Two to tango – In­fla­tion man­age­ment in un­usual times

Ja­pan is an ob­vi­ous can­di­date for tak­ing bet­ter ad­van­tage of the syn­er­gies be­tween mon­e­tary and fis­cal poli­cies.

Financial Nigeria Magazine - - Contents - By Vi­tor Gas­par, Mau­rice Ob­st­feld, and Chang Yong Rhee

Mon­e­tary and fis­cal poli­cies in­ter­act in com­plex ways. Yet modern in­sti­tu­tional ar­range­ments typ­i­cally fea­ture a strict sep­a­ra­tion of re­spon­si­bil­i­ties. For ex­am­ple, the cen­tral bank tar­gets in­fla­tion and smooths busi­ness cy­cle fluc­tu­a­tions, while the fis­cal author­ity agrees to re­spect its bud­get con­straint and to sup­port fi­nan­cial sta­bil­ity by main­tain­ing the safe as­set sta­tus of its debt. This gives gov­ern­ments the free­dom to pur­sue a mul­ti­plic­ity of eco­nomic and so­cial ob­jec­tives (in IMF par­lance, in­clu­sive growth).

This sep­a­ra­tion of re­spon­si­bil­i­ties typ­i­cally works well, but can come at a cost as it lim­its the po­ten­tial ben­e­fits that arise when fis­cal and mon­e­tary pol­icy work to­gether. While in nor­mal times the for­gone ben­e­fits may be small, in more ex­treme sit­u­a­tions the ben­e­fits of co­or­di­nated pol­icy are much larger.

By look­ing at the case of low in­fla­tion in Ja­pan, we il­lus­trate – in par­tic­u­larly dif­fi­cult cir­cum­stances – how vi­tal it is for these poli­cies to work to­gether. Good co­or­di­na­tion be­tween mon­e­tary and fis­cal pol­icy is key and calls for poli­cies that are: ·com­pre­hen­sive – ex­ploit­ing the full range of syn­er­gies be­tween mon­e­tary, fis­cal, and ap­pro­pri­ate struc­tural poli­cies; and ·con­sis­tent – an­chor­ing long-term ex­pec­ta­tions by demon­strat­ing a clear com­mit­ment of mon­e­tary, fis­cal and struc­tural re­form poli­cies to­ward com­mon ob­jec­tives.

Ja­pan's low in­fla­tion

Ja­pan is an ob­vi­ous can­di­date for tak­ing bet­ter ad­van­tage of the syn­er­gies be­tween mon­e­tary and fis­cal poli­cies. In­fla­tion is well be­low tar­get af­ter decades of de­pressed nom­i­nal GDP growth, de­spite the Bank of Ja­pan's ef­forts to push the bound­aries of mon­e­tary pol­icy in­no­va­tion – in­clud­ing the in­tro­duc­tion of yield curve con­trol in Septem­ber 2016.

How­ever, a lack of con­sis­tency in fis­cal pol­icy has un­der­mined the ef­fec­tive­ness of mon­e­tary pol­icy. Fis­cal plans have been caught be­tween the short-term need to help mon­e­tary pol­icy es­cape the low in­fla­tion tar­get, and the very clear medium-term pri­or­ity of re­duc­ing Ja­pan's large and un­sus­tain­able bur­den of public debt.

Set­ting ob­jec­tives

The gov­ern­ment could build cred­i­bil­ity by in­tro­duc­ing a pol­icy frame­work wherein pol­icy ac­tions are data-de­pen­dent – so as to pro­mote the achieve­ment of cru­cial pol­icy ob­jec­tives, such as in­fla­tion or price level tar­gets. If the gov­ern­ment feels com­pelled to tighten cer­tain poli­cies sooner, they should in­tro­duce tem­po­rary off­set­ting mea­sures to con­tinue to sup­port progress to­ward re­fla­tion. The re­sult­ing higher nom­i­nal GDP growth would also have the added ben­e­fit of help­ing re­duce the real bur­den of the debt.

Of course, such con­di­tional poli­cies po­ten­tially carry fis­cal risks: if the req­ui­site tar­get is not met, then con­tin­ued fis­cal stim­u­lus could im­peril debt sus­tain­abil­ity. A con­sis­tent and com­pre­hen­sive ap­proach there­fore also re­quires a frame­work to man­age public sec­tor bal­ance sheet risks that mit­i­gates the fi­nan­cial sta­bil­ity risks from a po­ten­tial loss of safe as­set sta­tus for Ja­panese gov­ern­ment bonds.

