Japan needs tighter monetary policy

Last month, returning to Japan for the first time since the Covid-19 pandemic, I was struck by how significantly prices had increased. In February 2020, a simple lunch in downtown Tokyo cost about JP¥1,000, then the equivalent of about $10; today, it costs more like JP¥2,000. To some extent, this mirrors the experience in the US, where, even as inflation moderates, prices remain well above their pre-pandemic levels. The difference is that Japan has also experienced a sharp currency depreciation, which benefits foreign visitors: that JP¥2,000 bill translated to just $13.
My visit coincided with the election of a new prime minister, Shigeru Ishiba, who had just eked out a victory in a tight race within his Liberal Democratic Party. But I have some reservations about whether Ishiba will pursue the economic policies Japan needs.
In a private conversation with Ishiba in the early 2000s, while I was head of the Economic and Social Research Institute at the Cabinet Office, I noted that the Bank of Japan (BoJ)’s excessively austere monetary policy was hurting Japanese industry. Ishiba – then a member of the lower house of the Japanese Diet (parliament) – responded that, since monetary policy is technical and complex, the government would continue following the opinions and advice of BoJ experts.
This deference has merit. The BoJ, as well as the Ministry of Finance and other organs, benefits from a solid pool of talent, as well as deep knowledge of how and why past policies – monetary, fiscal, and otherwise – have or have not worked. Their advice should therefore be heeded – to a point. The problem is that government technocrats tend to favour familiar policy approaches, even when they are not actually what the economy needs.
Japanese monetary policy after 1990 reflects precisely this bias. Japan’s post-World War II economic boom had been fuelled partly by an undervalued yen. But, in 1985, Japan – along with the rest of the G5 – signed onto the Plaza Accord, an agreement to devalue the surging US dollar relative to the yen, the French franc, pound sterling, and the Deutsche Mark. With that, Japan’s economic miracle came to a rapid end.
Yet for the next three decades, successive BoJ governors remained committed to maintaining a stronger yen, with all its deflationary implications. One of them, Masaru Hayami, once commented to me (before becoming BoJ governor) that, as a central banker, the undervalued post-war yen had made him “miserable.” In other words, politicians’ commitment to listening to the experts at the BoJ, with their distinct central-bank bias, contributed directly to Japan’s post-1990 “lost decades” of deflation and stagnant growth.
This changed when prime minister Abe Shinze came to power in 2012. Thanks to a sound understanding of economics, Abe knew better than to follow central bankers blindly. At the same time, he recognised the importance of putting the right person at the top of the BoJ. So, he selected Haruhiko Kuroda, who committed to pursuing the monetary expansion that Japan badly needed.
A country’s monetary policy does not directly dictate its exchange rate. What matters is the money supply relative to that of other countries. In 2012, Japan was living in a world of low interest rates. So, to prevent excessive yen appreciation – which would stifle Japanese industry – the BoJ had to keep its own interest rates low, even negative. Through unprecedented monetary easing, starting in 2013, Kuroda managed to ensure that the production costs of traded goods remained just low enough to keep Japanese exports competitive, giving the economy a significant boost.
Since then, however, the global monetary-policy environment has changed dramatically. A post-pandemic surge in inflation spurred major central banks to hike interest-rates aggressively, beginning in 2022. Though interest rates have come down, they remain relatively high: the US Federal Reserve’s policy rate, for example, stands at nearly 5%. The interest-rate differential between Japan and its major trading partners spurred Japanese investors to move their savings into foreign currencies, where they received higher interest rates – and caused the yen to depreciate.
Japan’s economy undoubtedly suffers when the yen is too strong; that is why I have often advocated for more expansionary monetary policy. But lower is not always better. And today’s dollar exchange rate of around ¥152 is simply too low. The undervalued yen is already contributing to labour shortages in certain sectors (such as construction), encouraging excessive tourism, and discouraging Japanese students from studying abroad. Moreover, it raises the risk of a dangerous inflationary surge.
In this context, a dollar exchange rate of around ¥120 would be far preferable. To this end, the BOJ should immediately adopt a conventional short-term interest-rate policy. If this proves to be too restrictive, the BOJ can return to more relaxed policy arrangements. Fortunately, while I do worry that Ishiba might put too much stock in central bankers’ opinions, he currently seems inclined toward the tighter monetary-policy approach that Japan needs. – Project Syndicate
lKoichi Hamada, Professor Emeritus at Yale University, was a special adviser to former Japanese Prime Minister Abe Shinze.