Monetary policy really needs to tighten in Japan

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 (324 baht); 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 within his Liberal Democratic Party. But I have some reservations about whether Mr Ishiba will pursue the economic policies Japan needs.
In a private conversation with Mr 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’s excessively austere monetary policy was hurting Japanese industry. Mr Ishiba — then a member of the lower house of the Japanese Diet — 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. 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 fueled 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. 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 told me 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, contributed directly to Japan’s post-1990 “lost decades” of deflation and stagnant growth.
This changed when Prime Minister Shinzo Abe came to power in 2012. Thanks to a sound understanding of economics, Mr 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, the BOJ had to keep its own interest rates low, even negative. Through unprecedented monetary easing, starting in 2013, Mr Kuroda ensured the production costs of traded goods remained just low enough to keep Japanese exports competitive, boosting the economy.
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 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 suffers when the yen is too strong; that is why I have often advocated a more expansionary monetary policy. But lower is not always better. And today’s dollar exchange rate of around ¥152 is too low. The undervalued yen is already contributing to labour shortages in certain sectors, encouraging excessive tourism and discouraging Japanese students from studying abroad. Moreover, it substantially raises the risk of an 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 Mr Ishiba might put too much stock in central bankers’ opinions, he currently seems inclined toward the tighter monetary policy approach that Japan needs. ©2024 Project Syndicate
Koichi Hamada, Professor Emeritus at Yale University, was a special adviser to former Japanese Prime Minister Shinzo Abe.