Transcript of interview with Haruhiko Kuroda, governor of the Bank of Japan

January 3, 2014 1:48 pm

Transcript of interview with Haruhiko Kuroda, governor of the Bank of Japan

Conducted by Martin Wolf, Jonathan Soble and David Pilling in Tokyo, December 12 2013

Speaker key: 
MW Martin Wolf (FT)
JS Jonathan Soble (FT)
DP David Pilling (FT)
HK Haruhiko Kuroda, governor of the Bank of Japan

MW: I’d like to start off with where you think you’ve got to in terms of the performance of the economy and the performance particularly against the inflation objective you’ve set. I know the Bank of Japan accepted a 2 per cent inflation goal in January of this year, and you set out in April a timetable. So how far do you think you’ve come against the objectives you’ve set yourself?HK: I think I can say we are half way. We set a target of 2 per cent inflation basically to be achieved within two years time, and the latest inflation statistics show that inflation rate has reached plus 0.9 per cent. So literally, we are almost half way, but that means there is still a long way to go to achieve the 2 per cent inflation target.

By the way, we intend to achieve the 2 per cent inflation target and maintain that in a stable manner. So it’s not good just to touch on the 2 per cent inflation and then go down to 1 per cent or less – that is not good. We intend to achieve the 2 per cent inflation target and maintain around 2 per cent inflation in coming years.

So on the one hand, we are satisfied with the outcome of what we call quantitative and qualitative monetary easing decided in early April of this year. We are on track. The financial markets responded very favourably, and the real economy has been making significant progress on economic growth, as well as on the rate of inflation. So we are on track. But there is a long way to go.

And by the way, you may know that the median forecast of Monetary Policy Committee members indicates that in fiscal year 2015 (April to March), inflation rate in terms of consumer price index, excluding fresh food, would reach 1.9 per cent. That is in fiscal year 2015. That is our forecast and we are on track.

MW: Just let me get clearer about the nature of the target. In Japan, as in many other countries, there’s been a big divergence between headline and core inflation. When you’re talking about sustainable inflation, do you mean core inflation? Because I understand core inflation has not been rising as much as 0.9 per cent; more like 0.3 per cent.

HK: We intend to achieve the 2 per cent inflation in terms of consumer price index, and in order to figure out the underlying trend of the index, we mainly use consumer price index, excluding fresh food, which in Japan is called “core inflation”. And consumer price index, excluding food and energy items, we call “core-core inflation rate”. And as Martin mentioned, core-core inflation reached positive 0.3 per cent lately. This is, I think, the first time in the last fifteen years, or something like that. But we basically focus on the core inflation rate.

MW: Was that 0.9 per cent core inflation?

HK: Yes.

MW: As opposed to core-core or “headline”?

HK: That’s right.

MW: OK. Just to make sure that I understand.

HK: Yes. And in Japan, prices of fresh food fluctuate widely. So headline inflation does not show the trend inflation rate in the short run. So we always talk about inflation rate in terms of the CPI, excluding fresh food, when we try to figure out the trend of the CPI from its monthly figures.

The core-core inflation rate, as I said, excludes food as well as energy items. That is also useful to see the underlying medium/long-term inflation trend. But since the Japanese economy, as you know, has no oil or gas reserves, almost 100 per cent of oil and gas is imported from abroad, the core-core inflation rate sometimes doesn’t fit the real feelings of consumers, because consumers feel prices are rising, maybe reflecting an energy price hike, and yet if you exclude those items, core-core inflation rate may appear quite flat.

So I think it’s a matter of choice. In some countries, core inflation may exclude not only food but also energy items, and so on and so forth; but in Japan, usually, we talk about inflation rate in terms of the CPI, excluding fresh food. But also, we look at the core-core inflation rate as well. And as I said, and as you said, even the core-core inflation rate reached positive 0.3 per cent.

MW: But this does reveal a problem, in the sense that if the core inflation was 0.9 per cent, core-core was 0.3 per cent, and obviously energy prices have made a big difference, which you don’t control, except via the exchange rate, now that gets you to the transmission mechanism.

Well, there are two questions here. One is how far can you really stabilise an inflation rate that includes such an immensely important volatile element. And the second is how do you actually think the transmission mechanism has been working from your policies, because many would argue that really it’s just exchange rate that has given you this benefit and you aren’t going to have that again.

HK: I think I shall respond first to the second point. We envisage basically three channels through which the QQE or quantitative and qualitative easing would affect the economy, the real economy, including the inflation rate. The first is, of course, that the massive amount of JGB purchases would suppress or contain the long-term interest rates, over the entire yield curve, from rising too fast.

MW: An important point there is that you’ve extended the average maturity. That’s something we have to explain as well.

HK: That’s right. And the second channel is the so-called portfolio rebalancing effect. Banks, companies and households, would shift their portfolios, which are now dominated by fixed-income assets, mainly JGBs, to portfolios with more emphasis on risk assets, like stocks, foreign bonds; or – so far as banks are concerned – lending to the economy.

The third channel is shifts in expectations. That would affect the real economy, as well as the inflation rate, in coming months.

Now, the exchange rate is not explicitly mentioned. Why? Because, on the one hand, the exchange rate fluctuates, depending on many factors outside our control: foreign monetary policies and other factors would affect our exchange rates. And, of course, I understand that monetary policy could affect our exchange rate. But first, we do not target our monetary policy at the exchange rate; and second, I think you’ve seen that, after we introduced the QQE, the exchange rate fluctuated, but did not depreciate so much. Exchange rate depreciated before the QQE was adopted, early in April. So when we think about channels through which our QQE could affect the real economy, including the inflation rate, we always thought about three channels, although, as you can see, some impact could come from exchange rate changes.

MW: It’s part of portfolio rebalancing, isn’t it?

HK: Yes.

MW: I mean, one way the Japanese people may respond to the lower real interest rates is by foreign assets.

