Haruhiko Kuroda: How to overcome deflation
Speech by Mr Haruhiko Kuroda, Governor of the Bank of Japan, at a conference, held by the
London School of Economics and Political Science, London, 21 March 2014.
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Introduction
It is indeed my honor to be given an opportunity today to speak at this conference hosted by
the London School of Economics and Political Science.
Just one year has passed since I became Governor of the Bank of Japan on March 20, 2013.
In short, this past one year was one marked by the challenge of overcoming deflation. The
word deflation might remind you of the price decline associated with rapid contraction of the
economy during the Great Depression of the 1930s. Some might even look back to the much
earlier episode of the downtrend in prices for more than 20 years that the United Kingdom
experienced in the second half of the 19th century. What is deflation actually like? Why is
deflation a problem? As I would expect that nobody here has actually experienced those past
deflations, you might be able to conceive of answers to these questions, but it could be
difficult to have a true sense of the reality of those situations. Therefore, in my speech today,
I will talk about Japan's experience of 15 years of deflation and how we are trying to
overcome that.
Let me first ask you a question. What is the average annual rate of decline in consumer
prices in Japan in the past 15 years? The answer is minus 0.3 percent. Unlike the rapid and
substantial price decline during the Great Depression in the 1930s, a feature of Japan's
deflation is that an extremely moderate price decline has continued for a long period. The
unemployment rate was 5.5 percent at its worst and there has been no such scene as
jobless people predominating in a town, as was the case in the Great Depression.
This is not to say that there weren't any problems simply because the decline in prices was
moderate. If we were to regard the price decline during the Great Depression as a fierce and
acute symptom, Japan's deflation has come to show a symptom akin to a chronic lifestyle
disease. Once an expectation that prices will fall becomes built-in among the public, real
interest rates, which are obtained by subtracting expected rates of inflation from nominal
interest rates, will increase. Of course, a central bank can cope with such a situation if it can
lower nominal interest rates, but in Japan the policy rate had already been lowered to
0.5 percent in 1995 and there was little room to further reduce nominal interest rates. An
increase in real interest rates restrains business fixed investment and household spending,
and thus economic activity in Japan remained stagnant. In addition, under deflation, holding
cash and deposits becomes a better choice than making investment, and incentives to
launch new businesses by taking risks become weakened. In this situation, Japan's economy
lost vitality and the growth rate declined. It can be said that a moderate price decline has
gradually undermined Japan's economy.
Therefore, what we should do to restore the vitality of Japan's economy and let the economy
grow in a sustainable manner is to achieve the 2 percent price stability target and overcome
protracted deflation. As I will describe later, to overcome deflation, the Bank of Japan
introduced last April quantitative and qualitative monetary easing, dubbed QQE - an
unprecedented bold monetary easing - and has been pursuing this policy. Today, so as to
enhance your understanding of the Bank's initiatives to overcome deflation, I will address
three questions. First, why has Japan's economy been unable to overcome deflation?
Second, how are we trying to get out of deflation? And lastly, how far have we come in the
process of overcoming deflation?
I. Why has Japan's economy been unable to overcome deflation?
As I mentioned earlier, deflation has been continuing in Japan since the late 1990s, but the
economy has not been in recession during the whole period. Instead, a recovery phase of
more than six years, from the beginning of 2002 to early 2008, marked the longest post-war
economic recovery. Since 1999, to overcome deflation, the Bank adopted ahead of other
central banks various unconventional policy measures, such as the zero interest rate policy,
quantitative easing policy, a commitment to the duration of these policies, and purchases of
risk assets. If we had named the commitment to the duration of the zero interest rate policy
introduced in 1999 an eye-catching "forward guidance", the Bank might have received an
honor as the inventor of this policy tool.
However, despite the tailwind in the real economy and considerable efforts by the Bank,
Japan's economy could not overcome deflation. What was lacking? To state the answer first,
what lacked was the central bank's strong and clear commitment to achieve its price stability
target and its actions to work on inflation expectations through that commitment.
To begin with, if we look into the causes of Japan's price declines, various factors have had
an effect at each point in time. To name several, these were an adjustment of excess
capacity and employment after the bubble period, low-priced imports from emerging
economies and firms' low-price strategies, financial institutions' nonperforming loan problems
and financial system uneasiness, and an excessive appreciation of the yen. As actual prices
declined due to those factors, deflationary expectations that prices will not rise but instead
decline were generated among people. Subsequently, even if those factors that induced
price declines diminished, once deflationary expectations became entrenched, people would
make decisions and take actions on the assumption that prices would not rise. Through this
process, deflationary expectations themselves created in a self-fulfilling manner an economy
in which prices did not easily rise. Explained by using the jargon of economics, Japan's
economy is in a situation in which the Phillips curve, which expresses a negative relationship
between inflation and unemployment, has shifted downward due to a decline in people's
inflation expectations. Even when the economy is trapped in such a situation, we can raise
prices temporarily by rejuvenating economic activity through stimulative policies. However, if
the Phillips curve remains shifted downward, the economy will eventually return to a
deflationary state once economic activity declines over the business cycle. This is why
Japan's economy could not overcome deflation after all, despite experiencing an economic
expansion several times while deflation was continuing.
