The Role of Expectations in Monetary Policy: Evolution of Theories and the Bank of Japan’s Experience episode 3

Haruhiko Kuroda, Governor of the Bank of Japan

Speech at the University of Oxford , June 8, 2017

4.New Challenges under Low Inflation

It can be said that Japan’s experience over the past four years illustrates the effectiveness of the kind of monetary policy approach that works on expectations first pointed out by economists in the first half of the 20th century. That being said, while the policy approach has steered Japan’s economy in the right direction, our intellectual journey has not yet been completed. The rate of change in the consumer price index (CPI) recently has been around 0 percent and there is still a longway to go until the price stability target of 2 percent is achieved.

The main reason is that inflation expectations, which had clearly risen as a result of the introduction of QQE, have since declined again and have continued to be subdued (Chart 9). Analysis by the Bank of Japan suggests that, as a result of prolonged deflation, the backward-looking, or adaptive, component in the formation of inflation expectations continues to be much stronger in Japan than in Europe and the United States. Therefore, if, for whatever reason, the observed inflation rate declines — even if only temporarily — this will tend to drag down inflation expectations. With the observed inflation rate having fallen due to a drop in crude oil prices since autumn 2014 by more than 70 percent and to turbulence in global financial markets in 2015 and 2016 reflecting uncertainty regarding the prospects of emerging economies, this meant that inflation expectations also declined. The Bank of Japan aims to fundamentally dispel the deflationary mindset that has become entrenched among the public, but changing people’s inflation perceptions is not easy. As Hawtrey argued, the problem is psychological.

Japan Inflation expectation

Bank of Japan “Comprehensive Assessment: Developments in Economic Activity and Prices as well as Policy Effects since the Introduction of Quantitative and Qualitative Monetary Easing (QQE)” (September 2016)

In response to this situation, when the Bank of Japan introduced “QQE with Yield Curve Control” in September last year, it also introduced an inflation-overshooting commitment (Chart 10). Specifically, the Bank of Japan committed itself to expanding the monetary base until the year-on-year rate of increase in the observed CPI exceeds 2 percent and stays above the target in a stable manner. The idea is that if people actually experience inflation above 2 percent, inflation expectations will rise through the adaptive component of expectation formation. At the same time, if people experience inflation above 2 percent, this will boost the credibility of the Bank of Japan’s price stability target and the formation of inflation expectations will become more forward-looking, helping the Bank of Japan to anchor inflation expectations at about 2 percent.

overshooting inflation

The problems that Japan’s economy has faced since the second half of the 1990s were long regarded as specific to Japan. However, following the global financial crisis, which saw the collapse of an asset bubble and severe damage to the financial system, a relatively prolonged slowdown in economic growth and a fall in the inflation rate have become an experience shared by many economies. As a result of the bold response of central banks based on the knowledge and insights gained in the field of economics over the decades, a recurrence of the Great Depression was avoided and global concerns over deflation have faded to a considerable extent. However, the performance of the global economy today is by no means satisfactory.

Looking back, monetary policy to work on expectations has played a major role in keeping inflation in check following the bout of high inflation worldwide during the 1970s. The introduction of inflation targeting in many economies since the 1990s as well as the remarkable developments in monetary policy theory implicitly focused on responding to high inflation. While these policies and theoretical developments helped to bring about the Great Moderation, central banks at the same time started to face a new challenge, namely, how to appropriately manage inflation expectations in a low-inflation environment under the zero lower bound.

Central bankers and scholars have only just started to find responses to this new challenge,  both from a policy and a theoretical perspective. In particular with regard to the inflation expectation formation process, which likely differs across countries, regions, and periods, more empirical analysis is needed. As a central bank, we need to examine concrete measures to appropriately manage inflation expectations based on such analysis. The inflation-overshooting commitment introduced by the Bank of Japan last year is one answer, representing a response to the specific situation in Japan, but I strongly hope that scholars and policy makers will further deepen the debate from a global perspective.

British scholars produced sharp insights into the importance of expectations in monetary policy nearly a century ago. Nevertheless, the role of expectations continues to provide challenges — both old and new — today. Thank you very much for your attention.


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