HK: That’s right. So in that sense, the portfolio rebalancing effect could include, as you said, that aspect. However, the major part of portfolio rebalancing would come from switching from fixed-income assets to stocks and for the financial sector, lending to the real economy.

Then I can say that, initially, the rise in the inflation rate reflects the depreciated currency, and that certainly contributed to raising the inflation rate gradually. But now, if we look at core-core inflation rate, as I said, core-core inflation rate, excluding food and energy items, already shows positive 0.3 per cent increase. And also, if we look at the hundreds of items of household expenditure, we can find that more than half of the items show an increase of prices.

So now rise in the consumer price index reflects more the rising trend in many expenditure items, apart from energy-related and food-related items. So, initially, you are right in saying that rise in consumer price index reflected depreciated currency, but now the rise in consumer price index reflects more the domestic factors, rather than exchange-rate factors.

MW: Do you see strong signs of shifts in inflationary expectations already, in addition to these transmission mechanisms we’ve discussed, and what are they?

HK: Yes, some. As you know, inflation expectations are not seen in any hard data. You can only calculate them from various statistics. And also, you can make use of survey data. All of them show that inflation expectations have been rising steadily, but moderately, not rapidly, and many indicators show that inflation expectations may be 1 per cent or 1.5 per cent. Some statistics show that it’s close to 2 per cent; some show less than 1 per cent. But from various survey data and the so-called “break-even” inflation rate, that is the difference between conventional and inflation-adjusted JGBs, you can see that inflation expectations have been rising moderately, but steadily, and are now probably around 1 per cent to 1.5 per cent.

MW: Do you think that you are also seeing signs that output is growing faster than potential?

HK: Yes.

MW: And how much output gap do you in the BoJ now feel there still is?

HK: We feel that probably the output gap at this moment may be between minus 1 per cent and minus 1.5 per cent [of potential output]. According to the Cabinet Office calculation, it’s minus 1.3 per cent. So already, the output gap has shrunk considerably. And since we expect economic growth will continue to be well above our potential growth rate, the output gap will continue to shrink and eventually become slightly positive.

MW: What sort of growth rate do you here at the BoJ expect next year?

HK: We expect growth rate – in terms of fiscal year, the fiscal year, like in the UK starts in April and ends in March: so this fiscal year ends next March, and the next fiscal year, fiscal year 2014, starts April next year – And for this fiscal year, we expect growth will be 2.7 per cent, and the next fiscal year, 2014, 1.5 per cent, despite the 3 per cent consumption tax hike. And then, in fiscal year 2015, we expect the growth rate would be around again 1.5 per cent, including the impact of the second stage consumption tax hike of 2 per cent.

So we expect 2.7 per cent, 1.5 per cent and 1.5 per cent – three straight years well above our growth potential. On growth potential, our estimate is far less than 1 per cent, around 0.5 per cent. IMF calculate 0.75 per cent, or something like that.

MW: So still half the rate you’re expecting.

HK: That’s right. Anyway, our medium-term growth potential is less than 1 per cent, and our growth rate for three years will be well above that growth potential.

MW: And do you think that the monetary policy that you’ve adopted is the principal reason that the economy has accelerated to a level well above potential, or do you think it’s actually really got very little to do with what you’ve done?

HK: I think certainly our monetary policy, the QQE, must have contributed to realising positive growth well above potential, but of course, government fiscal policy also contributed, because, as you know, the government declared in the joint statement [in January] that they would employ so-called flexible fiscal policy, meaning that, in the short run, they would provide fiscal stimulus, but, in the medium to long run, they would consolidate the fiscal position. And actually, the government delivered initially a strong fiscal stimulus, but now, from the next fiscal year, the government would reduce deficit through raising the consumption tax. And so far, the economy responded to very aggressive monetary easing and to the government fiscal stimulus.

MW: So our readers, who are not familiar can understand this, just a couple more questions and then we’ll move to the future. You’ve called this “quantitative and qualitative monetary easing”, which is a term that I think is new. Could you explain in what way this is similar to, and in what way it’s different from what the other major central banks are doing – the Fed, the Bank of England, the ECB – and why you think this is particularly appropriate for Japanese circumstances? And what is the nature of those circumstances?

HK: As you may know, the Bank of Japan actually started QE.

MW: You invented it.

HK: QE – yes. We started it in 2001. And it was ended in 2006. Why we called it QE, or quantitative easing. We were faced with the zero lower bound – the short-term interest rates reached zero. So the only way to stimulate the economy through monetary easing, the Bank of Japan thought, would be quantitative easing. But, at that time, quantitative easing was really quantitative, because the Bank of Japan purchased relatively short-term government bonds, treasury bills, in massive amount.

MW: The theory would suggest it doesn’t do much, because it’s near-cash. It’s cash and near cash.

HK: Yes. And also, after the Lehman shock, the Bank of Japan adopted the so-called comprehensive monetary easing, in which again the Bank of Japan purchased a massive amount of JGBs, but again, relatively short-term – one to three-year remaining maturities. Again, this comprehensive monetary easing did have some positive impact, but not much. So this time, we decided to include whatever maturity of JGBs – five-year, ten-year, or 20-year or 30-year JGBs, we decided to purchase.

So this is not the quantitative easing we did in the past. So we called it quantitative and qualitative monetary easing, because we decided to massively increase JGB holdings with substantially extended maturities, and we intend to purchase JGBs with average maturity of around seven years. But that does not mean we do not purchase ten-year or 20-year or 30-year bonds. We have been purchasing a lot of longer-term bonds, but on average, we . . .

MW: If the average maturity is seven, you must be buying longer term bonds.

HK: Yes. We were the inventor of QE. So this is different from the past QEs, so we called it QQE, quantitative and qualitative monetary easing.

By the way, I understand the Federal Reserve, the Bank of England, they are doing almost the same thing. They are purchasing . . .

MW: Across the yield curve.

