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Two approaches to central bank action

One approach is the standard approach, that the central bank’s expectation is a hypothesis about the economy (e.g. “inflation will rise soon”). If this hypothesis is supported by the data, then the central bank is justified in acting to prevent adverse consequences of their outlook. Is there ever a case for preemptive policy tightening? Yes, there is. As Blinder wrote in his 1998 Robbins lectures (“Central Banking in Theory and Practice,” MIT Press, 1998), most people carry out maintenance on their cars before breakdowns. To extend Blinder’s metaphor, this is especially true if the car is making funny noises. However, if the car is running smoothly and makes no funny noises, standard maintenance is enough.

In this approach, the question for monetary policy makers is, “what constitutes a funny noise?” Since the MPM has said that the center of its reference range for price stability is 1%YY, it seems hard to think that a CPI ex fresh food rising by 0.5%YY would constitute a funny noise.

The next question concerns the loss in case of a mistake. If the loss from a breakdown is huge, then even the slightest funny noise suggests that the car be taken to the shop soon. On this logic, since a move of CPI inflation above 0.5% — to say 1% — will only bring inflation to the center of the BoJ’s range, it is again hard to see why the BoJ should be eager to hike quickly. Thus, on the standard approach to forward looking policy, it is hard to see why the BoJ should be aggressive.

The second approach is very different. Rather than testing a hypothesis against emerging data, the central bank engages in “presumptive preemption” — i.e. it bases policy mostly on its expectation for the economy, and gives very little weight to actual data. Let there be no doubt:  Preemption is often a good policy. However, successful preemption requires credible evidence that action is needed, not a presumption that evidence may exist. It also requires that the specified action will actually preempt the feared consequence. Finally, it requires that the feared consequence be feared not only by central bankers but by the economy as a whole.

Is Presumption Preemption Justified in Japan?

Financial markets — which now are discounting three rate hikes of 25bp each over the next year — clearly believe that the BoJ will be preemptive. For this to be the right policy, the three conditions of the previous paragraph need to be fulfilled. Is there credible evidence that action is needed now? Will the specified action preempt the feared consequence? Does the economy fear the consequence as much as the BoJ?

As for evidence, the jury is still out. True, the economy is very much better. However, the big surprise of recent years has been that inflation has not followed the output gap (however measured). (See my “Four Big Weaknesses of the Output Gap,” March 22, 2006.) Indeed, most economists — including ourselves and those at the BoJ — missed the productivity surge over the last year. Without this productivity surge, inflation most likely would have been higher. But it is not, even with real GDP growth at 2.3% in CY2004 and 2.8% in CY2005.

Implicit in the BoJ’s tilt toward early tightening is a view that the productivity surge was a one-off event. This is an argument for this viewpoint. To the extent that the productivity surge came from benefits of shifting production to low-cost Chinese factories, and to the extent that this shift is over, the productivity benefits are over too. However, one must be careful. Shifting factories to China only raises Chinese productivity, not Japanese. Only when the resources are redeployed in Japan more efficiently does productivity in Japan rise. The forces that allowed redeployment of resources, such as accelerated M&A, high IT metabolism and high levels of business investment, remain with us.

What about labor market tightness? Yes, unemployment is down, and Tankan DIs are showing more labor tightness across the board. Compensation per hour is up by about 1%YY continuously over the last year. The job offers-seekers ratio is back above 1.0 for the first time since September 1992. Prospectively, very large retirements will occur in 2007-08, as baby boomers retire, so that the labor market will be tighter. On the other hand, globalization continues to ease the pressure in labor markets, especially when better IT allows closer connections to markets with excess skilled labor. Moreover, to the extent that the retirements occur in industries with high average ages (e.g. agriculture and construction), average productivity may surge. In addition, some retired workers will return to their old jobs as contract employees — at much lower wages.

Given all these plusses and minuses, it is far from clear that there is a compelling case for action now. The BoJ’s case for acting soon remains presumptive. Only when credible evidence emerges can presumptive preemption revert to regular preemption.

What about the connection from the action (higher rates) to the feared consequence? Again, the connection for Japan today is not so clear. Most of the arguments about an impending inflation problem stem from the supply side, e.g. lower labor supply or the end of the wave of globalization. It is hard to see how raising interest rates will solve these problems. Moreover, with so many large companies so well cushioned against rate hikes, it is hard to see how a small rate hike (one consistent with the BoJ’s inflation expectations) will cool demand enough relative to the potential supply problems. No point in using a band-aid for a stomach ache.

Finally, does the economy fear the consequences of slightly higher inflation as much as the BoJ does? On the question of a renewed financial bubble, the answer is yes. There is universal agreement that a new bubble is not wanted. That said, is Japan truly in danger of a new asset bubble? True, the equity market was up 43% last year, but it has struggled to rise another 8% this year, even with large new inflows from abroad. Valuations, while high, are not greatly stretched — and are far below the bizarre levels of 1989. Land prices are beginning to rise is some places, but from very depressed levels. The fact that land prices in some specific locations are up 30% should trigger the question “30% of what?” Moreover, a rate of CPI change high enough to end fears of renewed deflation could actually improve economic efficiency, by making real wage adjustment easier. In general, central banks dislike inflation more than the nations they serve. This is no less true in Japan than in other countries.

So What?

So what if the BoJ does act with presumptive preemption? Will the BoJ be like Macbeth’s poor player, who struts and frets his hour on the stage and then is heard no more? I think not. There are three consequences of presumptive preemption.

First, presumptive preemption by the BoJ will likely flatten the yield curve, as my colleague Takehiro Sato has emphasized. Since market expectations include a very strong component of momentum about inflation, but also a strong dose of reality about the BoJ, markets are likely to remain skeptical that long end yields should rise as much as short end ones must — given the BoJ’s expected actions. Hence, the yield curve will flatten.

Second, as outlined in an earlier paper (“Who’s Afraid of the BoJ?”, April 4, 2006), earnings of large firms will likely benefit from presumptive preemption. This assertion is based on two factors. One is that the yield curve steepens, as mentioned above. Since short rates rise more quickly than long rates, the earnings on cash balances will rise before the costs on borrowings. The second is that interest bearing liabilities have been cut sharply for large firms. Even among small firms, the damage from higher rates should be small, since profits are so much higher that increased net interest costs can be much more easily absorbed.

Third, and more ominously, confidence in the BoJ could erode if the BoJ continues presumptive preemption — particularly if actual inflation does not conform to the BoJ’s expectations. Conversely, if (contrary to Sato-san’s and my expectations) inflation rises quickly and the presumptive preemption turns out to be correct, confidence in the BoJ will soar.

Risks

There is a major risk for the BoJ — and for the economy — in all this. Although I do not believe measured inflation will go negative again, there is a non-trivial chance that it will. If so, then the BoJ would face stinging criticism. This will be particularly true if BoJ follows the path of presumptive preemption.

Indeed, under these circumstances, the BoJ Law could well be revised. A benign, even beneficial revision, might be a numerical inflation target, set by the government. Less benign would be a grant of voting power to the government on the BoJ Policy Board. If the Diet gets very angry, BoJ independence could be constrained. Since a central bank with operational independence (although not goal independence) is essential to credible financial markets, a reduction or loss of operational independence would be adverse for the economy.

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