Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target

Japanese Finance Minister Naoto Kan has recently exerted pressure

on the Bank of Japan (BOJ) to act more quickly to defeat deflation,

saying he wants the falling price trend to end this year. “Two or

three years is too long. If possible, I hope that the consumer price

index turns positive by the end of this year” Kan told a parliamentary

session.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. The finance minister also said that the BOJ may have to set an

inflation target aimed at dragging the economy out of grinding

deflation … a policy where a central bank declares a target for

inflation and guides actual price levels toward that goal through

monetary policy such as interest rate changes.

BOJ Governor Masaaki Shirakawa made it clear he had no intention

of taking such a step, and explained in detail why he considers it

inappropriate. “There is a mood to reconsider the use of the

framework of inflation targeting following the recent financial

crisis," Mr. Shirakawa said at a recent news conference.

“If a central bank concentrates only on achieving a short-term

price goal, that could have an adverse effect on sustainable economic

growth, which is the final goal of monetary policy”, Shirakawa said.

Moreover, “such a mechanism would reduce the BOJ’s flexibility

on policy”.

Inflation targeting has become a favoured policy among many

central banks worldwide, but since the start of Japan’s deflationary

era in 1999, the BOJ has stoutly resisted calls to set an inflation

target against which it can be judged, and by which it can be

embarrassed if it misses it.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. Instead it has relied on softer price guidance in determining policy.

Its inflation objective is defined in the loosest terms, as a rate

between zero and 2% for the core consumer price index, as one

that meets its “understanding of medium- to long-term price

stability”, with no time-frame to achieve it and no penalty for

failure.

Still, core consumer price index, which excludes volatile fresh food

prices, fell 1.3% on year in December, dropping for the 10th straight

month.

Shirakawa’s comments suggest the central bank will not embark

on any further easing for now to put a stop to deflation. However

the BOJ might be forced to loosen policy toward the middle of the

year if the domestic economy loses momentum from its recent

strong performance … recent data showed the economy grew at a

4.6% annualized pace in the final quarter of 2009.

And with a key upper house election coming up in the summer, at

which the ruling Democratic Party of Japan hopes to win a majority

in the chamber, political pressure on the BOJ to do more to improve

the economic picture could rise.

Can the introduction of inflation targeting under deflation and

zero interest rates contribute to the Japanese economic recovery?

Generally, inflation targeting has been increasingly viewed as a

good monetary policy framework and widely applauded by

economists and policymakers.

In the literature, there are benefits of inflation targeting for both

inflation and output behaviour.

Inflation targeting should stabilise the level of inflation, reduce its

variability and persistence, and also decrease the variability of

output.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. A recent study by Daniel Leigh, an economist at the IMF, shows

that had Japan introduced an inflation target in the 90’s its

economy’s performance would have substantially improved and

the BOJ would have avoided the zero lower bound on nominal

interest rates.

But the essence of the question is to what extent the introduction

of inflation targeting will enhance credibility of the BOJ’s reflation

policy in a deflationary phase and help economic recovery.

More importantly, whether or not the BOJ monetary policy is

credible enough for inflation expectations to be anchored to an

inflation target.

Takehiro Sato of Morgan Stanley says that, unlike the Federal

Reserve, which has won a high degree of respect for its handling

of monetary policy, Japan’s central bank is not yet trusted by

markets because of its past moves. “The BOJ’s policy track record

is bad.

A target for inflation helps to anchor future expectations of

monetary policy, but BOJ lacks credibility.

The mere announcement of an inflation target would not change

expectations”, he said.

Indeed, the introduction of inflation targets among advanced

countries tends to be accompanied by an institutional framework

that makes inflation targeting credible and accountable.

In several countries, including New Zealand and Australia, inflation

targeting is an agreement between the government and the central

bank, and both are committed to policy that is consistent with the

inflation target.

