March 28, 2017
Bank of Japan
Lessons of Japan: Focusing on Issues regarding
Long-Term Inflation Expectations
Speech at Yale University in New Haven
Takehiro Sato
Member of the Policy Board
Introduction
First of all, I thank Senior Fellow Stephen Roach for giving me the opportunity to talk to
this esteemed audience at Yale. I understand that he teaches macroeconomic policy issues,
focusing on the lessons Japan learned from deflation. The Bank of Japan is the frontrunner
in combating deflation. As one of its board members, I hope that my remarks today will
help stimulate academic discussion.
Deflation has prevailed for almost a quarter century in Japan. To overcome deflation, theory
and practice were introduced and tested, and the policy effects were examined. As a result, a
range of knowledge and wisdom has been acquired. The Bank, on its part, conducted a
comprehensive assessment of quantitative and qualitative monetary easing -- or QQE for
short -- in September last year, and learned some important lessons. Among these, I will
today focus on the issues regarding long-term inflation expectations. This is because they
are the key factor in overcoming deflation. I admit that conceiving such expectations is a
somewhat elusive task, but it is worth discussing.
I. Lessons of Japan
A. Determinants of Long-Term Inflation Expectations
Japan's experience refutes the premise for monetary policy that long-term inflation
expectations are determined by a central bank (Chart 1).1 This is because monetary policy
effects are asymmetric when a central bank decreases long-term inflation expectations
toward the target and when it raises them toward the target.
In other words, once long-term inflation expectations -- the norm of prices -- are
de-anchored, a central bank's ability to influence inflation is constrained significantly due to
the zero interest rate bound. Those in academia might feel that this is somewhat
troublesome. In fact, however, when a central bank re-anchors long-term inflation
expectations toward the target, there will be a limit if monetary policy is the only game in
town. What is needed, in addition to continued powerful monetary easing, is a raise in the
potential growth rate, which roughly equals the natural rate of interest. This should be
achieved through structural policies including labor market reform.2
Academic discussion is seriously needed on this point. This is because Japan is not the only
country that has learned lessons on deflation. Namely, simultaneous declines in the potential
growth rate and long-term inflation expectations have been observed in many countries
since the latest global financial crisis (Chart 2).
B. Negative Effects of Excessively Low Long-Term Inflation Expectations
Let me elaborate. The more fundamental lesson we learned was that central banks should
not allow long-term inflation expectations to decline to excessively low levels.
Central banks can lower excessively high long-term inflation expectations because of the
credibility they have earned through the past achievements. The fight against inflation is
easier and the strategy can be simpler compared with combating deflation. There is a
premise for economic theory that holds true with the fight against inflation; namely,
long-term inflation expectations are determined by inflation targets set by central banks.
By contrast, an inflation target will not be the basis for an economic model when set by a
central bank that has lost credibility due to excessively low inflation. For example, the
declines in the potential growth rate and long-term inflation expectations occurred
simultaneously in Japan. However, the academic side of economics has yet to provide an
answer as to whether it is possible to raise excessively low long-term inflation expectations
through monetary policy. This is because of the present unique situation in Japan -- as I will
touch on later -- that long-term inflation expectations are at virtually 0 percent and the
potential growth rate is at slightly above 0 percent, while there is a zero nominal interest
rate bound to usual economic transactions.
In reality, even under a large-scale unconventional monetary policy, both the mechanism of
Friedman's quantity theory of money and the New Keynesian model of a jump in
expectations have operated insufficiently so far. In terms of re-anchoring long-term inflation
expectations, the glass is both half full and half empty. If the potential growth rate and
long-term inflation expectations had not declined to the current low levels, monetary policy
would have been more effective.
Next, I will discuss long-term inflation expectations in the following aspects: (1) their
formation mechanism; (2) reasons for low expectations in Japan; (3) the relationship with
Japan's financial crisis; and (4) the relationship with labor market reform.
