The recent experience of the Federal Reserve dealing with high inflation should serve as a cautionary tale for the Bank of Japan, urging them to be careful in their desire for higher inflation.
The Bank of Japan faces a crucial moment in its monetary policy as it tries to avoid falling below its 2% inflation target. However, it should be wary of maintaining an excessively loose monetary policy for too long, just like the Federal Reserve did before. This eventually led to the need for aggressive tightening measures to control inflation. This scenario would have negative implications for the Japanese economy and global financial markets, which have grown accustomed to the generous monetary policy from the Bank of Japan.
Interestingly, while the United States is grappling with the impact of surging inflation, not long ago, the Federal Reserve was concerned about inflation being too low. In 2020, after years of struggling with very low inflation, the Fed adopted a “flexible average inflation target” to replace the fixed 2% target. This policy allowed for temporary periods of higher inflation to achieve a sustainable 2% target.
To boost inflation after the 2020 Covid recession, the Federal Reserve implemented an extensive monetary stimulus, keeping interest rates near zero for an extended period and buying around $5 trillion in U.S. Treasury bonds and mortgage-backed securities. Consequently, the broad money supply increased by 40% between the beginning of 2020 and the end of 2021, leading to a surprising surge in U.S. headline inflation to over 9% by June 2022.
The current monetary policy of the Bank of Japan appears to echo the Federal Reserve’s recent experience. In its pursuit of achieving a 2% sustainable inflation rate, the BOJ has maintained a negative short-term interest rate of 0.1% and adopted a yield curve control policy by heavily intervening in the government bond market to keep the 10-year government borrowing rate close to 0%. Consequently, Japan’s interest rates have remained low, while other central banks are raising rates to tackle inflation, causing the Japanese yen to depreciate significantly against the dollar.
Evidence suggests that Japan’s ultra-loose monetary policy is leading to higher inflation. In June, Japan’s headline consumer prices rose by 3.3%, surpassing the corresponding U.S. figure for the first time in eight years. When volatile food and energy prices are excluded, Japan recorded a 4.2% inflation rate, more than twice its inflation target. Consequently, while U.S. interest rates are now positive in inflation-adjusted terms, Japanese interest rates are negative by 2-3%.
It is essential to understand that monetary policy operates with long and variable lags, meaning that if a central bank waits for inflation to take hold before raising interest rates, it might be too late. Given the signs of rising inflation in Japan and the persistent pressure on the Japanese yen, the Bank of Japan risks repeating the same mistake as the Federal Reserve did in 2021 by keeping interest rates too low for an extended period.
Especially considering the Federal Reserve’s decision to raise interest rates to 5% and the relatively higher yields offered by long-dated U.S. Treasury bonds, it is likely only a matter of time before the Bank of Japan is compelled to abandon its policy of maintaining both short and long-term interest rates near zero. Japan can only tolerate a depreciating currency for so long.
Inevitably, there will come a time when Japan will have to abandon its yield control experiment. This shift would mean that U.S. and world financial markets will no longer benefit from the abundance of liquidity provided by the Bank of Japan, potentially resulting in adverse effects on global financial markets. While this development might be advantageous for the Japanese yen, it will probably be detrimental to the rest of the world’s financial markets.