The inflation-targeting demanded by Bank of Japan critics, if successfully conducted, could spark demand in a stagnant economy struggling with protracted deflation, but many analysts say it is a highly risky bet.
With the Bank of Japan's (BOJ) highly accommodative monetary policy clearly not boosting business activity, the central bank is under increasing pressure to do more.
On Friday, the BOJ Policy Board decided to keep monetary policy unchanged.
Immediately, Economics Minister Heizo Takenaka called for more radical steps to reverse the deflationary trend.
"The Bank of Japan has been targeting an increased volume of money, but that's not going to be enough. We have to think of new policies," Takenaka told reporters after attending the BOJ meeting. "Those would be unorthodox steps."
He did not say what these might entail, but one frequently mentioned option is for the BOJ to aim for an explicit inflation target to wipe out expectations that goods and services will be cheaper in the future.
Proponents of inflation-targeting say artificially boosting prices would make people spend now before prices went up.
Japan's consumer price index has been declining for 23 straight months and the weakness in demand is seen as a major factor behind the stagnant economy. Consumer spending accounts for about 60 percent of gross domestic product (GDP).
Proponents also say creating inflation would eat into the real value of debt and relieve some of the burden on industry and government.
"If inflation were able to be created, this may effectively bring change to the vulnerable financial system as deflation is generating new bad debts," said Izuru Katoh, senior market economist at Totan Research, a research arm of Japan's largest money broker, referring to the rising value of existing debt in a deflationary economy.
"But this is highly theoretical and we aren't even sure whether or how inflation could be created to begin with," he added.
Yasunari Ueno, chief market economist at Mizuho Securities, said the only positive effect he could imagine from targeting inflation was that it could boost the accountability of the BOJ's monetary policy.
"Adopting such a policy means a strong commitment from the BOJ to fight deflation," he said.
What's the problem?
Since nominal interest rates cannot fall below zero, deflation effectively pushes up real rates. Thus, proponents say, inflation would lower real interest rates.
But many analysts worry that real long-term interest rates would rise, too.
With no sign of inflation despite the BOJ's increased purchases of government bonds and low long-term interest rates, proponents of inflation-targeting say the BOJ could expand the range of assets it buys, such as stocks, land and other higher-risk assets as ways to provide liquidity.
But some see the risk of a higher fiscal burden if the BOJ's balance sheet deteriorated.
"The BOJ purchasing long-term JGBs outright is already another form of fiscal expansion and this could lead to further downgrading of Japan," said Katoh, adding it would contradict Prime Minister Junichiro Koizumi's pledge to curb debt issuance.
Kazuhiko Sano, chief strategist at Nikko Salomon Smith Barney, agreed, saying inflation-targeting would increase risk premiums, resulting in a rise in real interest rates.
And while proponents argue that a rise in long-term rates would reduce debt burdens, others say this would create a serious moral hazard industry-wide and delay structural reform.
A rise in long-term rates could also increase Japan's debt-servicing costs.
Finance Minister Masajuro Shiokawa, an advocate of still easier credit, has said creating inflation would be harmful to the economy, although he wants to see prices begin to rise. "Deflation is a burden for the Ministry of Finance, but inflation-targeting is also a risky bet for it," Katoh said.
Japan's debt service payments are expected to eat up more than 20 percent of this fiscal year's budget.
Boosting consumption?
Analysts wonder if consumption would really grow as inflation undermines savings and would raise Japan's high cost of living.
"Price differences between Japan and overseas are wide and Japanese tend not to spend despite large savings," Katoh said.
"Japanese consumers' sluggish spending has nothing to do with deflation," said Ueno at Mizuho Securities. "They are not buying PCs even though prices have fallen so much."
BOJ Governor Masaru Hayami has firmly rejected the notion of artificially boosting prices.
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