II. Issues regarding Long-Term Inflation Expectations
A. Formation Mechanism
In economics theory, long-term inflation expectations are irrelevant to the potential growth
rate. However, I doubt that this holds true in reality, in light of what is happening in Japan.
Rather, I think that long-term inflation expectations and the potential growth rate do have a
correlation, although it may not be strong (Chart 3).
Long-term inflation expectations declined sharply in Japan, before and after the financial
crisis in the late 1990s. Economic fundamentals already had been weak before the crisis
because of the negative interaction between demand and supply conditions; specifically, (1)
a negative financial accelerator on the demand side due to the dire asset price deflation, and
(2) the impairment of the financial intermediary function, as well as the distortion of
economic resource allocation caused by the bubble economy on the supply side. The
financial crisis triggered further weakening of economic fundamentals (Chart 4). In this
situation, pessimism about the future led to a decline in people's expectations for medium-
to long-term growth, and the potential growth rate remained low over a long period of time.
As a result, people's perception of prices became excessively conservative. In other words,
long-term inflation expectations turned downward.
B. Reasons for Low Expectations in Japan
Next, let us take a look at developments in survey-based measures of expected long-term
inflation in Japan. A survey-based rate marked a sharp decline during the period of the
financial crisis in the late 1990s, and then leveled out at around 1 percent. Since then, even
throughout the period of the global financial crisis and the European sovereign debt crisis, it
has been more or less unchanged at around 1 percent (Chart 5). However, I am somewhat
doubtful about this figure.3 I believe that it is more persuasive to say that long-term
inflation expectations in Japan have actually declined to around 0 percent, for the following
four reasons.4
First, the frequency of micro-level price changes suggests that the mode value remains zero.
In other words, the year-on-year rate of increase in the prices of sample items concentrated
on 0 percent. Therefore, people are likely to consider that zero inflation is a steady and
constant state. It is helpful to see the comparison with the U.S. situation (Chart 6).5
Second, administered prices are excessively sticky (Chart 7).6,7 For example, the starting
subway fare in Tokyo has been unchanged for over 20 years since 1995 -- disregarding the
effects of the consumption tax hikes.
3
Market-based measures of long-term inflation expectations -- such as the 5-year, 5-year forward
inflation swap rate -- have less credibility than survey-based ones in Japan, due to a lack of market
liquidity and depth, and therefore do not represent a useful reference.
4
On this point, it seems intuitively unlikely that many of the surveyed economists project that the
inflation rate will remain at about 0 percent over the next 5-10 years. On the other hand, there might
be a disparity between the perception of prices of economists and that of households and firms, i.e.,
long-term inflation expectations of households and firms might be lower than those of economists.
5
See Watanabe and Watanabe (2016).
6
In reality, amid the prolonged economic stagnation in Japan, a mechanism was established firmly
in which the rise in costs for administered prices was compensated for by fiscal deficits reflecting the
increasing political pressure to avoid the rise in administered prices. Such a process itself suggests a
decline in long-term inflation expectations, which is the norm of prices.
7
See Shintani, Kurachi, and Nishioka (2016).
Third, the rate of increase in wages resulting from the wage negotiations between labor and
management continued to be 0 percent for a long time. Even after the recent resumption of
base pay increases, the rate is less than 1 percent (Chart 8).8
Fourth, Japan's deflation equilibrium cannot be theoretically explained on the basis of the 1
percent long-term inflation expectations (Chart 9).
I will elaborate on the fourth point. Let us assume that there is a zero nominal interest rate
bound. Even if that is the case, as long as long-term inflation expectations are meaningfully
positive, the real interest rate will fall below the natural rate of interest, which is around 0
percent, by making the real interest rate negative. In this case, monetary policy should be
effective, and Japan's economy should be able to get out of deflation equilibrium. This
suggests that, if long-term inflation expectations are at least around 1 percent, monetary
policy can be more effective.