HK: Yes, across the yield curve. But for them, this is the first QE, so probably they don’t feel it necessary to differentiate from former QE. So I think it’s quite OK. But for us, it is important. It’s not the QE we have done in the past. It’s new QE, so QQE . . .

MW: So it’s to differentiate you from your past, not to differentiate you from other central banks.

HK: That’s right.

MW: OK. That’s important. How important is it in terms of the effectiveness of this policy that you get negative real interest rates, particularly at the shorter end of the curve?

HK: I think even in the relatively long end of the yield curve, real interest rates may be in the negative range, because ten-year JGB . . .

MW: 0.6?

HK: Yes, 0.6 per cent.

MW: If you get 2 per cent inflation, it’s minus 1.4.

HK: Yes. At this stage, of course, inflation expectations are not 2 per cent, but 1 per cent to 1.5 per cent, or something like that.

MW: So the longer-term real interest rates are negative.

HK: Yes. We continue to suppress the yield curve from rising. At the same time, we have been moderately successful in raising inflation expectations. So maintaining low nominal interest rates and raising inflation expectations resulting in reduced real interest rates across the curve. And, at this stage, many of them would be in the negative range, supporting the investment and consumption.

MW: One final question on where you are. The government and the Bank of Japan have agreed on the target, and so that’s essentially a mandate for you. That can’t be a matter of dispute any more. So in that sense, you’ve become like other central banks where there is an agreed target. But the means, of course, you have chosen. You have a large monetary policy committee, a substantial monetary policy committee. I understand there was agreement in April, but there have been some disagreements. Are the disagreements essentially about what sort of policy will work in these circumstances? I’m trying to get a sense of how deep the consensus is on the mechanisms you’re using to deliver the agreed target and the nature of any disagreements, as you perceive them.

HK: I think there is still basic agreement among all members of the Policy Board. We have nine members; three from the management and six from outside. And as you said, in April of this year, the QQE was supported, unanimously, by nine members and they continue to support the QQE. Basically, every month we have Monetary Policy Meeting to assess the impact of our policy and other factors, and every month, the Monetary Policy Board agreed to continue this QQE. Also, as you said, the 2 per cent inflation target was adopted by the Policy Board in January with the joint statement between the BoJ and the government, and this is also well recognised by all members that this is their target, this is the objective of BoJ monetary policy.

There may be some differences of nuance, difference of views, not about the channels through which monetary policy can affect the real economy, but about the extent. Some of them – a few of them – think that even in two years’ time, even with this QQE, consumer price inflation may not reach 2 per cent; and also, as you can imagine, there are many factors outside our control that could affect the inflation rate. External demand may change. Foreign monetary policies may change. Many factors could affect the real economy, including the inflation rate in Japan. So the assessment of various external and internal factors may differ from one another.

MW: The implication of that, obviously, is that you might have to do more. So that leads you actually perfectly to consider the next stages. You have made an announcement that covers two financial years, essentially. Inevitably, since you’re managing expectations, at some point in the not too distant future, people are going to ask, well, what are you going to do next; are you going to suddenly stop? Or are you going to do the same thing? So my first question is have you decided when you will make an announcement. not what, but when you will make an announcement about the future monetary policy, as the two-year period comes to an end? You obviously don’t want to be in a position in which suddenly people ask in the summer, or next autumn, what’s going to happen next? You don’t want that to happen.

HK: When you see the so-called policy statement on monetary policy in recent months, you can find a kind of forward guidance, which says that the Bank of Japan would continue with the QQE until it achieves the 2 per cent inflation target and maintains that in a stable manner. So our QQE is not time-contingent.

Of course, we intend to achieve the 2 per cent inflation target basically in two years’ time, but inflation rate could be affected by many factors, domestic and external.

MW: Do you want to sustain it?

HK: Yes. So that we may be able to achieve the 2 per cent inflation target before two years pass, or after two years pass. So our forward guidance is not calendar- based. It’s state-contingent, or economic condition-based. But, having said that, of course, as I said, every month, the Policy Board has extensive discussions on our monetary policy and its impact, and so on and so forth; and so every month, we have an opportunity to assess the impact, and if necessary, we could adjust the policy. So I have been saying that we have enough flexibility, so that, if necessary, we can expand our QQE or even we can reduce QQE, depending on economic conditions and the future prospects of our inflation rate.

MW: Let me be clear that I understand what you mean by extending QQE. Would the implication of that be that essentially in a third year you would do the same amount and same composition of quantitative easing as you’ve done in the first two years, or that you would do some amount? How far do you feel that, as it were, the quantities you’ve chosen . . . I can’t remember the exact figure, 50 billion JGB? . . . is the right thing to get 2 per cent flow, and therefore it would just go on like that until you sustainably hit it? Just to get it precise.

HK: Two things. It’s about the future. So, as I said at the outset . . .

MW: It’s just the nature of the guidance.

HK: Yes. As I said at the outset, we are on track and we still think that, with this QQE, we will be able to achieve 2 per cent inflation target basically within two years time. So, at this stage, we don’t think it’s necessary to expand or add anything, but, as I said, even before two years time has come, we can adjust our policy, if necessary. So that is one sort of flexibility.

And another, as I said, is our forward guidance clearly shows that the QQE itself, this form, is not calendar-based. It’s economic-condition based. So, without any new kind of decision, the current QQE can continue until the 2 per cent inflation target is achieved and maintained in a stable manner.

So two things I said. It’s not time bound: the QQE itself can continue until the 2 per cent target is achieved and maintained in a stable manner. And, second, at any time we can adjust our QQE upward or downward, in whatever form necessary and appropriate.

MW: So there is no particular time point that is particularly important; say the beginning of next fiscal year?

HK: Of course, since we said that we intend to achieve the 2 per cent inflation target basically within two years time, or something like that; after two years, if inflation rate is still far below, then there would be . . .

MW: More action.

