is not up to BOJ to turn on the faucet.

The central bank's job, imply such critics as Massachusetts Institute of Technology's Paul Krugman, is to manage monetary policy, not to make decisions about corporate bailouts. Mr. Krugman, in fact, argues that in attempting to expand its decisionmaking powers, BOJ jeopardized its independence from politicians, who now may reclaim what they regard as their legitimate policy-formulation responsibilities.

Analysts might have ignored BOJ's concerns about reluctant-to-restructure companies had they thought that the central bank's assessment of monetary conditions was on target. They did not. This disagreement is surprising in light of the current consensus that economic conditions are improving (see JEI Report No. 31B, August 11, 2000), even though prices still are falling. The argument made by the critics is that as long as deflation persists, BOJ has no business tightening monetary policy, a move normally designed to head off inflation. They draw uncomfortable parallels to April 1997, when Tokyo boosted the consumption tax rate to 5 percent from 3 percent in the context of what appeared to be rapidly improving economic conditions, only to see consumer confidence plunge and the economy slip into a recession more severe than the one from which it had recently escaped.

If anything, uncertainty about Japan's economic prospects is greater now than in 1997. In the spring of that year, real GDP was thought to have registered a 3.6 percent gain in 1996 (now revised to 5 percent) in contrast to last year's measly 0.2 percent inflation-adjusted increase in GDP. The IMF pegs Japan's real 2000 growth at 1.4 percent. Estimates for FY 2000 range from a contraction to an increase of 3 percent or more.

The agreement on Japan's current economic conditions and the divergent opinion about the future actually point to the choice that BOJ rejected — maintenance of zero short-term interest rates. If the economy's recovery continued, nothing would be lost by a do-nothing policy since, by all accounts, inflationary signs are nowhere in sight. If the economy did start to sputter again, at least the central bank would not stand accused of having knocked another cylinder out of commission with higher interest rates.

All that is in the past now. Predictions about the economic impact of BOJ's decision to raise the overnight interbank lending rate are swamped by the divergence of existing forecasts. What does not seem likely is the argument of The Wall Street Journal's editorial board that the central bank's interest-rate boost and the resultant increase in the cost of financing debt will restrain the government from continuing its policy of deficit spending, which has left Japan with the world's largest budget shortfall. Given the political leadership's view that BOJ's action was inappropriate, the Mori administration now is more likely to embrace a stimulus package this fall that will maintain, or even increase, the flood of red ink.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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