So, as well as be­ing ori­ented to­ward key pol­icy ob­jec­tives, deficits must be off­set by real fu­ture sur­pluses. To avoid the ap­pear­ance of pol­icy in­con­sis­tency, the gov­ern­ment should tighten fis­cal pol­icy grad­u­ally, and con­sis­tently with the eco­nomic cy­cle. Such an ap­proach should also in­clude struc­tural re­forms that boost fu­ture sur­pluses, for ex­am­ple, mea­sures that close wage gaps.

Cred­i­ble poli­cies

We should also be clear that fis­cal pol­icy should be sus­tain­able, tak­ing as given that the cen­tral bank has de­signed mon­e­tary pol­icy to achieve the in­fla­tion tar­get. It may seem tempt­ing to in­stead spend with­out the prom­ise of (or even rul­ing out) fu­ture tax raises, in the hope that the price level rises to equate to the real val­ues of debt and fu­ture sur­pluses. But this idea, which in­vokes the so-called Fis­cal The­ory of the Price Level, as­sumes that the safe as­set sta­tus of gov­ern­ment debt is guar­an­teed.

The risk of such a pol­icy, which re­lies on the shaky as­sump­tion that Ja­panese con­sumers have very par­tic­u­lar ex­pec­ta­tions of fu­ture pol­icy, is that a bond mar­ket scare oc­curs and gov­ern­ment bonds lose their safe as­set sta­tus. This would then rel­e­gate mon­e­tary pol­icy's role to that of guar­an­tee­ing fis­cal sol­vency (by guar­an­tee­ing the promised nom­i­nal pay­ments on gov­ern­ment bonds), pre­clud­ing its use in sta­bi­liz­ing in­fla­tion and an­chor­ing in­fla­tion ex­pec­ta­tions. This would de­stroy pol­icy cred­i­bil­ity.

The de­bate on Ja­pan's con­sump­tion tax in­crease is a good ex­am­ple to il­lus­trate the im­por­tance of con­sis­tency and cred­i­bil­ity. The planned con­sump­tion tax in­crease has been post­poned twice: once from 2015 to 2017, and again un­til 2019, in fear of a neg­a­tive im­pact on growth. This pol­icy re­ver­sal and the as­so­ci­ated lack of a cred­i­ble an­chor has re­duced the ef­fec­tive­ness of fis­cal pol­icy.

In our view, a pre-an­nounced, grad­ual in­crease of Ja­pan's con­sump­tion tax rate, off­set by tem­po­rary fis­cal mea­sures when nec­es­sary, re­mains a pre­ferred op­tion. The grad­ual in­crease should con­tinue un­til the tax rate reaches a medium-term level that en­sures fis­cal sus­tain­abil­ity. This ap­proach will help raise in­fla­tion ex­pec­ta­tions and has high rev­enue po­ten­tial given the rel­a­tively low level of rev­enue col­lected from the con­sump­tion tax in Ja­pan, com­pared with VAT col­lec­tions in other Or­ga­ni­za­tion for Eco­nomic Co­op­er­a­tion and De­vel­op­ment coun­tries. In the process, Ja­pan should pre­serve its sin­gle rate, which makes its con­sump­tion tax sys­tem sim­ple, and con­sti­tutes an im­por­tant struc­tural ad­van­tage.

Lessons learned

The ex­pe­ri­ence of low in­fla­tion in Ja­pan has a clear mes­sage for the in­ter­ac­tion be­tween mon­e­tary and fis­cal pol­icy. And that mes­sage is in such ex­treme cir­cum­stances, macroe­co­nomic poli­cies will only be suc­cess­ful if they take full ad­van­tage of the syn­er­gies of dif­fer­ent poli­cies work­ing to­gether.

Vi­tor Gas­par, Di­rec­tor of Fis­cal Af­fairs De­part­ment; Mau­rice Ob­st­feld, Eco­nomic Coun­sel­lor and Di­rec­tor of Re­search; Chang Yong Rhee, Di­rec­tor of the Asia and Pa­cific De­part­ment, all of the In­ter­na­tional Mon­e­tary Fund.

Source: IMFDirect, the blog of the In­ter­na­tional Mon­e­tary Fund

Shin­juku shop­ping dis­trict, Tokyo, Ja­pan. Strong co­or­di­na­tion be­tween mon­e­tary and fis­cal poli­cies can help Ja­pan tackle its low in­fla­tion

Mau­rice Ob­st­feld, IMF's Eco­nomic Coun­sel­lor and Di­rec­tor of Re­search

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