Money and Metals

Business Week looks at central bank policy and deflation. "Inspired by Japan, some of the best minds in economics have looked at the question of deflation in recent years and have come to two conclusions. The first: There are various measures financial authorities can take to pull an economy out of the sort of corrosive slide in consumer prices that has hurt Japan over the past decade. The second: It makes sense to avoid succumbing to deflation in the first place."

"Japan has isolated itself from this discussion. Having fallen into deflation a decade ago, the Bank of Japan (BOJ) rejected the more-radical and imaginative solutions, apparently because the outcomes were unpredictable [unlike the predictable damage of deflation]. Instead, from 2001, the central bank pushed short-term rates to zero and flooded the money markets with liquidity that no one wanted."

"Now the BOJ seems to reject the possibility of having a too-low inflation rate. Most inflation-targeting central banks around the world aim for consumer price rises of around 2%. However, the BOJ's view is that price stability means inflation averaging just 1%. And if you take out the effect of fuel prices, inflation amounts to just 0.1%. The central bank seems ready to raise rates for the first time since 2000 as early as July 14, at the end of a two-day BOJ policy board meeting."

"After a decade when falling prices meant that real interest rates were too high, due to the inability to cut nominal interest rates below zero. This 'liquidity trap' contributed to a decade of poor performance by the Japanese economy, but the BOJ is taking the risk of a recurrence."

"Why does the BOJ feel so afraid of inflation? The most persuasive explanation: that the bank's officials are still suffering nightmares from the real estate bubble of the late 1980s, and fear a repeat. The current policy framework gives them the freedom to raise interest rates even when no inflation exists if they believe that asset price increases are potentially destabilizing. No matter that land prices in major cities fell by three-quarters from the bubble peak and have since risen by just 4%."

"Despite its regrets about the late-1980s bubble, the BOJ appears to accept no responsibility for the damage to the economy from the persistent deflation of the past decade. Meanwhile, the politicians don't seem to care too much. We are seeing criticism of the BOJ, but this may be politicians shifting accountability, so if anything goes wrong over the coming year, they can escape the blame. Appointments to the BOJ board show that the government does not have a problem with its hawkish bias."

"What is worrying is that the BOJ is unnecessarily increasing the downside risks. There are plenty of external candidates to deliver a shock to demand at the moment; the U.S. housing market, policy tightening in China, commodity prices, global epidemics bringing the danger of temporary recession and return to deflation in Japan. In that light, prudent policy would argue for a pro-growth stand with a positive inflation bias."

"The downside risks are all the greater because in the event that external factors turn bad, it's going to be very hard for the BOJ to admit it made a mistake. Self-preservation would probably lead the BOJ to hope for the best and enter a state of denial. As a result, any policy reversal would be delayed, with further costs to the economy. Even a return to zero interest rates would prove less effective the third time around."

"In a world where central banks of most major economies are tightening policy, it is overly dramatic to lay the blame for financial market weakness at the door of the BOJ. Moreover, the conservative stance of the BOJ does not come as a great surprise, considering its behavior over the past decade. Nevertheless, there is the unnecessary risk of periods of renewed deflation in the future because of the decision to try to stabilize the inflation rate at such a low level."