Having analyzed why protracted deflation occurs, let's turn to the second question: what is
required to get out of protracted deflation and achieve the 2 percent price stability target in a
sustainable manner? As the problem lies in the fact that people have a deflationary
sentiment that prices will fall, we have to dispel such sentiment. We have to convince people
that a situation in which prices will increase by around 2 percent every year is nothing
special, and change the economy to one in which people make decisions and behave based
on that assumption. In other words, it is necessary to raise people's expected rates of
inflation to 2 percent and re-anchor them at that level. The Bank had repeatedly implemented
various leading-edge policies. While a series of such policies stimulated economic activity,
they fell short of showing a strong and clear commitment to achieve the price stability target
by any means. As a result, these were insufficient to work on inflation expectations and failed
to raise them. Therefore, even in the face of a temporary rise in prices, the rise was not
sustained and the economy could not get out of deflation for a long period.
II. How to overcome deflation
Let me next talk about how the Bank is now trying to raise people's inflation expectations and
overcome deflation. It is clear from the results of past policies that deflationary sentiment that
has been embedded under protracted deflation cannot be easily dispelled. There have been
only a few examples. Looking back, one can immediately think of the U.S. New Deal Policy
of the 1930s as an episode in which people's inflation expectations substantially rose in a
short period of time through policy measures. At the same period in Japan, a similar series of
macroeconomic policy measures called the "Takahashi Economic Policy", named after the
finance minister who took the initiative, were implemented. In these policies, an exit from the
gold standard enabled foreign exchange rates to adjust in line with actual economic
conditions, and macroeconomic policies that combined aggressive fiscal and monetary
policies were implemented. By contrast, the powerful monetary tightening by Chairman
Volcker of the U.S. Federal Reserve (Fed) from the end of the 1970s to the beginning of the
1980s can be noted as an episode in which inflation expectations were substantially lowered.
All these events are associated with the policy authorities' strong will to drastically change
the economic situation, and with a bold policy conversion that underpinned such will.
Therefore, to convert people's deflationary expectations and raise their expected rates of
inflation, it is necessary to demonstrate the Bank's strong resolution and commitment toward
overcoming deflation and to implement decisive policy that is sufficient to achieve that goal.
We also have to make the conversion of expectations happen under a zero lower bound for
nominal interest rates.
Taking these points into account, at the Monetary Policy Meeting on April 4 last year, the
Bank introduced the unprecedented large-scale monetary easing policy of the QQE. It was a
policy, upon strongly committing to achieve the 2 percent price stability target with a time
horizon of about two years in mind, to increase the monetary base by an unprecedented
amount of about 60-70 trillion yen to underpin the commitment. As a result, the monetary
base will be doubled in two years. In addition, aiming to achieve the 2 percent price stability
target, the Bank committed to continuing with the QQE as long as it is necessary for
maintaining the target in a stable manner.
The Bank clearly committed to achieving the 2 percent price stability target, with a time
horizon of about two years in mind, and also to continue with the unprecedented large-scale
monetary easing of the QQE as long as it is necessary for maintaining the target in a stable
manner. We considered that such a combination would raise people's inflation expectations
in a forward-looking manner. We also assumed that, as a result, if actual prices start to
increase, that would affect inflation expectations in a backward-looking manner as well. And
with an increase in the number of people who believe in the Bank's commitment, the
forwardlooking influence would also be strengthened.
Let me be more specific about the transmission mechanism of the QQE. Three transmission
channels are assumed: containing interest rates and risk premiums through massive asset
purchases, portfolio rebalancing, and raising inflation expectations. What I would like to focus
on in particular is the channel starting from a rise in inflation expectations.
As a rise in inflation expectations shifts the Phillips curve upward, under the same level of
economic activity, the actual inflation rate will be higher. In addition, a rise in expected rates
of inflation, if nominal interest rates rise by less than that, will lower real interest rates and
stimulate economic activity. That is, if the Bank can contain nominal interest rates through
massive asset purchases while raising expected rates of inflation, it can lower real interest
rates. In the case of central banks in the United States and Europe, as inflation expectations
have already been anchored at the price stability target, they have no choice but to reduce
nominal interest rates in order to lower real interest rates. However, in the case of Japan, as
inflation expectations have been below the level of the price stability target, there is room for
lowering real interest rates through raising inflation expectations. A decline in real interest
rates will stimulate business fixed investment and consumption, and raise the actual inflation
rate by narrowing the output gap. Once prices start to rise, this will further induce a rise in
inflation expectations, which in turn work on real interest rates to decline again. In such a
manner, a virtuous cycle starting from a rise in inflation expectations will take hold.
III. How far have we come?
So, how far have we come toward the goal of achieving the 2 percent price stability target
and overcoming deflation? To state the conclusion first, Japan's economy has been following
a path toward achieving the 2 percent price stability target as expected, and we are halfway
there.
The transmission mechanism of the QQE has been functioning as initially intended.