Shaw Capital Management Korea: Fresh Pressure on BOJ for Adopting an Inflation Target. In several countries, including New Zealand and the UK, when

inflation exceeds the target by a wide margin, the Governor is

required to provide an explanation to the parliament. With

accountability and commitment, inflation targeting does become

credible.

A central bank in a deflationary environment

is subject to a time-inconsistency problem: it

cannot credibly commit to “being

irresponsible” and so continue to shoot for

high inflation.

Furthermore, there is a concern that once the Japanese economy

has emerged from a deflationary spiral and starts to recover, the

central bank will be tempted to renege on its commitment to a

high inflation target, because it would like the economy to return

to an inflation rate consistent with price stability.

Thus a central bank in a deflationary environment is subject to a

time-inconsistency problem: it cannot credibly commit to “being

irresponsible” and so continue to shoot for high inflation.

The result of the time-inconsistency problem is that the markets

would not be convinced that inflation would remain high, and

inflation expectations would not be high enough to lower real rates

sufficiently to stimulate the economy out of the deflation trap.

To overcome deflation and restore economic activity Japanese

policymakers may not need to adopt an inflation target.

They could simply use unconventional instruments, such as

purchases of riskier assets and foreign assets, more aggressively

so to persuade the markets and the public that there will be higher

inflation.

Shaw Capital Management Korea: Competitive tax system in UK

Now consider UK taxation. Already under this current UK

government tax, and stealth taxation in particular, has become the

soft default option. By the mid-2000s the top marginal rate of tax

including all imposts, whether on wages or consumption, had

reached 60%, the average tax rate was 40% and the marginal tax

rate on the average person 43%.

Now that the explicit top rate of income tax has gone over 50%,

the top rate has gone up to around 67%. So far for the average

worker not much has changed since the mid-2000s. However,

further rises in tax rates from these levels are not an option and

indeed they must be cut, for two reasons.

The first reason concerns the ‘Laffer Curve’; which computes the

extra revenue raised for every rise in the marginal tax rate.

This curve reaches a peak at some fairly moderate marginal tax

rate because of the effect on effort and tax evasion.

All informed observers, including the Institute of Fiscal Studies

which is generally in favour of higher taxes and redistribution,

agree that the 50% new top tax rate will not increase revenue and

will probably lower it for this reason.

The second reason concerns growth. Growth comes from the

innovative activities of entrepreneurs, who are extremely sensitive

to marginal tax rates because their activities are risky and any

gains uncertain; the more these are taxed the less the expected

return and if this drops below some threshold they will not bother

at all.

The UK needs both to make the fiscal

adjustment on the spending side by reviving

old-style Treasury control and then quickly

bring their tax system back into the land of

reasonable incentives, following that up with

reforms ‘flattening’ the marginal tax rates

across the economy and income groups.

Estimates of the effects on growth of marginal tax rates are for

obvious reasons uncertain; but the sort of effect that comes out of

empirical studies is an elasticity of one third, i.e. for every 10%

reduction in tax growth would rise by 3% (e.g. a reduction of the

marginal tax rate from 40% to 36% would raise growth from 2.5%

to 2.58%).

This effect seems small but it accumulates into something large.

So in short the UK needs both to make the fiscal adjustment on the

spending side by reviving old-style Treasury control and then

quickly bring their tax system back into the land of reasonable

incentives, following that up with reforms ‘flattening’ the marginal

tax rates across the economy and income groups.

The supporting role of monetary policy

This fiscal adjustment, however gradually brought about, is going

to be a fairly grim process and it will dampen growth further.

It will require the efforts of the monetary authorities to support

the economy through it, without pushing inflation over the target.

At present the bank credit is not expanding, whereas a growing

economy requires bank credit growth usually of twice or more

times the GDP growth rate.

The Bank of England is keeping interest rates low but has suspended

the printing of money (‘quantitative easing’), even though bank

credit growth has not responded.

