Financial Times: News from Japan gets worse and worse. How bad do you expect things to get economically?
Masaaki Shirakawa, Bank of Japan governor: Until recently, the Japanese economy was relatively immune from turbulence in credit markets overseas. But the picture changed after the collapse of Lehman Brothers.
Both exports and domestic demand have decreased. We expect this situation to persist over the next several quarters, but the situation is changing rapidly and obviously we are reviewing our assessment periodically.
FT: Can you predict when we might see a recovery?
MS: We are stressing the extraordinarily unusual uncertainty of our predictions. Risk factors, or uncertainty, are enormous.
According to the latest semi-annual forecast published at the end of October, we said the Japanese economy is expected to pick up gradually some time after the middle of next fiscal year. But since then the global economy has changed a lot. I think the economy for fiscal year 2009 may turn negative. I don’t stick with an exact number because there are so many uncertainties involved.
This recession is a synchronized recession so I don’t think the trajectory of the Japanese economy is much different from the rest of the world.
FT: What can the Bank of Japan and the government do?
MS: In the previous financial crisis the Bank of Japan took various measures and several years later the Federal Reserve and some other central banks are taking almost the same measures.
We have to frame this discussion in terms of what central banks can do rather than what conventional monetary policy can do.
Given the nature of this crisis, I want to emphasise the importance of maintaining financial market stability. This is very crucial.
Each crisis has its own features. Quantitative easing contains two elements: one is to provide massive liquidity into the market, the second is promise to maintain low interest rates (zero) until the consumer inflation rate becomes positive on a sustainable basis.
The massive increase in reserves was effective in maintaining financial system stability when the financial system was in a delicate and unstable situation, but [it] was not that effective in boosting demand. This was a result of the dysfunctionality of financial institutions.
The commitment to maintain very low interest rate levels was somewhat effective in boosting demand at the stage when the economy started to recover.
FT: We may move back into deflation next year, which begs the question: might you be prepared to make the same commitment to keep interest low again until price inflation recovers? Did it work sufficiently last time for you to consider doing it again?
MS: I have some uneasiness about using the word “deflation” in policy discussion, simply because the word can be misleading and ambiguous.
Japan recovered with mild deflation in terms of consumer price index. This expansion was the longest in the post-war period. And we have to seriously think why Japan enjoyed the longest expansion with mild deflation.
The cumulative decline of consumer price index from the peak in 1997 to trough in 2005 was less than 3 per cent, while the cumulative decline in property prices was 60-80 per cent.
The deflation that Japan experienced was asset price deflation rather than consumer price deflation.
What is important is the expected inflation rate of the medium to long term. Because of pass-through of commodity prices, the consumer inflation rate climbed to 2.4 per cent. In the process we carefully watched whether this would create second-round effects, triggered by increase in costs but it did not materialize, fortunately.
From now on the reverse will happen. The consumer inflation rate will decline rapidly. The issue is whether this creates a second-round effect, meaning a decline in the expected inflation rate. If that happens it creates a problem and we are of course carefully watching developments. But, like the previous surge, at this moment we are not observing a change in long-run expected inflation rate.
FT: I turn to the fiscal side. Should the government be spending lots of money, both for Japan and because there is an international expectation that every country does what it can?
MS: If the financial system is dysfunctional there is some room for deploying fiscal policy in a prudent manner. That is the received wisdom of economists.
Obviously, we have to maintain the long-run sustainability of the fiscal position. This is important, especially in a country where the fiscal situation is constrained.
FT: The yen has appreciated significantly in recent months to the extent that it could be seen to damage exporters. G7 made a statement that was widely interpreted as giving Japan the green light to intervene should it wish. Should Japan intervene?
MS: As you know, the BoJ itself is not the authority for deciding on foreign exchange intervention. Our position is what you mentioned, in terms of the G7 statement of a month ago. We continue to monitor markets closely and cooperates appropriate. Monetary policy does not just focus on exchange rate. Our general stance is to assess overall economic conditions and we don’t think about the effect of exchange rates as an isolated factor: everything affects the economy.
We have to think through the nature of this recession, as well as the nature of the previous expansion. In retrospect, the world economy grew at a very rapid pace between 2004 and 2007. The growth rate of the world economy was around 5 per cent and this growth continued for four years. And we didn’t experience this growth for such an extended period of time in the past. During that process, the imbalances, broadly defined, accumulated. Now it is the process of eliminating the imbalances and it takes some time for the world economy to remove this excess.
What is important for policymakers is to avoid a situation in which the adjustment leads to serious downturn of the economy, and one crucial factor is maintaining the stability of the financial system.