C. Relationship with Japan's Financial Crisis
Looking back, if Japan's financial crisis in the late 1990s had been settled more promptly
with ample liquidity provision and capital injection, the large-scale credit crunch could have
been avoided, and thus the subsequent path of Japan's economy might have been different.
This widely shared lesson was put to good use at the time of the global financial crisis
afterwards. I note that it is important to address the private sector's solvency problem
through provision of a massive scale of liquidity and through credit enhancement by means
of swift capital injection.
In Japan, the bailout of financial institutions with taxpayers' money experienced a strong
backlash from the public. It took a considerable amount of time before public funds were
actually injected into financial institutions. In the aftermath of the financial crisis, the
injection of public funds was carried out several times. However, it actually took several
years before concern about the stability of the financial system subsided (Chart 10).
It was only after the introduction of the zero interest rate policy in 1999 and the introduction
of quantitative monetary easing in 2001 that the market's liquidity concern was alleviated
through the Bank's provision of ample funds (Charts 11-1 and 11-2).9
Quantitative monetary easing was a pioneering attempt in increasing the predictability of
monetary policy. It was conducted both by lowering market interest rates to virtually 0
percent through the provision of ample funds surpassing the required reserves and by
introducing forward guidance. Nevertheless, I have a feeling that the Bank could have
addressed liquidity concern in the late 1990s at a much earlier stage. In that regard, I
somewhat have understanding toward the criticism that the Bank's monetary easing was
insufficient at that time, and as a result the financial crisis was prolonged and the economy
fell into a deflationary trap.10
I also note that the Bank paid particular attention to the negative feedback loop between
asset price deflation and the real economy. It did not pay due attention to mild deflation for
a long period. In fact, the Bank repeatedly explained that the deflation was mild and the
economy was not falling into a deflationary spiral, unlike at the time of the Great
Depression in the 1930s.11
It is true that the Bank's provision of ample funds and the government's capital injection
helped avoid a deflationary spiral, although these were somewhat delayed. Long-term
inflation expectations were declining, but not much attention was paid by the Bank or those
in academia to their potential effects on monetary policy.
9
In response to Japan's financial crisis in the 1990s, the Bank expanded its balance sheet and
conducted both funds-supplying and funds-absorbing operations -- i.e., it actively provided funds to
money markets and at the same time absorbed excess reserves by selling bills. However, this does
not mean that the Bank provided excess reserves and allowed the decline in market interest rates to 0
percent. After all, there was no such concept of quantitative easing at that time.
10
Another significant lesson was that the excessive monetary easing before the financial crisis was
the source of the huge economic bubble. In the United States as well, large-scale monetary easing
after the bursting of the IT bubble and subsequent moderate tightening at a measured pace became
the source of the housing bubble, which led to the global financial crisis.
11
See Bank of Japan (2006).
With hindsight, the Bank at least should have clarified its firm determination not to allow
the decline in long-term inflation expectations, as was done by the Federal Reserve after the
global financial crisis and by the European Central Bank after the sovereign debt crisis.
D. Relationship with Labor Market Reform
In my view, as a measure to raise long-term inflation expectations that already have
declined to a low level, it is important to have structural policies, particularly labor market
reform.
If long-term inflation expectations have some kind of relevance to the potential growth rate,
it is necessary to raise both at the same time. To this end, one important measure is labor
market reform. If such reform leads to rises in labor productivity and the labor force
participation rate, the potential growth rate will increase from a longer-term perspective and
firms' expected rates of return and households' permanent income also will increase. This
will strengthen monetary easing effects and the inflation rate will increase. Then, the
adaptive formation mechanism of inflation expectations, which is unique to Japan, will
bring about a positive influence on long-term inflation expectations.
In Japan, some labor market practices could be constraints on raising long-term inflation
expectations. Therefore, labor market reform should be actively pursued. Given that there is
an increasing sense of labor shortage caused by the population decline, now is an ideal time
to take a step forward in labor market reform. I will next focus on three possible reform
measures.
First, a more flexible adjustment mechanism should be implemented in Japan's labor market.
