hiroshi nakaso : the conquest of japanese deflation – interim report remarks by mr hiroshi nakaso, deputy governor of the bank of japan, at the athens symposium “ banking union, monetary policy and economic growth ’ ’, athens, 19 june 2014. * * * introduction it is my great pleasure to be able to take part in these discussions with such distinguished panelist. i hope you will forgive my presumption in borrowing the title of my remarks today from nobel laureate thomas sargent ’ s influential book, ‘ ‘ the conquest of american inflation ’ ’. 1 i would like to talk about the most important challenge facing the bank of japan at the moment, which is how to conquer deflation in japan. however, before doing so, let me spend some time considering how we came to be struggling with this mild but persistent deflation. i. deflationary equilibrium japan ’ s cpi began to dip into negative territory in 1998, and remained there on the whole for the next 15 years. this deflation has two distinctive features. one is its long duration, which clearly sets it apart from the usual business cycle frequency. the other is its mildness. for most of the time, deflation has remained at less than minus 1 percent on a year - on - year basis, except for very short spells such as the period just after the lehman crisis. given the length of this deflation, some economists naturally argue that this is not a temporary disequilibrium phenomenon, but an indication that the equilibrium itself has shifted so that deflation prevails ( chart 1 ). 2 i am inclined to believe that this is the case, and that the equilibrium shift was triggered by the two huge shocks that hit japan simultaneously in 1997 : the banking turmoil and the asian currency crises. the combination of two such shocks would be a severe challenge to any monetary authority trying to protect its economy from the threat of serious deflationary pressures. the banking turmoil was a particularly severe blow in that the ability of the credit intermediary function of the banking sector to support economic recovery was seriously impaired, and this in turn exacerbated the deflationary threat. worse still, there was very little room to cut the interest rate : the policy rate was already as low as ½ percent prior to these shocks hitting japan. given the magnitude of these negative shocks, the question arises as to why deflation was so mild in japan. there may be several determining factors3 but i believe that a decline

influence of communism, japan could continue to play the role of " the world's factory " in the market economies during the period from the late 1950s to the end of the 1960s. furthermore, japan increased its business fixed investment at a rapid pace because world war ii had erased a large amount of domestic capital stock. the period of high economic growth in japan coincided with the baby boomers'entrance into the labor force. in fact, the labor force increased from about 40 million in 1955 to about 50 million in 1970. furthermore, population growth around that time followed a bell - shaped curve, which led to a relatively light burden being imposed by the pension and other social security systems compared to other industrialized countries. b. shift to a floating exchange rate system and the two oil shocks from the 1970s through the early 1980s, the japanese economy experienced several major disturbances, including the revaluation of the yen triggered by the " nixon shock " and the subsequent shift to a floating exchange rate system, and the two oil shocks. in particular, the first oil shock combined with the excess liquidity of the time to produce rapid inflation. in contrast, japan managed to overcome the second oil shock smoothly, perhaps we can say the most smoothly among the industrialized countries. behind this was not only a timely macroeconomic policy response, but also the fact that japanese industry, having learned the lesson of the first oil shock, actively improved energy efficiency. as a result of these efforts, japan's economy became the least dependent on oil among the industrialized countries, and at the same time succeeded in making energy - efficient technology a new source of value added. this can be cited as a classic example of japan turning a problem to be overcome into a source of strength by using its technological capability. the success of japan's economy in overcoming the second oil shock contributed relatively smoothly to raising its international reputation. c. stronger yen and the emergence of the bubble economy in the latter half of the 1980s, the plaza agreement triggered the large - scale correction of the strong u. s. dollar at the time, and japan experienced a period of economic stagnation caused by the yen's appreciation. this stagnation, however, ended rather quickly, and, as is well known, what followed was economic expansion accompanied by asset price bubbles. the coexistence of high economic growth and low inflation throughout this period suggested gains in productivity, and we observed widespread optimism that japan had overcome the adverse effect of not only the