Stimulating Japan
Time for a permanent change to a non-deflationary monetary policy.

Mr. Malpass is the Chief International Economist for Bear Stearns.
October 3, 2001, 8:00 a.m.

But the key issue in turning bullish on Japan is whether it is in the process of making a permanent change to a non-deflationary monetary policy. If it did, Japan could begin adding to the world economy rather than subtracting from it, with positive financial market implications.

In recent days, the Bank of Japan has caused excess reserves to rise beyond 10 trillion yen, exceeding the 6 trillion yen target established in mid-August. It looks like this will turn out to be a temporary injection similar to the U.S. Federal Reserve's recent short-term injections. For a few days following September 11, the Fed allowed the fed funds rate to fall below the 3% target; then it reversed the injections and began enforcing the 3% target, a very high real interest rate.

As in the U.S., Japan's extra liquidity is probably just a temporary response to September 11 and to abnormally large liquidity needs related to the half-year that ended on September 30. In past half-year instances, Japan has given the impression of constructive monetary policy changes, then promptly reinstalled a deflationary policy.

For example, in March 1999, the Bank of Japan injected overnight liquidity, cut the interest rate fractionally, and allowed a public discussion of a shift from interest-rate targeting to quantitative -- then it reversed the impact. In March 2001, the BOJ finally shifted to a quantitative target, but set a deflationary level and left it unchanged for five months.

Japan's economic problems are primarily the result of a deflationary monetary policy and will not be solved by fiscal stimulus or the proposed reforms in the banking system. Japan was already in a deflation and recession (most likely a deep one) prior to September 11. The economy shrank at a 3.2% annual rate in the second quarter and the downturn probably accelerated in the third quarter.

On September 28 (Japan time), the government released September inflation data (actually deflation data) for Tokyo showing a 0.2% decline in prices in September from August and a 1.2% decline over the last 12 months. Housing rents and personal computer prices led the September price cuts.

Also on September 28, the government released industrial production data for August showing an 11.7% decline from August 2000, substantially worse than expectations. Unemployment remained at 5% in August.

On September 27, Japan reported a worse-than-expected 3.4% decline in August retail sales versus August 2000. This continued the long-term stagnation pattern of the 1990s. It fugures that shrinking consumption is a response to the deflationary monetary policy, as deflation makes the consumer wary about their jobs and gives them a price incentive to delay consumption.

The forward-looking Tankan survey of business sentiment released on October 1 gave another indication of Japan's deepening recession. It showed sentiment down substantially at both large a small Japanese businesses, suggesting that the recession will deepen unless Japan maintains the constructive monetary stimulus of recent days.

To restart the economy, the BOJ should adopt a stimulative monetary policy, a step Japan still hasn't tried despite ten years of deflation and stagnation. Even though interest rates are at 0%, the monetary policy is tight in terms of real interest rates (factoring in the deflation) and in terms of the cumulative appreciation of the yen in the 1990s.

To become stimulative, the BOJ could expand the supply of yen by buying Japanese government bonds and dollars, making clear that these mechanisms will provide long-term liquidity (not short-term) until deflation stops. It would also need to make clear that it would be able to withdraw liquidity to avoid excessive yen weakness or inflation. Those advocating a yen devaluation or an inflation target are wrong. These would be destabilizing, especially given the global recession.