HK: But, as I said, we are on track.

MW: I understand that. But there’s another possibility, which is very important it seems to me. Let us suppose for the moment . . . this I understand; that’s clear; if you’re not on track, you’re going to do something. That’s what you’ve said. Let us suppose it looks as though you are going to hit 2 per cent, because of the policies you’ve taken, but, as you’ve already clearly said, the commitment is to sustain 2 per cent. It is extremely possible, not certain, that to sustain 2 per cent, monetary policy will need to continue to be easy, as we’re seeing in the US. They’ve now had many years of this. So it is perfectly possible that, even if you hit the 2 per cent, it’s really important I think for people to understand, even if you hit 2 per cent, you may still have to do this. That is an implication of your sustainably keeping 2 per cent. Isn’t that right? You may have to go on for all we know for many years. Nobody knows. But the commitment is the 2 per cent, so you will do what is required. I just want to be clear about this.

HK: Yes. Basically, you are correct. You are right. But I must emphasise that monetary policy is always managed based on the current statistics, but, at the same time, on the assessment of future prospects of the economy. So when the inflation target, the 2 per cent target is met, even then if you expect that this would soon become less than 2 per cent, then you may, even if you hit the 2 per cent target, you may wish to continue for some time, or tapering gradually and gradually.

MW: But in Japan, at the moment you have an enormous purchase programme.

HK: Yes.

MW: And this is a comment. But it’s difficult to imagine your suddenly going from that to zero.

HK: That’s right.

MW: That would be quite surprising. So tapering of some kind, even if the programme worked, would not be an unlikely outcome.

HK: I understand that the Federal Reserve is purchasing something like 85 billion . . .

MW: It’s purchasing $85 billion a month.

HK: Yes. And tapering means that . . .

MW: 10 billion less.

HK: Maybe. I don’t know. But anyway, it’s not selling the portfolio. It’s just . . .

MW: Reducing the rate at which you buy. That is precisely what I want to get to.

HK: Yes. And of course, we are carefully looking at the Federal Reserve for this policy management, because, as I said at the outset, we are still so long away from the 2 per cent target. On the other hand, the US economy has been recovering very strongly, so that presumably the Federal Reserve is thinking about how to reduce the amount of asset purchases per month, and so on and so forth. That’s quite appropriate and quite good, even from the global perspective, because that means that the US economy is strong and will continue to be very strong. That’s good. But, at the same time, as you are alluding, the technical challenge faced by the Federal Reserve, that is quite useful for other central banks, including BoJ and BoE, who have been making unconventional monetary policies or QE.

DP: Martin, I think you wanted to ask about potentially other policies and it’s potential to doing more of the same.

HK: Whenever I was asked about our future policy, I always responded by saying that we are on track but we are only half way, so it’s premature to discuss in complete terms about how we would or should exit from the QQE because it’s too premature. Having said that, of course, there could be many ways to exit from any unconventional . . .

MW: I want to talk about exit, but I was actually thinking more about how you continue than how you exit, because it seems to me that, given the entrenched deflation expectations, the difficulty of getting to 2 per cent and sustaining it, well . . . The important point is that just exit doesn’t seem very imminent to me. I mean, you’re further away than really anyone else because you’re further from the 2 per cent inflation target.

HK: I agree.

MW: So that’s an important point, isn’t it?

HK: Yes. It’s premature to discuss about exit policy, as far as BoJ is concerned. As you said, yes, the Federal Reserve is likely to exit, or start some adjustment . . .

MW: Early next year, or maybe even this year.

HK: And then you think the Bank of England?

MW: In the next year or so.

HK: That leaves . . .

MW: The ECB and you, and you are the furthest from meeting your own targets. The ECB, inflation is falling, and you’re rising, but from a lower level. For everybody, it’s potentially it’s the same 2 per cent target. Interestingly, we’ve all converged on the idea that the right rate of inflation is 2 per cent, which is itself an interesting phenomenon.

Can I just ask about some of the other possible policy instruments that other economists have been thinking about: negative interest rates on reserves; the purchase of foreign assets; the purchases of a wider quantity of assets, other than Japanese government bonds – I know you’re purchasing some other assets, but you could shift more dramatically towards risk assets, that’s obviously a possibility; and then you could in theory be more precise about forward guidance, about what you would do in different circumstances?

The impression I’m getting from what you’re saying so far is you’re not really thinking about any of these other possibilities, or is that wrong?

HK: At this stage, we are not thinking about any other policy tools to be adopted at this stage. So in that sense, you are right.

MW: Negative interest rates on reserves would seem quite attractive given that you really want the banks to lend.

HK: There are, of course, pros and cons, and I understand it was discussed at the ECB. And also, they have been discussed at some other central banks. So two things. One, at this stage, we are not thinking about any other policy tools, since we are on track and we are likely to achieve the 2 per cent inflation target, basically, within two years time bound. Second, I can say that those potential instruments, they are possible, and, at this stage, I don’t want to exclude any one of them, although as I said at the outset, we are not thinking about any instrument other than we are now utilising.

By the way, foreign bond is – what is your purpose? If it is to depreciate your currency, I think it’s not a monetary policy objective. So . . .

MW: That would be a government decision, and it would be a very political government decision.

HK: So, anyway, it’s outside the BoJ’s . . .

MW: The BoJ’s remit.

HK: Correct. But others – negative interest rate, or whatever assets, other than the assets we are purchasing – those instruments are possible and, at this stage, I don’t want to exclude any of them. But as I said, we’re not thinking about those instruments other than the ones we have currently employed because we are on track and we think that still . . . we’re only half way but we still think that we . . .

MW: But a key point, as I understand from what you’re saying, is to quote one of your colleagues in this business, Mario Draghi, you are going to do “whatever it takes” to get this inflation target. I mean, the key point I think for the world outside is: is the BoJ serious about its inflation target? And I understand you to say you are very serious about your inflation target. You are planning to hit it, and you will use the instruments needed to achieve it. Is that right?

