The Importance of Agile Monetary Policy in Addressing Japan's Inflation Uncertainty

 Summary and Conclusion of The Article, “Uncertainty Around Japan Inflation Underscores Need for Nimble Monetary Policy”

By Purva Khera and Salih Fendoglu, from IMF(https://www.imf.org/en/News/Articles/2023/05/24/cf-uncertainty-around-japan-inflation-underscores-need-for-nimble-monetary-policy?utm_medium=email&utm_source=govdelivery)

The article discusses the uncertainty surrounding Japan's inflation and emphasizes the need for nimble monetary policy to address the situation. Japan has experienced a four-decade high in headline inflation due to the economic recovery, supportive monetary and fiscal policies, and a surge in tourism. The momentum in core prices, which exclude fresh food and energy, has also strengthened. While rapid price gains are usually undesirable, Japan's history of deflation makes this inflation surge a positive development.

The article highlights three reasons for hope that Japan is at a turning point in sustaining inflation around its 2% target. First, price pressures are becoming broader and more durable, indicating a shift from the initial trigger of the global energy and supply-chain crisis. Second, the annual labor union negotiations signal agreement on larger wage gains to keep up with rising prices. Third, business surveys indicate a sustained increase in inflation expectations, influencing corporate price-setting.

However, there are important caveats that make sustaining this inflation challenging. Small and medium-sized enterprises, which employ a significant portion of the workforce, may struggle to afford the wage increases necessary to support inflation. Additionally, a weakening global economy could strengthen the yen, making exports less competitive and potentially leading to low inflation or deflation. Household surveys also indicate that inflation expectations remain below the 2% target.

The Bank of Japan (BOJ) faces the policy challenge of achieving its inflation target without significantly overshooting while safeguarding financial stability. The BOJ's ultra-accommodative monetary policy includes a negative interest rate and yield curve control. However, the yield gap created by other central banks raising interest rates has put downward pressure on the yen and forced the BOJ to buy a large amount of government bonds to defend the yield ceiling, destabilizing the market.

Photo from:https://www.imf.org/en/News/Articles/2023/05/24/cf-uncertainty-around-japan-inflation-underscores-need-for-nimble-monetary-policy?utm_medium=email&utm_source=govdelivery

To address these challenges, the article suggests that the BOJ should allow greater flexibility in longer-term yields, allow market forces to play out, and maintain accommodative stance by keeping the short-term policy rate unchanged. This flexibility would make monetary policy more nimble, reduce undesirable side-effects, and minimize risks to the economic recovery and price stability. The article outlines several ways the BOJ could be more flexible, including widening the target band around the 10-year rate and shifting to a quantity-based purchasing objective.

The article also discusses the global spillovers of Japan's monetary policy, as it is the world's largest net creditor. Rising government bond yields in Japan could attract investors back to domestic assets and put upward pressure on global yields, affecting countries where Japanese investors own a significant share of local debt. Clear communication of any changes to Japan's monetary policy stance is crucial to mitigate unintended consequences and market volatility.

Ultimately, achieving Japan's 2% inflation target sustainably requires the support of other policies. These include withdrawing pandemic-related fiscal support, implementing limited and targeted measures for vulnerable households, and addressing structural barriers to wage growth to boost personal income and purchasing power. Overcoming these challenges will contribute to a virtuous cycle of income and growth in the country.