The BoJ’s decision earlier this week to hold an extraordinary monetary policy meeting, seemingly to head off the political pressure on it to do more to support the economy, has merely served to raise further doubts about the BoJ’s independence and the future path of monetary policy.

Having come to power on the back of manifesto commitments to, among other things, raise child allowance and cut taxes, the new DPJ-led government has rapidly discovered that its fiscal room for manoeuvre is severely constrained. A collapse in receipts has coincided with a growing recognition that the Japanese government will not be able to finance an ever increasing stock of debt over the medium term. Indeed, the new government has already acknowledged that it may have to row back from some of its manifesto commitments. This has led to growing frustrations within the government over both its inability to boost demand through fiscal policy and what many members of the government view as the BoJ’s failure to provide sufficient support to growth and end deflation.

The BoJ had tried its best to ignore the politicians and at its meeting at the end of October announced a timetable to withdraw the temporary corporate financing measures it had introduced at the height of the global financial crisis. So, the past week’s decision to hold an unscheduled meeting announcing a new fund-supplying operation was both surprising and perplexing. There was certainly no need to call an unscheduled meeting to do that. There have been no signs of funding strains for financial institutions and the BoJ could easily have waited until its next scheduled meeting on 17-18 December to put the flesh on the bones of the MPC’s statement at the end of October that it will provide “ample liquidity” once its temporary measures come to an end. That leaves the distinct impression that, ahead of BoJ Governor Shirakawa’s meeting with Prime Minister Hatoyama on 3 December, the BoJ was merely trying to placate the growing political pressure on it to do more, while doing the minimum it could get away with.

But although ministers appear to have been appeased for now, the past week’s action is highly unlikely ultimately to satisfy the government. Government ministers were certainly after more, in particular an increase in the BoJ’s JGB purchases. This raises questions as to whether the BoJ will finally be forced into more concerted action.

The BoJ’s view has been that additional JGB purchases will do little or nothing to boost economic activity and prices – indeed it is highly sceptical about the effectiveness of quantitative easing to boost activity. And, as it is always happy to point out, it is already buying ¥1.8tn of JGBs per month, having increased its so-called rinban operations from the ¥1.2tn it was buying up until December last year. But, with deflation having intensified over the past year, a huge amount of spare capacity still remaining in the economy, and the government up against a tightening fiscal constraint, it seems entirely reasonable for the government to question whether the BoJ to doing enough.

What could the BoJ do?

Over the years the BoJ has received plenty of advice from (particularly non-Japanese) economists about how it could end deflation. Most vocal among these has been Paul Krugman, who argued even back in 1998  that Japan’s problems stemmed from a lack of aggregate demand. With deflation and short-term rates at zero he suggested that the BoJ needed to raise future inflation expectations by convincing people that it would do everything necessary to generate inflation, hence engineering a negative real interest rate.

Meanwhile, Ben Bernanke, in his famous 2002 speech on deflation suggested that “political constraints, rather than a lack of policy instruments, explain why deflation [in Japan] has persisted for as long as it has.” In particular, Bernanke argued that any country with a fiat (i.e. paper) money system that finds itself faced with persistent deflation even after short-term rates have fallen to zero should always be able to generate increased nominal spending and inflation. The central bank simply needs to inject sufficient cash into the economy, expanding both the size and scope of its domestic asset purchases. This is what the Fed and the BoE are already doing in an attempt to stave off deflation. The BoJ, of course, had already gone down this path, buying significant quantities of JGBs and smaller amounts of other assets over the years. But these have been insufficient to generate faster nominal growth and inflation. As Bernanke pointed out, if asset purchases don’t work, then the central bank has plenty of other options, including purchases of foreign government debt in an effort to weaken the exchange rate. Ultimately, if all else fails, Bernanke suggested that the central bank and the fiscal authority should cooperate, with the central bank directly financing tax cuts or additional government spending, effectively removing the government’s financing constraint. So the BoJ has hardly embraced all of the policy options open to it.

Bernanke was speaking in 2002. Seven years on, deflation in Japan is deeper than ever, and even the BoJ expects deflation to persist into FY11. So why won’t the BoJ go all out to boost demand? In the late 1990s and the start of this decade, the BoJ argued that what Japan suffered from was not just a lack of demand, but also an impaired monetary policy transmission system as a result of the weaknesses in the financial sector. Putting the banking system on a sounder footing, the argument went, would make the monetary transmission system more powerful, negating the need for the more radical policy options advocated by Krugman and Bernanke. This argument had some merits and received a sympathetic hearing in some quarters. But with the major Japanese banks having now decisively dealt with their NPL problems, that argument holds little water this time around. Instead, at present, the BoJ expects the economy to recover gradually, with deflation pressures easing slowly. It also doesn’t believe that the sort of relatively mild deflation that Japan has experienced over the past decade or so has been overly damaging to the economy, while it appears to have serious philosophical problems with doing anything more radical, centred on concerns about protecting its independence, worries about potential asset price bubbles and a fear of generating rapid inflation that would then be difficult to get back under control. But many would argue that they are risks worth taking if it would deliver a decisive end to the more than a decade of deflation that we believe continues to damage the Japanese economy and which, anyway, is arguably inconsistent with its legal duty to achieve price stability. The arguments for not undertaking either significantly more aggressive JGB purchases or even direct deficit financing are therefore very weak. The politicians’ exasperation with the BoJ’s refusal to do more now is understandable.

Banknotes in circulation and the BoJ's JGB holdings

Source: BoJ

What will the BoJ do?

The past week’s action is not likely to placate the government particularly if, as we expect, growth slows sharply as we head into 2010. If that is accompanied with a deepening in deflation, the pressure on the BoJ is almost certain to resurface. History suggests that the BoJ will try to resist for as long as possible, but will eventually compromise, perhaps with a modest increase in its JGB purchases. Certainly, even within its self-imposed rule of maintaining its holdings of JGBs below the level of banknotes in circulation there is scope to do this (see chart). But the BoJ will not want to do anything that it feels will impinge on its independence, so a move to aggressive deficit financing does not look to be on the cards, however compelling the economic arguments are for it to do so. As such, for as long as the government is willing to leave the BoJ’s independence in place as it is currently formulated, the sort of help in boosting the economy that the US and UK governments would likely see from their central banks if faced with the same circumstances, will not be forthcoming.

Grant Lewis, Head of Fixed Income Research

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