HK: Yes.

MW: Can I move then to . . .?

JS: Actually, before we jump on, why do you think the markets have got it so wrong then? There are very few investors and private sector analysts who think you are on track the way you say you are. What’s the key difference here in the model and your thinking?

HK: That’s a good question, because if you look at the forecasts made by market economists, you can find that as far as real economic growth is concerned, there is not much difference, for, as I said, for this fiscal year, 2.7 per cent, next fiscal year, 1.5 per cent; year after that 1.5 per cent. And as far as this fiscal year is concerned, there is not much difference because we are already in December, so only three months left. And then next fiscal year, some may be forecasting only about 1 per cent, but some may be forecasting near 2 per cent. But many are forecasting growth rate around 1.5 per cent, and the year after the next, similar.

How about the inflation rate? Here, there are differences. As far as this fiscal year is concerned, of course, not much difference. We are forecasting consumer price index would be up around 0.7 per cent, again most business forecasters say almost the same figure. And next fiscal year, we’ve forecast 1.3 per cent. Again, most of private forecasters say similar things; maybe 1 per cent or 1.25 per cent or 1.5 per cent, or something like that.

The big difference is the third year. In fiscal year 2015, we as I said, expect the CPI to reach 1.9 per cent inflation, but market economists tend to think that the inflation rate will stay around 1 per cent or 1 per cent plus.

So what is the difference between our model and their model? And the general structure of models may be quite similar. As I said, we expect the output gap continue to shrink and becomes positive. I also think market economists, with almost the same growth forecast, they would also expect the output gap to continue to shrink and become slightly positive, something like that.

And then there is the famous Phillips curve: you can use the Philips curve based on the past ten-year or 20-year statistics. Then through this mechanism, they would have forecast almost similar inflation rate.

But the difference means we expect this Philips curve would shift up, while they may think inflation expectations would not rise so much, so that, even with a substantially reduced output gap, or a positive output gap, inflation rate may not reach 2 per cent. I’m not quite sure [about market economists’ assumptions]. But big difference between our forecast and private forecasts is basically about the fiscal 2015 inflation rate. Otherwise, there is not much difference.

JS: So this is based, you think, on the assumptions about how inflation will respond . . .

HK: Yes, I think so. Here I must say that the expectations have been rising moderately – not a big jump to 2 per cent, but it’s rising gradually. And we think that expectations are formed partly by an adaptive mechanism. So looking at the actual inflation rate rising from negative to 0.5 per cent, 1 per cent, 1.5 per cent, and so on and so forth, inflation expectations will also rise gradually. Through these two mechanisms, [that is] the output gap shrinking and becoming positive, plus inflation expectations rising based on adaptive mechanism, inflation rate will increase gradually.

MW: So if they change their minds, then it indicates that your model of adaptive expectations is correct and they are an important part of the recursive process.

HK: Yes, recursive process. I think . . . because you see, actually, the market forecasts for inflation this year were initially very low, some even negative. But now, forecasts have been adjusted.

MW: Very adaptive.

HK: Yes.

MW: One final question I forgot to ask. You’ve been very supportive of the rise in consumption tax, which is a risky thing for a central bank governor. This might be because you’re concerned about fiscal dominance. But it does seem, and I’d like you to discuss how worried you are about fiscal dominance, that fiscal policy will determine monetary policy, in the long run.

It does look rather badly timed, so the government has to offset it. So what is your view of the relationship – I mean this is an absolutely fundamental issue, particularly because Japan obviously has so much public debt, though it’s very cheap, it’s very cheap, and you hold a quarter of it – but what is your view of the relationship between monetary and fiscal policy in Japan? And the role of fiscal consolidation while needing fiscal stimulus? How do you manage that? Why are you supporting this tax?

HK: Basically there is a clear division of labour between the central bank and the government. The central bank is in charge of monetary policy, and the government, that is the Diet, is in charge of fiscal policy or structure of fiscal policies. And that is a clear division of labour. So in that sense, we, the Central Bank don’t want to be involved in fiscal policy making. However we are purchasing huge amount of JGBs in order to make the QQE effective. The order of our purchase is Y50tn per year, which is quite huge.

So far we have been able to contain the JGB yield from rising. But we are concerned about the possibility – although probability may be low – the possibility that JGB market participants may feel that the government fiscal policy is not prudent enough, and some of them may expect a substantial fall of government bond prices, in view of the fiscal policy management and so on. Then, the actual JGB prices may fall rapidly.

In other words, long term interest rates would shoot up in that event. That is a very difficult situation for the government as well as for the central bank, because, in view of this situation, the government of course cannot mobilise aggressive fiscal stimulus, because bond prices are falling sharply. Also the central bank may be faced with difficulty, because we have been trying to contain long term interest rates, JGB yields, from rising, and yet, if market participants think the JGB prices will fall, because of imprudent fiscal management by the government, then JGB prices fall. And, in that case, for the central bank, it’s very difficult to manage the market.

With 200 per cent or more than 200 per cent of public sector debt relative to GDP:, so far no JGB crisis. So [people may think] why not 250 per cent, or 300 per cent. I can’t say when the JGB crisis will come. But if there’s such a JGB crisis, it’s very difficult to manage the situation, not just for the government but for the central bank. That is the risk of postponing fiscal consolidation.

On the other hand, of course, if you raise consumption tax rate, that would have impact on consumption as well as economic growth. That is true. But, as I said, given the two-stage consumption tax hikes, we still expect economic growth rate in three straight years would be well above our potential growth rate. If that assessment or forecast is wrong, if the economy is really negatively affected and the growth rate becomes so low that the inflation rate could not rise, could not approach 2 per cent, then, of course, the government as well as the central bank can do something to ameliorate the situation.

So there are two kind of risks. One is the risk arising from delaying fiscal consolidation. Another risk is the risk arising from starting consolidation next year.