Let me elaborate on this point. The way people form their expectations could be affected by
how labor market adjustments are made during periods of recession -- i.e., whether to have
quantity adjustments in terms of headcount or price adjustments in terms of wages. For
example, in the U.S. labor market, quantity adjustments are mainly made in the form of
layoffs. Japan's labor market mostly makes price adjustments and layoffs tend to be avoided
(Chart 12).
Let me add a few things about wage adjustments in Japan. In the face of the past shocks,
including oil crises during early 1970s and 1980s, Japan's labor unions had a practice of
prioritizing the job security of regular workers and accepting management's proposal to set
lower wages. Under such coordination between labor and management, restraining wage
increases of regular workers was effective in controlling inflation. Afterwards, the base pay
of regular workers significantly shifted downward following Japan's financial crisis, and
then became sticky at low levels. Since then, non-regular workers have acted as a buffer
against wage adjustments as they are outside the protection of labor unions.
As illustrated, Japanese-style employment and wage practices of prioritizing the job
security of regular workers and restraining wage increases may have influenced long-term
inflation expectations to shift downward. If that is the case, the solution is to implement
dynamic U.S.-style employment practices and allow the compensation of regular workers to
reflect risk premiums.
I note that, in Japan's labor market, job mobility and a social safety net are not necessarily
sufficient. In this situation, the U.S.-style employment system is unlikely to be socially
acceptable. In fact, it has been difficult to reach a consensus between labor and management,
and thus progress in labor market reform has been moderate.
I believe that a key to success in labor market reform is to implement dynamic U.S.-style
employment practices while modifying them to fit Japan's own circumstances. For example,
it is important to gain the understanding of labor unions by establishing a social safety net
that leads to economic growth. One option is to build a framework for employment and
reemployment assistance in coordination with the government, labor, and management.
Second, a forward-looking wage negotiation system should be established. Let me elaborate
on this point. In Japan's wage negotiations, the observed rate of increase in the consumer
price index (CPI) of the previous year is used as a benchmark in determining the rate of
increase in wages for the following year (Chart 13). For this reason, even when a decline in
the CPI is attributed to external factors, including a decline in crude oil prices, the low
inflation rate tends to be referred to in wage negotiations. That said, such a price decline is a
positive factor in corporate profits with an improvement in the terms of trade at a
macroeconomic level.12
In my view, it is necessary to replace the existing practice of referring to the observed CPI
in the past and negotiating the wage increases for only one year in an adaptive manner.
Instead, it is necessary to implement the practice of negotiating wage increases for several
years in a forward-looking manner by sharing the outlook on the path of price changes over
several years, or over the medium to long term.13
Third, there should be a change in the practice of applying the result of labor-management
wage negotiations at large manufacturers to other industries. In Japan, the result of wage
negotiations at large manufacturers -- especially automobile, steel, and other major
manufacturers -- tends to be used as a benchmark for such negotiations in other industries,
including non-manufacturing. Therefore, even when the terms of trade at a macroeconomic
level improve due to the yen's appreciation, if a higher yen causes major manufacturers to
have lower profits and depress the rate of wage increases, such a rate for non-manufacturers
also tends to be depressed accordingly.
In Japan, the share of manufacturing in gross output is less than 20 percent. Therefore, it is
not suitable at this time to use wages at major manufacturers as a benchmark for wage
negotiations in other industries. I believe that wage increases should reflect individual firms'
profits with forward-looking inflation expectations being used as a basis.
III. Addendum: Recent Discussion on Fiscal Policy Measures
The roles of fiscal policy measures have regained attention in Japan recently, following the
insufficient increase in expectations even with the large-scale unconventional monetary
policy. "Helicopter money" and the Fiscal Theory of the Price Level (FTPL) are examples
of this (Chart 14).
The issue they have in common is whether or not additional fiscal expenditure will exert
positive effects on the way people form their positive expectations in a sustainable manner.