It is not appropriate to frame the discussion as if we can manipulate or control the level of the exchange rate. Of course, monetary policy affects exchange rates indirectly, but there is no one-to-one correspondence.
At the end of the day, the exchange rate is determined by market forces. When I hear your question, I feel that the assumption is that the central bank can control the exchange rate, but it cannot.
FT: The BoJ has always maintained that it is important not only to look at the CPI, but also to look at other factors, including asset bubbles. Sometimes it was criticized for that position. But given what has happened with the creation and bursting of a huge asset bubble with horrendous implications for the real economy, do you feel vindicated?
MS: Allow me to tell you a rather long story. Japan and the Bank of Japan learned a lot of things from the bursting of the bubble resulting in the banking crisis. You use the word vindicated in your question. If I use the word vindicated, then I am vindicated by the credit market turmoil since the summer of 2007. But the answer is not that simple.
There are a lot of similarities between our experience and this experience. The bubble had three elements in common: one is the benign conditions, characterised by high growth and low inflation rate. The second is a seemingly plausible justification for the benign economic situation. The third is the rapid increase in credit and leverage, fostered by the sense of low interest rates during an extended period of time.
The issue was whether a central bank should refrain from raising policy rates pre-emptively when the economy is growing strongly with a sharp expansion while price inflation is well anchored. To put it differently, can a central bank afford to leave policy rates unchanged as long as price inflation remains low?
Of course, the consumer price inflation rate is very important information in judging price stability. But, based on our experience and the experience this time in other parts of the world, the leverage of the expansion was also important. We have to watch carefully whether the broadly defined imbalances are accumulating or not. Very often in the recent decade we experienced a situation in which imbalances are accumulating, despite the fact that the inflation rate is quite subdued.
Once the bubble burst, the economic cost is so huge. Given the capital shortfall at financial institutions, monetary policy tends to lose its effectiveness. So all in all, we have to think seriously about both monetary policy and prudential policy in a bubble period. I’m not saying that monetary policy can alone solve this situation, we need both.
Inflation targeting itself is one of a good framework to explain monetary policy. But if inflation targeting creates the social presumption that the central bank can look at consumer price inflation alone, then it might have some unintended effect of helping the creation of a bubble.
One school of thought said that the central bank should be engaged in mopping-up operations only after the bursting of the bubble. But in retrospect, to spot the timing of the bursting of the bubble is equally difficult.
In the case of the US, the US residence investment peaked out in the first quarter of 2006 and Case-Shiller, the housing index, hit its all-time high in July 2006. The US Federal Reserve started monetary easing in September of 2007. In the case of Japan, the equity market bubble reached its peak in December 1989 and economic activity peaked in February 1991. Land prices peaked in 1991, among them those of the large cities in September 1990. The first reduction in policy rate was in July 1991. This casual reading of the timing is suggestive of how difficult it is to spot the timing of the bursting of a bubble. So in that sense I am not in favour of so-to-speak asymmetry.
I’m not saying we should prick the bubble as such. No central bank is saying we should target asset prices. It is not appropriate. One important element is how to judge price stability, but we cannot capture the imbalances by focusing only on the consumer price index, especially the consumer price inflation rate over a very narrow period.
FT: How long will the global crisis run? Is the US likely to fall into deflation or, conversely, as a result of all this fiscal and monetary expansion, is there a danger of high inflation?
MS: The public capital injection is a crucial step toward rebuilding the balance sheet of financial institutions. This was very much needed. But this is not a magic formula.
Based on our experience, the world economy or the US economy needs the elimination of excesses. Of course the exact excesses vary from country to country. In the case of Japan, there were the three excesses of production capacity, workforce and corporate debt. In today’s US, for instance, housing is excessive; household debt is also excessive – I don’t know by how much, but anyway “excessive” is there.
Negative feedback is now at work and I cannot give you a precise answer. What is crucial is to avoid a situation in which the adjustment leads to a serious downturn in the economy. In that sense we have already taken necessary measures.
I don’t think the expansion of the balance sheets of central banks at this time creates inflation. We are struggling to increase demand, so I don’t think it creates inflation. The issue here is whether central banks all over the world can exit from these extraordinary measures once the economy starts to recover.
FT: Japan was helped by external demand, which is lacking in this synchronized downturn. Without an external anchor for the US and Europe, is there danger of a vicious downward spiral?
MS: In the case of Japan, we had to tackle not only the non-performing loan problem, but also the drop in potential growth rate stemming from a gradually declining population. But this time, even though the world economy is weakening, I don’t think the world economy as a whole has lost its growth potential.