And the first risk, the probability may be quite low, because we have been able to see 200 per cent or more, 220 per cent of JGB [relative to GDP: ] as public sector debt. The other risk, the probability may be higher, but, in the event that the second risk is realised, the government, as well as central bank, can do something to ameliorate the situation. But if the first risk were realised, although the probability of the first risk may be quite low – a kind of tail risk – I would say it’s very low, but, if this risk is realised, then it’s almost impossible for the government and the central bank to do anything.

So, as I said, we are only concerned about the implications, risks to our 2 per cent inflation target. And the two risks are assessed and we think that the second risk could be managed. On the other hand, the first risk would be very difficult to manage, if the risk is realised.

We are not involved in the fiscal management itself, or consolidation or whatever. But, given the extremely high debt to GDP: ratio, more than 200 per cent, by far the highest amongst OECD countries, [even if] the probability may be extremely low, but still . . .

JS: Now, I just want to clarify that you are in favour of the second phase of the consumption tax rise, although it’s still some way off, as much as you were the first one.

HK: The 3 per cent, then 2 per cent, two-stage consumption tax hikes, I think both of them are appropriate and necessary. And when we make our QQE and when we make our forecast, we have already taken into account these two-stage tax increases. Because, after all, the consumption tax law was changed in August last year already. And without any action, the law would be implemented by the government. Of course the government and the Diet can change the law, so the second stage 2 per cent consumption tax hike may be subject to possible change.

JS: You wouldn’t advise them to do that, though?

HK: That’s right. And also, anyway, our policy and our forecast are based on the current tax law, which prescribes two-stage consumption tax hikes.

MW: Some people think it will need further tax increases beyond this to consolidate the public finances. Do you agree?

HK: Whether a tax increase or an expenditure reduction, yes. Because the government’s medium term fiscal consolidation programme is a three stage consolidation programme. The first stage is to halve the primary deficit by 2015, and that is likely to be met with the two-stage consumption tax hikes. The second stage is to eliminate completely the primary deficit by 2020. Now, based on the current policies, tax rate and social welfare system, that is unlikely to be met, unless something is done. There would be about 2 per cent of GDP: equivalent primary deficit, even in 2020. So 2 per cent of GDP: equivalent fiscal deficit reduction is necessary.

That is already envisaged in the government medium term fiscal consolidation scenario or programme. So, either raising tax burden, including consumption tax rate, and/or reducing expenditures, particularly social welfare expenditure would be necessary, because Japanese government’s fiscal size is not so huge. Unlike many OECD countries, our defence budget is almost minuscule, and largest expenditure items, I think roughly half of expenditures are related to the social welfare. And so if you wish to reduce deficit through expenditure cuts, you have to cut social expenditure.

MW: Can I just move, because it’s very important, to some of the risks. You talked about the tail risk on the fiscal side. I’d like to discuss the risks and benefits on the monetary side.

One obvious risk is: You succeed. Inflation gets to 2 per cent, real interest rates are negative, people realise that their real assets, their financial assets are losing value, they say to themselves: “Maybe the Japanese government will raise inflation further. There’s a lot of debt, they’re trying to get rid of their debt. We can’t trust the Japanese government and the BoJ, and we should get out of the yen. And you destabilise expectations, but you don’t re-anchor them. And there could even be some flight from the yen. If you got into a situation, in fact, where inflation really started overshooting, you’d have to tighten. That could create a tremendous mess, in this situation. So how concerned are you that you can make this jump and then stabilise it?

HK: I must say that raising the inflation rate as well as the inflation expectations from the negative range to 2 per cent is quite challenging. On the other hand, to contain inflation rate from rising beyond the 2 per cent target, that is less challenging, I would say. Because many monetary authorities have accumulated their experiences and lessons, and also we have enough tools to contain inflation from rising. So, we can face such a situation as you describe.

MW: You’re talking about higher interest rates, higher reserve requirements.

HK: Many things you can . . .

MW: Lots and lots of things. But even if this doesn’t happen, you move to an environment of higher nominal interest rates, particularly at the long end. So long bonds normalise, existing JGBs lose value, the Japanese government has to pay a higher interest rate, to some extent that’s a nominal allusion, but the fiscal deficit will rise. I mean, you’ve got 200 per cent debt, and you’d have to pay a higher interest rate, not just to the BoJ. So banks stand, and other companies stand, to lose money as their portfolios lose value. The Japanese government stands to pay more interest – nominal, possibly even real if there’s an inflation risk premium. You think all this is completely easily manageable? Some people say banks will go insolvent. Some people think the Japanese government’s debt-management problem will become really serious. You think this is all quite manageable?

HK: I think as far as the financial system is concerned, I think it’s quite manageable, because every year we have been making a macro stress test of the banking sector. And we made scenarios of 100 basis point, 200 basis point or 300 basis point parallel shift in the yield curve [, a rise in interest rates across the yield curve], and even with 300 basis point parallel shift, the financial system would not be damaged much. Of course, there may be some small financial institutions suffering from loss, but banking sector, or financial sector as a whole, would be able to manage the situation – even the parallel shift. If the yield curve becomes steeper, that would not affect much. So, anyway, the financial system, as far as it is concerned . . .

MW: That’s fine.

HK: That’s OK. How about the public finance? You’ve made, I think, deliberately, the negative aspect more profound than . . .

Look, you mentioned that rising JGB interest rate means a capital loss for the banking sector, or for the financial sector. On the other hand, the government would suffer from rising cost of . . .

MW: Borrowing.

HK: Borrowing.

MW: Or rolling over.

HK: Yes. But that’s a bit asymmetric. Because, if that is the case, the capital loss, it would mean the government has a capital gain of course. And if the government has to pay higher interest rates . . .

MW: That’s normally not included in the public accounts. Capital gain on defaulting is not included in the accounts.