Households do not act as rationally as Ricardian equivalence assumes. Meanwhile, it also is
plausible to assume that their concerns over possible tax hikes and an increase in social
security tax burden provide a reason for their cautious outlook. These arguments might have
given rise to the idea that it is desirable to have permanent fiscal policy expansion without
an accompanying future tax hike.
Even if government debts are assumed to be financed in the future through inflation that
will be triggered by fiscal expansion, empirical research on related theoretical models is still
insufficient. Therefore, the models cannot be applied to the actual policy formulation, nor
used as the basis for macroeconomic forecast for such formulation.
Economic policy is implemented based on a critical decision that takes account of more
than just gains and losses for various economic entities. This is because it is difficult to
obtain the consent of stakeholders based on an economic model that considers future
inflation to be inevitable but cannot predict when it will occur. Let me also note that actual
policy management cannot help being prudent. The reason for this is that the policy
authorities have to strongly recognize various constraints. In fact, macroeconomic policy is
managed under various constraints -- such as those in terms of legal, accounting, and
practical affairs, as well as the need for parliamentary consent.
Concluding Remarks
I will close by noting the lesson learned from the 4-year experience since the introduction of
QQE. Once long-term inflation expectations decline, it is not easy to raise them, even
through the large-scale unconventional monetary policy. Given that monetary policy on its
own has limited effects, it is vital to make steady efforts, such as through the labor market
reform that I discussed earlier, in order to change conservative inflation expectations that
are deeply rooted in people's mindsets. In particular, I consider it important to produce a
change in the wage determination mechanism.
In the process of wage determination, it is desired that inflation targets set by central banks
be the basis for the medium- to long-term path of inflation. For this purpose, central banks'
inflation targets should gain sufficient credibility with the public. To this end, it is necessary
to see achievements that prove monetary policy is able to change the inflation trend. It is not
easy to regain credibility. As the frontrunner in combating deflation, however, the Bank of
Japan will continue to endeavor to do so, always deliberating on what can be accomplished
through monetary policy.
Thank you.
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Lessons of Japan:
Focusing on Issues regarding
Long-Term Inflation Expectations
Speech at Yale University in New Haven
March 28, 2017
Takehiro Sato
Bank of Japan
Today's Topics
Introduction
I. Lessons of Japan
1. Determinants of Long-Term Inflation Expectations
2. Negative Effects of Excessively Low Long-Term Inflation
Expectations
II. Issues regarding Long-Term Inflation Expectations
1. Formation Mechanism
2. Reasons for Low Expectations in Japan
3. Relationship with Japan's Financial Crisis
4. Relationship with Labor Market Reform
III. Addendum: Recent Discussion on Fiscal Policy Measures
Concluding Remarks
Chart 1
Statement on Longer-Run Goals
and Monetary Policy Strategy
Board of Governors of the Federal Reserve System
Adopted effective January 24, 2012; as amended effective January 26, 2016
"The inflation rate over the longer run is
primarily determined by monetary policy, and
hence the Committee has the ability to specify a
longer-run goal for inflation."
2
Chart 2
Potential Growth Rate and Inflation Expectations
in Advanced Economies
(1) Potential Growth Rate (2) Inflation Expectations
y/y % chg. y/y % chg.
4.0
2.5
Japan United States Euro area
Japan United States Euro area
3.5
2.0
3.0
2.5
1.5
2.0
1.0
1.5
1.0
0.5
0.5
0.0
0.0
CY 05 06 07 08 09 10 11 12 13 14 15 16 CY 05 06 07 08 09 10 11 12 13 14 15 16 17
Note: As for inflation expectations, figures for Japan are the expectations for the CPI 6-10 years ahead and are based on the "Consensus Forecasts."
Those for the United States and euro area are 5-year, 5-year forward inflation swap rates.
Sources: OECD; Bloomberg; Consensus Economics Inc., "Consensus Forecasts."
