Putting On The Brakes

Japan's economy is looking rosier than it has in years. Corporate profits are up. The stock market has been zipping along. Even households have been doing their part by buying more consumer products. And Tokyo real-estate prices recently moved into positive territory for the first time in years--just possibly signaling an end to the deflationary misery that has characterized Japan's economy for more than a decade.

You'd think that Japanese economic policymakers would be celebrating. Instead, they're at each other's throats. The reason for the fight is the normally austere topic of monetary policy, and at stake is nothing less than the continued health of the world's second largest economy. On one side is Bank of Japan (BOJ) governor Toshihiko Fukui and some of his central-bank colleagues, who have been signaling that, given the imminent end of deflation, it might soon be time for the bank to start raising interest rates, which were lowered to zero about four years ago to stimulate the economy. Fukui cites positive growth data and a consumer price index (CPI) that seems poised to move above zero for the first time in recent memory. On the other side are members of the Koizumi government and the Ministry of Finance, who fear that a premature monetary tightening could wring the life out of Japan's long-delayed economic revival.

In a coincidence, the tussle comes just at the moment that George W. Bush's nomination of Ben Bernanke to head the U.S. Federal Reserve looks set to trigger a new discussion about central-bank strategy in America. Bernanke is well known in Japan, for he often cited the country's economic predicament during his years of service on the Federal Reserve's board of governors.

Nobuyuki Nakahara, a leading economist and former member of the BOJ policy board, recalls Bernanke's repeatedly admonishing the bank to "continue easing monetary policy aggressively and massively." (One measure that both Bernanke and Nakahara advocated: the controversial technique of setting specific inflation targeting.) The Japanese central bankers didn't take the advice--and paid for it with years of listless economic performance. It seemed all too characteristic of a central bank whose international reputation had already been tarnished by its dismal record during the economic slump of the 1990s. Richard Jerram, chief economist of Macquarie Securities in Tokyo, says that the BOJ's position was essentially " 'We don't know if this will work so we're not going to try it.' " Adds Jerram: "It's quite inexcusable to let an economy remain in a state of deflation for over a decade and do nothing about it. Ten years of deflation can only be explained by policy failure."

Nakahara would agree. During his BOJ stint he witnessed one of the most ignominious moments in the history of Japanese monetary policy. In the summer of 2000, spurred by reports of an imminent economic recovery, the BOJ made a fateful decision to raise interest rates, ditching the zero-interest-rate policy it had begun in February 1999. The bank's optimism proved unjustified, the move to tighten premature, and Japan's economy soon slid back into a slump. Nakahara was the only member of the bank's policy board to vote against that move -- and now he's worried that the BOJ may be ready to make the same misjudgment.

Nakahara argues it's too soon for the central bank to fret about inflation when rising prices are what the economy needs. "Our economy is still fragile," he says. "The BOJ's policy change may very well fail again." He cites the threat of rising oil prices and the possibility of slowdowns in China and the United States, the country's biggest trade partners, which could stifle Japan's growth prospects. Higher interest rates also would exacerbate Japan's fiscal mess. Public debt now amounts to a dizzying 170 percent of GDP.

One signal of the BOJ's intentions will come this week, when the bank releases a biannual report that's expected to contain a slight rise in the CPI forecast. An increase in the CPI would mean that one of the BOJ's crucial conditions for tightening monetary policy has been met. That will strengthen the hand of optimists on the bank's policy board who want to suspend the current loose policy as early as next April--despite the pessimists' argument that it would be safer to let inflation move well into positive territory before applying the brakes. As Jerram notes, "Inflation is an animal you know how to tame, whereas deflation is quite hard to [fix]." The BOJ should have learned that lesson by now.