HK: But we are not discussing about accounting. We’re discussing about economics. And of course the government . . .

MW: People are obsessed with public accounts, after all.

HK: The government may have to pay more interest for new borrowing, but that means that of course the financial sector can also gain from higher interest rates of JGBs, newly issued. So I think you have to always assess both the negative and positive impact on the financial sector.

As I said, as far as the financial sector is concerned, it’s quite OK. The Japanese banking sector has huge capital. Enough capital. How about the government? This is a bit more difficult. Why interest rates rise? It’s because it’s reflecting rising inflation rate, or improving economic situation. That means that the government would gain through significantly increased tax revenue. So financing costs may rise, but, at the same time, the government may be able to receive more tax revenue.

But anyway, I agree. At this level – more than 200 per cent of GDP: public sector debt – that is huge. And that large amount of debt has been relatively easily managed with extremely low interest rates, and if interest rates rose, that certainly would make the government pay significantly more interest. So consolidating the fiscal position continues to be a big challenge. I’m not quite sure whether it would become more challenging, because as I said . .

MW: Yes, it’s challenging, whatever.

There are two other very big questions.

Why is it important to eliminate deflation? The Japanese economy since 2000 has not done too badly. Productivity growth has been quite good compared to other countries. GDP: per head has been quite good. Of course the population and working force is shrinking, but there’s nothing you can do about that with monetary policy: you can’t produce children. So why are you going through this very risky upheaval, when actually deflation was steady? Why does this matter?

HK: Actually, deflation started around 1998, and it continued and continued until now. I mean there’s been basically a 15 year deflation. But as you said, deflation in our case had been relatively mild. On average, a 0.5 per cent decline in prices year-on-year. Except 2008 – in 2008 we had a huge global commodity price boom that affected Japanese prices as well. But, anyway, 15 year long deflation really resulted in a few things.

One, because prices are declining, people just tend to delay expenditures, investment or consumption or whatever. So we have a continuous demand shortage, and the gap was filled by continuous fiscal stimulus or fiscal measures. So the fiscal situation has become so bad and almost unsustainable.

Second, since prices are declining and inflation rates are so low, interest rates are low. I mean that, relatively speaking, holding deposits or notes, holding cash became relatively profitable: completely safe, completely liquid and yet it would pay positive real interest rates. Negative 0.5 per cent point deflation means 0.5 per cent point real interest rates on cash. So corporations accumulated cash. They have nearly, at this stage, 50 per cent of GDP: in cash. And they don’t invest much. In the past ten, 15 years, they consistently invested less than their cash flow in physical assets. So cash flow increased and real physical investment declined and they accumulated. It is not good for economic innovation, economic growth if companies just hoard cash without much spending on physical assets or R&D or human capital or whatever.

So, at least there are two things. One is deflation means that households and companies just delay spending. The second is making companies, and also households, less adventuresome, less risk- taking, less interested in innovation. This made the Japanese economy and society achieving low-level stability, so to speak. Yes, the Japanese economy, I think, has been nearly stable at lower levels. Growth has not been so prominent. Even per capita growth in the last ten, 15 years has been far less than the growth rate we realised 20 years ago, or 25 years ago. Always we compare our deflation – 15 year deflation on average 0.5 per cent point deflation – with the 10 per cent deflation for three years in the US, during the Great Depression. The Great Depression had huge deflation [for a relatively short period]. In our case, negative 0.5 per cent deflation continued for 15 years. That made these two problems.

And also, the third problem is that it has become very difficult to get out of deflation. Deflation mindset is deeply embedded in the economy and the society. Companies, households, banks, even the government are so accustomed to mild deflation.

By the way, in terms of consumer price index, it is 0.5 or 0.4 per cent, but, as you know, CPI tends to exaggerate rate of inflation. So in reality it may be 1 per cent deflation or 1.5 per cent deflation. But, even if it’s 1 per cent or 1.5 per cent deflation, it is still a relatively mild deflation. It is true, but it made always two problems: [one is] delaying the expenditure, and [the other is] discouraging risk-taking, making innovative things, investing in physical assets, R&D, human capital, and so on and so forth. So we thought that we had to get out of this even mild and stable, but still very much damaging deflation.

MW: Is the implication of this that the move from deflation to inflation is really the most important structural policy? Because your answers are really structural answers. They’re monetary. The implication would be that in terms of the so-called third arrow or third bazooka, actually really the inflation policy is the most important element, because the other elements really don’t amount to much.

HK: I think the third arrow is still quite important. As you know, the government intends to raise potential growth rate to 2 per cent.

MW: Do you believe that’s at all possible?

HK: That’s possible. At this stage it may be 0.5 or 0.75 per cent, so you need to raise the potential growth rate by 1.25 or 1.5 percentage points. I don’t think it’s extremely difficult, although not so easy. I agree.

MW: I think it’s impossible, just impossible. It implies infeasible productivity growth rate for an advanced economy.

HK: Yes, there are two things, of course, regarding how to raise your potential growth rate. The first one is to increase the quantity and quality of your labour force. The second is to raise labour productivity. And as far as the first part is concerned, you may know that the Japanese age profile of labour participation rate for women makes this M-shape curve. After graduation from university they join the labour market, maybe nearly 100 per cent, but then they are married and they have to take care of children and many of them leave the labour market. After three, five years’ time they may come back to the labour market, but their career is . . . not destroyed but it’s undermined and many of them could not reach the management level.

This M-shaped curve is seen only in Japan and Korea, among OECD countries, entire OECD countries. US, UK, France, Germany, their age profile of labour participation ratio for women is like this [plateau-shape], but in Japan and Korea it is like this [M-shape]. And if you can eliminate this bend, that would increase the quantity as well as quality of female labour. And according to a back-of-the-envelope calculation, by so doing you can raise the potential growth rate by 1 per cent, in the medium term.

