Abenomics and the BOJ’s challenge of being a credible central bank

Abenomics — a bundle of economic policies designed to get Japan out of the long-lasting deflation and stagnation — has been a center of discussions regarding Japanese economy ever since the Prime Minister Shinzo Abe took his office. Among “three arrows” of policies (monetary policy, fiscal policy and structural reform), many observers should agree with the idea that the monetary policy has been playing the biggest role thus far. For instance, the surprise move by the BOJ last October made the yen exchange rate (against the US dollar) depreciated by roughly 1.4 percent in one day, which should help to raise inflation rates via higher importing prices. Since the limited fiscal resources is available given the huge national debts and little real progress has been observed from structural reform side, monetary policy will continue to play an important role in Abenomics this year.

Given this situation, Japan’s policymakers should worry about the survey result released last week. This survey, which is done by the BOJ, showed skepticism raised over the BOJ’s ability to stimulate the economy. Being asked the question “Do you think the BOJ is credible?” 10.7 percent (8.8 percent in six months ago) of the survey respondents answered “no”.

Why is this result so worrisome? A key to answer this question is the “Fisher equation” which basically says the real interest rate equals the nominal interest rate minus the inflation expectations. Since a central bank can stimulate economy by lowering the real interest rate, it can be achieved either lowering the nominal interest rate and/or raising the inflation expectations. However, one should remember the important fact that Japan is a “pioneer” of zero interest rate policy, which means the BOJ cannot lower the nominal interest rate any further unless it decides to implement negative interest rates policy. Therefore, at least the Fisher equation suggests, the only way that the BOJ can lower the real interest rate is through the inflation expectations channel which hinges on the credibility of the BOJ. In other words, it is really important for the BOJ (and of course PM Abe) to maintain their credibility that they continue to have a strong will to achieve 2 percent inflation to keep the real interest rate low enough to stimulate consumption and investment.

Yes, it is just a survey result. But Japan’s policymakers should take this seriously since they will have to rely on the monetary policy, and maintaining expectations is far difficult than maintaining the nominal interest rate.

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