Bank of Japan Fails Test of Policy Presentation

October 31, 2008

Japanese officials in the past fortnight had gone to great lengths to promote a softer yen and firmer share prices. Nice progress was being made toward each goal until the Bank of Japan bungled the public relations surrounding today’s rate cut and release of new economic forecasts. The presentation of central bank policy is often more important than policy itself. For one notable example, the former ECB president, the late Wim Duisenberg, was a particularly poor communicator of policy, being inconsistent, often flippant and not especially clear in defining the thinking of the Bank’s Governing Council, and his style, more than the ECB’s rate decisions, contributed to the euro’s 30% decline from the start of 1999 until its record low in October 2000.

The difference between what the Bank of Japan did — a cut in its target for the uncollateralized overnight call to 0.30% from 0.50% — and what markets expected (a cut to 0.25%) was inconsequential from the standpoint of likely economic impact. Neither the actual move nor the one that markets expect will provide much stimulus. However, the Nikkei slumped 5%, and the yen soared against all currencies.

Bank of Japan officials made several mistakes in presenting its decision. One error was of the government’s making, not appointing a full nine-person slate of policymakers and leaving the Policy Board a person short at eight people and thus capable of producing a tie vote. That’s exactly what happened, forcing Governor Shirakawa’s vote to count as two to break a four:four tie. Secondly, it was not at first clear that four members had not opposed doing any easing. Only later was it revealed that only one unnamed member, presumably the perennial hawk Mizuno, had opposed any rate rate reduction. Three had actually preferred to meet the market’s assumed rate cut of 25 basis points. A fourth mistake was the failure to paper over the Board’s disagreement and air the dirty laundry in public. Officials should have understood that the revelation of such quibbling over a couple of basis points when all other G7 central banks will be cutting rates by far more would undermine the whole point of easing monetary policy in the first place.

For a fifth error, officials did not do a good job of linking their policy to the economic outlook. Such a disconnection conveys a backwards framework of first deciding what action to take and then examining economic developments and prospects for factors that might justify the intended action. The backdrop surely demands more stimulus than officials are providing. First, there had been no prior rate cut since 2001 and no change of policy since a tightening in February 2007. Second, officials concede that Japan is now in a recession that is unlikely to end until sometime after October 2009. Third, a return to sustainable growth with price stability may take even longer in the not so unlikely event that either global demand develops more weakly than the baseline forecast or that lending attitudes of Japanese financial institutions become even more severe. After all, it is acknowledged by officials in Japan and everywhere else that growth risks compared to baseline forecasts are skewed to the downside. Fourth, as defined in the appendix of the new semi-annual Outlook, the revised range of projected core inflation straddles zero next fiscal year and returns to merely 0.1% – 0.5% in the year to March 2011. That is sharply below forecasts made three months ago, and it provides an insufficient cushion from a return to deflation. When in a deflationary state, monetary officials in Japan as elsewhere have no choice but to abandon the targeting of a nominal interest rate in favor of quantitative provisions of unsterilized liquidity. In plainer English, officials are not only admitting that upside inflation risks have ebbed greatly but that downside risks from price stability have risen significantly.

The text of the semi-annual Outlook and of a separate statement announcing the rate cut justify a much more substantial gesture than a divided decision to reduce the target interest rate by 20 basis points. It’s not enough to declare a financial and economic emergency, to blame the world’s economic problems on sustained low interest rates in Japan and elsewhere, to insist on not going back to those same ultra-accommodative policies, and to let markets sort the mess out on its own. To do that is to shirk the mandate of all central banks to ensure stable financial markets.

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