But another more important but at the same time more difficult part is of course how to raise labour productivity. Here, there is huge room for labour productivity increase, particularly in the tertiary sector, the services sector. As you know, our manufacturing sector is basically OK. The Japanese manufacturing sector is competitive and enjoys comparable labour productivity compared with US, UK or Europe. On the other hand, in our services sector labour productivity is far below those in the US and Europe.

So we feel that through various structure reforms we can significantly raise labour productivity in the services sector. And, as you know, the service sector contributes more than half of GDP:, employs more than 60 per cent of total labour force, huge. And that means that various structural reforms would be and should be targeted at improving labour productivity in services.

MW: But higher inflation will itself, from what you said, contribute something to real performance. That’s what you are saying.

HK: Yes, I think so. I think so, yes. But basically, raising the potential growth rate is up to the government. It’s structural reforms in the less effective sectors, like services sector, agricultural sector and so on.

MW: Jonathan, do you want anything else?

JS: Actually the question I was wanting to ask was the one you’ve just asked.

MW: Because we could go on forever on structural, but it’s not your responsibility and it would be unfair.

JS: But it does seem that there is something of a disconnect between the argument that we must get rid of deflation, because of all the pernicious effects it has on the real economy and consumer behaviour and corporate behaviour and then this corresponding claim that once we move to inflation, well, then it becomes maybe not so important and then the government must do A, B and C.

HK: You can say that, in the last 15 years, our growth potential has been somewhat suppressed through the damaging impact of continuous . . .

MW: Deflation.

HK: Mild deflation. And by eradicating deflationary expectation, you maybe eliminate this negative impact on the potential growth rate. But in order to raise it to 2 per cent . . .

MW: That’s a different matter.

HK: . . . more important is structural reform.

MW: There is one thing that we never discussed and it’s very, very important. It would presumably be very bad if your inflation went to 2 per cent and nominal wages didn’t rise equally. If your policy ended up by lowering real wages that would be potentially quite disastrous for your policy aims. But many critics fear that that is what is going to happen.

HK: I think a few things that you can say. First, in Japan, in the past 20, 30 years, including the 15-year deflationary period, if you look at wage increases and price increases, then you find very similar movements, although the scale is a bit different because of labour productivity increase. So if labour productivity increases 1 per cent, on balance the wage increase would be 1 per cent higher than the price increase. But anyway the shapes are quite similar, almost synchronised. Maybe there is some time lag, but annual figures show almost the same movement. That means that, unless wages are rising, prices will not continue to rise, and unless prices are rising, wages will not rise. So that is one point, purely statistical correlation.

Second, wages or earnings, compensation, including bonuses and overtime payments, are already increasing, although the basic wages have not yet increased, because in Japan basic wages are subject to the so-called spring offensive.

MW: Yes, of course.

HK: . . . annual wage negotiation, starting . . .

MW: So you’ll know in a few months.

HK: That’s right. But already, as I said, the total compensation, total wages including overtime and bonuses, show an increase, coupled with substantial improvement of employment. The employment number is increasing. By the way, the unemployment rate declined already. The current unemployment rate is comparable to the rate before the Lehman shock. So the employment situation has substantially improved and employment increased. So employees’ income, that is nominal wages multiplied by employment mean, has been rising significantly, rising faster than price increases. So their real income, employees’ real income has been also rising. That is the second point.

The third point is of course basic wages, and we expect some basic wage increase during the next spring offensive or spring wage negotiation between employers and the trade unions. But that’s . . .

MW: So you are an unusual central bank that wants to see wages rise fast?

HK: Yes.

JS: Minimum wage?

MW: Do you think the government could help with a minimum wage or other measures?

JS: It’s been proposed, but shot down.

HK: I think that could help, but, unlike in the US, it’s not a huge political issue. Minimum wages could be raised, depending on the general wage conditions in Japan.

MW: In the US it’s a big inequality issue, but in Japan, as far as I can see, inequality has not risen so much, which is very remarkable given the long stagnation.

HK: That’s right, partly because in Japan economic adjustment usually takes place not in employment but . . .

MW: Hours.

HK: . . . wages.

MW: Wages?

HK: Yes, nominal wages or hours. In the US, usually companies lay off when a recession comes, while wages may be quite sticky. In Japan, wages have been relatively flexible, not just because of bonuses, but also overtime and so on and so forth, so that the employment situation of course fluctuates, but not so widely as in other countries, providing basic income to all the people, all classes of people.

JS: Is that a good and sustainable situation? Because some of the proposed third arrow reforms would actually make the labour market more flexible. Some people think it might be deflationary.

HK: Yes. I think, as I said, if you make the labour market more flexible, like in the United States, then you may expect the wages to become more sticky. So the point you made is a big question for labour economists, but the reality is that, in Japan, employment has been fairly stable, of course it fluctuates, but not so widely, while wages or employees’ nominal wages fluctuate widely, because of overtime and all these elements.

JS: That’s really interesting.

MW: Thank you very, very much. Thank you. That’s pretty comprehensive.

HK: Well, thank you for coming.

MW: A tremendous pleasure.

HK: I understand that you came to Tokyo to interview me.

JS: Sure.

MW: Well, I rarely need an excuse. I like coming here, though it is a long way. But yes, I came to interview you. I think what you’re doing in the area of monetary policy is an experiment of the most extreme kind. This is probably the most interesting experiment in the world. So it’s very important that people understand what you’re trying to do.

HK: The difference between Japan and the US, the UK or other countries, is that their inflation expectations are very stably anchored around 2 per cent, while our inflationary expectations have been anchored around zero or something. We are trying to raise these inflationary expectations toward 2 per cent.

MW: So it’s a different challenge.

HK: That’s right, although instrument tools are quite similar, buying large amounts of longer-term government bonds, as well as some private assets. But the objective is a bit different. We are trying to raise inflation, as well as the inflationary expectation, from zero or, let’s say, negative to 2 per cent.