Today's Topics
Introduction
I. Lessons of Japan
1. Determinants of Long-Term Inflation Expectations
2. Negative Effects of Excessively Low Long-Term Inflation
Expectations
II. Issues regarding Long-Term Inflation Expectations
1. Formation Mechanism
2. Reasons for Low Expectations in Japan
3. Relationship with Japan's Financial Crisis
4. Relationship with Labor Market Reform
III. Addendum: Recent Discussion on Fiscal Policy Measures
Concluding Remarks
4
Chart 3
Japan's Inflation Expectations and
Potential Growth Rates
y/y % chg.
y/y % chg.
3.0 5
Inflation expectations (left scale) Potential growth rate (right scale)
4
2.5
3
2.0
2
1.5
1
1.0
0
0.5
-1
0.0 -2
CY
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Note: Figures for inflation expectations are the expectations for the CPI 6-10 years ahead and are based on the "Consensus Forecasts."
Figures for potential growth rate do not include those of 2011, in which the Great East Japan Earthquake occurred.
5
Sources: Cabinet Office; Consensus Economics Inc., "Consensus Forecasts."
Chart 4
Japan's Asset Price Deflation
1989/Q4 = 0, in log-scale
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
-1.2
-1.4
Land price
-1.6 Stock price
CPI (all items less fresh food)
-1.8
-2.0
CY
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Note: The CPI (all items less fresh food) is seasonally adjusted by X-12-ARIMA with options of (0 1 2) (0 1 1) ARIMA model and level
shifts when the consumption tax was introduced in April 1989 and subsequently raised in April 1997 and April 2014.
Sources: Okina, Kunio, and Shigenori Shiratsuka. "Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth:
Lessons from Japan's Experience since the Late 1980s." Monetary and Economic Studies 22, no. S-1, December 2004; Bank of
6
Japan; Ministry of Internal Affairs and Communications; Japan Real Estate Institute.
Chart 5
Japan's Inflation Expectations
y/y % chg.
3.0
Consensus forecasts 5-year, 5-year forward inflation swap rate
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
CY
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Note: Figures for consensus forecasts are the expectations for the CPI 6-10 years ahead and are based on the "Consensus Forecasts."
Sources: Bloomberg; Consensus Economics Inc., "Consensus Forecasts."
Chart 6
Frequency Distribution of Price Changes
in Individual CPI Items
(1) Changes after the Introduction of QQE (2) Comparison of Japan and the United
States (as of March 2014)
%
%
30 40
35
25 Japan
United States
Dec. 2012
30
Dec. 2016
20
25
15 20
15
10
10
5
5
0 0
-11-10-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11
-11-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11
(year-on-year rate of price changes in individual CPI items, %)
(year-on-year rate of price changes in individual CPI items, %)
Sources: Watanabe, Tsutomu 渡辺努, and Kota Watanabe 渡辺広太. "Defure-ki ni okeru kakaku no kōchokuka: Geiin to gan'i" デフレ期における価格の硬
直化:原因と含意 日本銀
[Increased price rigidity during the deflationary period: Causes and implications]. Bank of Japan Working Paper Series
行ワーキングペーパーシリーズ, no. 16-J-2, February 2016; Ministry of Internal Affairs and Communications. 8
Chart 7
Comparison of Administered Prices
among Advanced Economies
CY 2000 = 1
1.9
1.8
Japan Europe United States
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1.0
0.9
CY
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
Note: Figures for Japan are aggregates of "public services" and "electricity, manufactured & piped gas & water charges" in the CPI. Figures for
Europe are weighted averages of administered prices in the harmonized index of consumer prices (HICP) of OECD member countries in
the EU.
Sources: Shintani, Kohei, Yoshiyuki Kurachi, Shinichi Nishioka, and Takashi Okamoto. "Administered Prices in Japan: Institutional
Comparisons with Europe and the United States." Bank of Japan Review Series, no. 16-E-9, July 2016; Ministry of Internal Affairs 9
and Communications; U.S. Bureau of Labor Statistics; Eurostat.
Chart 8
B