in potential growth played an important role. even before we began to struggle with deflation, potential growth in japan had started to show a secular decline due to both an ageing and a falling trend in population, as well as a slowdown in capital formation. thus, potential growth is estimated to have dropped to current levels of as low as ½ percent from about 4 percent in the early 1990s ( chart 2 ). this is not good news in itself, but it does help prevent the negative output gap from widening. sargent, t. j. ( 1999 ) : the conquest of american inflation, princeton university press, princeton. benhabib, j., s. schmitt - grohe and m. uribe ( 2001 ) : ‘ ‘ the perils of taylor rules, ’ ’ journal of economic theory, 2001, 96 ( 1 - 2 ), pp. 40 – 69 ; bullard, j. ( 2010 ) : ‘ ‘ seven faces of ‘ the peril ’, ’ ’ federal reserve bank of st. louis review, september / october, pp. 339 – 352. another important hypothesis is that inflation has become less responsive to the output gap. bis central bankers ’ speeches ii. lessons learned what lessons can we learn from this experience? to avoid falling into deflationary equilibrium, especially in the face of huge negative shocks, i think that it is important for the authorities to adhere to the following three principles. first, we definitely need to avoid a financial crisis. in 1997, we lacked a solid safety net such as a deposit insurance system and a bank resolution mechanism that could effectively deal with a systemic disruption. we failed to stop a large - scale banking crisis because these institutional frameworks were not in place. it was only in the wake of this painful experience that we set up a robust system for the prevention and management of financial crises. second, we need to keep a close eye on external events. in 1997, we underestimated the vulnerabilities of asian economies and it took some time for us to realize the depth, magnitude and interconnected aspects of the asian currency crisis. third, anchoring inflation expectations is critical for monetary authorities. we must not become complacent about seemingly stable long - run inflation expectations. this is because inflation expectations are inherently difficult to measure accurately and are susceptible to downward shifts once low inflation is observed for a certain period of time ( i. e. inflation expectations are formulated in an adaptive manner ). we

. jp / en / announcements / press / koen _ 2014 / ko140423a. htm bis central bankers ’ speeches long - term fiscal sustainability. in trying to escape from deflationary equilibrium, i believe that the monetary and fiscal policies that used to be conducted independently under an inflationary equilibrium, need to be pursued using a different approach. the joint statement issued by the bank and the government in january last year may have been playing an important role as a coordination device to enable the collective conduct of monetary and fiscal policies. this joint statement is an important foundation of abenomics. close cooperation between monetary and fiscal authorities can be observed not only in japan, but also in other areas where unconventional monetary policy has been deployed. 5 for instance, when the bank of england introduced its asset purchase facility, a letter from the chancellor made it clear that the british government would provide an indemnity to cover any losses arising from the facility. however, this close cooperation does not necessarily imply the loss of central bank independence for the following two reasons. first, a clear mandate of inflation targeting guarantees active monetary policy down the road. the zero lower bound on the nominal interest rate ties the hands of central bankers when it comes to deflation. as for inflation, central bankers can and should adjust policy rates flexibly if inflation is likely to stay above the stated target. second, governments well understand the importance of fiscal prudence. in the recent g20 communique, the respective governments made a firm commitment to maintaining fiscal sustainability. as the second arrow of abenomics, the japanese government has already made an important step forward in this respect by raising the consumption tax rate in april this year. presumably because of this commitment to fiscal sustainability, survey figures for long - run inflation forecasts in advanced economies have not increased to levels much above targeted inflation rates, although these figures are subject to considerable uncertainty, as i mentioned before. these forecasts for japan have not yet reached even 2 percent, although they do seem to be on a steady rising trend. iv. importance of raising potential growth since i have talked about the first and the second arrows of abenomics, let me touch upon the third arrow before concluding my presentation. as i mentioned, the decline in potential growth in japan has limited the range of the negative output gap. together with demand recovery, lower potential growth seems to be contributing to the recent rise in inflation through the tighter capacity constraint. in fact, the latest output gap is