But it may well need to restart it. This is something the UK will

need to watch and if, as seems likely, inflation falls back to well

below the target and the economy falters under fiscal retrenchment,

the Bank of England will need to take steps to get the broad money

supply growing again.

As we have noted before, other channels for money appear to be

working in substitution … UK equity and corporate bonds issues

have been substantial recently. So liquidity may turn out adequate

even without credit growth revival.

Our forecast for the UK

Though the UK Budget was predictably vacuous, being a pre-election

affair, our forecast assumes that action pretty much along the

above lines will be taken after the election by whatever government

is in power … hung Parliament or not.

The reason is that there is little room for manoeuvre and privately

in fact the parties do not materially disagree, except to some degree

on what modest room there could be for tax rises instead of spending

cuts.

So in short we think there will be fiscal retrenchment, monetary

policy will provide support, and so the UK recovery will slowly

continue.

The UK and the Budget: Shaw Capital Management Korea

In the UK it is obvious that there is no possibility of continuing

with budget deficits of some 13% of GDP, the present prospect if

no action is taken.

Unfortunately however the recent UK Budget produced no credible

plan for dealing with this problem. It swept it into the lap of the

new government after the May election, whatever that government

is.

The UK and the Budget: Shaw Capital Management Korea. The UK cannot delude themselves that rapid resumed growth will

lead to a rapid return of the previous revenue streams. UK growth

in most forecasts, ours included, is projected as slow.

In our view there is a good reason: the continuing shortage of oil

and raw materials worldwide prevents rapid growth for the world

as a whole and since emerging market economies are continuing

to grow rapidly that restricts the growth possibilities in countries

like the UK and other developed countries.

We are already seeing inflation spread into China and other

emerging countries, forcing a tightening of policy.

It seems likely that this tightening will be enough to restrain world

growth to rates that will not push commodity prices much higher.

So even the fast-growing world economies are being forced to limit

their growth ambitions; as for the UK they are achieving ‘recovery’,

but hardly enthusiastic growth.

All this will only change when innovation in raw material use has

freed up net world supplies.

Fortunately the flexibility of the UK labour market has restricted

the jobs fallout. Unemployment has peaked below 8% (just over 5%

on the benefit-claimant measure) as people have opted for wage

freezes or cuts and shorter hours … so there is underemployment

but not the disaster of double-digit unemployment rates.

But this environment is one in which tax revenues will not recover

much and in which the demands for public spending will continue.

Time will tell how big the ‘structural deficit’ … that will emerge

once the recovery is complete … may be.

But policy decisions cannot wait until this is better known. So in

this Budget the need was to produce a five-year public sector

adjustment plan.

Two things should guide this plan: keeping the taxes down and

competitive, so that growth and innovation resume, and restoring

efficiency in public spending.

The UK and the Budget: Shaw Capital Management Korea. Spending cuts

To begin with the last, the current government unleashed a massive

surge in public spending from 2000, raising it by 8% of GDP before

the crisis raised it by more again.

Everyone knew that without reform and gradual increases, such

money would be wasted; there is no practical way to spend such

vast sums without raising wages and wasting money on speculative

projects.

Productivity in the public sector duly slumped and public sector

remuneration including pensions has surged past the private sector

where market forces suggest pay should be higher to reflect greater

insecurity.

The UK and the Budget: Shaw Capital Management Korea. To reduce public spending back to where it started in 2000 as a

share of GDP (at around 36%) would require it to grow in real terms

by about 16% less than real GDP over the next five years.

Since total GDP growth over that period is likely to be about 10%,

that means that spending must be cut by about 1% a year in real

terms.

This is a feasible target. The UK Treasury under Gordon Brown

became a brute instrument of spending increase, oddly somewhat

against the protests of some departments worrying about wasteful

effects. The UK Treasury was never traditionally like this … very

much the opposite, a place from which wringing money was like

getting blood from stones.

It should be returned to its traditional function of restraint; Treasury

control, old-style, is the best instrument for forcing departments

to find the economies they privately know they can make.