According to various surveys and market indicators, we judge that inflation expectations have
generally been rising. Due to the Bank's massive purchases of government bonds, long-term
interest rates have been hovering in a stable manner at low levels. In fact, in the face of a
rise in U.S. long-term interest rates from below 2 percent to about 3 percent in relation to
speculation about the Fed's tapering of its asset purchases, Japan's long-term interest rates
have been stable and recently at around 0.6 percent. As a result, real interest rates have
been declining. There are also changes in bank behavior. The year-on-year rate of increase
in bank lending has gradually accelerated and has been around 2.5 percent. Lending has
increased not only to large firms but also to small firms, for which the year-on-year rate of
change has turned positive, suggesting that lending has become widespread to a variety of
businesses. Partly reflecting this development in bank lending, the year-on-year rate of
increase in the money stock has gradually been accelerating, hovering around 4 percent in
recent months.
In relation to this, last month, the Bank expanded lending facilities to support financial
institutions' initiatives to increase lending that are similar to the Funding for Lending Scheme
of the Bank of England. The Bank of Japan will provide funds to financial institutions up to
double the amount of their net increase in lending and, like the Long-Term Refinancing
Operations of the European Central Bank, provide long-term funds. It will provide funds with
a four-year fixed rate of 0.1 percent. While the Bank's main engine of its monetary policy is
the QQE, these facilities are designed to reinforce a transmission mechanism of the policy.
We have been taking a stance of doing whatever we can to achieve the 2 percent price
stability target.
Partly due to the effects of the QQE, Japan's economy has been growing above its potential
growth rate led by domestic demand, with real GDP growth increasing year-on-year by
1.5 percent on average in 2013, and by 2.5 percent measured from fourth quarter to fourth
quarter. On the employment front, the unemployment rate has declined to 3.7 percent, which
is close to the structural unemployment rate of around 31⁄2 percent. As for the outlook,
Japan's economy is expected to continue on a moderate recovery with a virtuous cycle
among production, income, and spending at work.
On the price front, the year-on-year rate of change in the consumer price index (CPI)
excluding fresh food was minus 0.5 percent as of March last year, turned positive in June,
and has been accelerating to mark plus 1.3 percent this January. It is still lower than that in
the United Kingdom, but almost the same level as that in Germany and higher than that in
most of the continental European countries. The rate of increase is likely to be around
11⁄4 percent for some time, subsequently return to the uptrend, and is likely to reach around
the price stability target of 2 percent from the end of fiscal 2014 through fiscal 2015.
Achieving an inflation rate of more than 1 percent in less than a year since the introduction of
the QQE was beyond many people's expectations. In fact, according to the ESP Forecast
Survey, which compiles economists' forecasts, the projection of the year-on-year rate of
growth in the CPI for this January-March quarter as of March last year was only plus
0.4 percent. While we introduced the QQE with confidence in its effects, for many people this
development in the CPI seemed to have been a positive surprise. When something occurs
that differs from expectations, people have a strong incentive to change their past views and
behavior. Our work to change deflationary expectations that have been entrenched over time
as well as people's behavior under such expectations has been progressing as expected,
with the strong reinforcement of an actual rise in the CPI.
As the consumption tax will be raised to 8 percent from 5 percent this April, it is expected that
there will be a decline in demand after the tax hike following the front-loaded increase in
demand prior to the tax hike. Based on the experience of the economy going into recession
when consumption tax was raised last time, in 1997, there are some concerns over the
outlook for the economy this time as well. However, looking back at 1997, the economy at
one point recovered from a plunge following the consumption tax hike, but Japan's financial
system instability and an outbreak of the Asian currency crisis substantially affected the
subsequent economic deterioration. By contrast, at present, Japan's financial system has
been maintaining stability and emerging economies in Asia have become more resilient due
partly to an accumulation of foreign reserves and an establishment of safety nets. In addition,
Japan's employment situation is far more favorable than that in 1997. Taking these points
into account, the Bank believes that, while Japan's economy will temporarily decline
immediately after the consumption tax hike, it will continue to grow above its potential growth
rate as a trend with a virtuous cycle among production, income, and spending being
maintained.
Concluding remarks
As I have mentioned, so far, with the QQE steadily exerting its intended effects, Japan's
economy has been following a path toward achieving the 2 percent price stability target as
expected. Of course, we are only halfway there and will steadily pursue the QQE. As the
economy is associated with upside and downside risks, we will examine them and make
adjustments as appropriate in order to achieve the 2 percent price stability target. By firmly
continuing with such policy, I am convinced that we can achieve the 2 percent price stability
target and overcome deflation.
In the past 15 years, Japan was not sleeping because it wanted to. It was only that, even if
one person or one firm wanted to take on new challenges, rewards meeting such challenges
could not be expected under a macroeconomic environment of persistent deflation. With the
QQE and the government's various initiatives, we have unlocked this "fallacy of composition".
Therefore, Japanese firms that originally were equipped with excellent technologies and
human capital have started to take on new initiatives again, and the economy and prices
have changed dramatically. We should not let this trend be reversed. To this end, we are
making efforts with strong resolution. The day that Japan's economy can contribute more
and more to the global economy is at hand.