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Japan/US Issue Matrix for BoJ and the Fed View GEF Archive

Legal issues

For the Federal Reserve, there were two legal issues discussed at the conference. The first arises from the wording of the Federal Reserve Act (see http://www.federalreserve.gov/GeneralInfo/fract/sect02a.htm).  Section 2A states the objectives of the Fed as follows:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.

Both economic theory and practice have rendered the law obsolete. First, the logical structure of the phrase is mathematically questionable. So long as “money and credit aggregates” are viewed as a single tool (it is hard to think that Congress meant that the Fed should adjust money supply and credit growth at different rates, in light of monetary theory at the time of the law changes (1978)), the law requires the Fed to achieve three goals with one tool. Second, the Fed does not have enough control over any of the monetary or credit aggregates to adjust them reliably. This is particularly true in the current policy methodology, since pegging interest rates makes monetary aggregates endogenous. Third, there are grave doubts about whether the monetary aggregates have stable relations with nominal GDP, much less the breakdown between inflation and real growth.

The second problem for the Fed is the legalities of introducing inflation targeting — if that decision is made. In particular, will the Fed itself have the power to set the target? Will the target require review by Congress? Which measure of inflation will be used, and will it be mandated by law or delegated to the Fed to choose? At the moment, the danger lies in an adverse confluence of circumstances. If inflation targeting is proposed while the economy is worsening and inflation is still rising, then the rules on inflation targeting could be hard to formulate.

For the Bank of Japan, there are also two legal issues. The first concerns independence. Fortunately, the BoJ Law is crystal clear in giving the BoJ operational independence. However, on the question of goal independence, the Law is not clear. The goal key is “contributing to the sound development of the national economy”, not price stability per se. The problems are (a) how to establish standards for price stability and (b) whether a given target for price stability is consistent with “sound development of the national economy”. The BoJ has referred to its 0-2% range for inflation as only its own “understanding” of price stability (see The Introduction of a New Framework for the Conduct of Monetary Policy, Bank of Japan, March 9, 2006). Many scholars have argued (see Inflation Targeting: A Trojan Horse for Structural Reform, Robert Feldman, January 10, 2006) that a concept so broad and important as price stability is best decided by the political process. Until the matter is clarified, however, investors and citizens will not be clear on who sets the goals.

Japan’s second legal problem stems from the first: So long as there is uncertainty about who sets the goals, the Bank of Japan is exposed to criticism from the Diet. Under these circumstances, the BoJ will naturally try to defend itself from radical critics. In short, another layer of protection is needed for the BoJ, so that it can focus on the operational aspects of monetary policy, and deflect questions on the targets (e.g., x% inflation) to the government, which is ultimately accountable to the voters. The Council on Economic and Fiscal Policy (CEFP), which is the highest economic policy body in the nation, and on which the BoJ Governor serves, is likely to put this matter on its agenda 2007.

Technical issues

The chief technical issue facing both the Fed and the Bank of Japan is the quality of price and wage indices.

In the US, the biggest issue on prices is the treatment of shelter in the CPI (for details of how the BLS calculates owner equivalent rent, see http://www.bls.gov/cpi/cpifact6.htm). Particularly, since “owner equivalent rent” (23% of the total CPI) is based on a re-weighted sample of rental units, with the weights reflecting characteristics of owner-occupied homes, there can be large effects from changes in rental market conditions. Now that house prices are soft, families are reluctant to buy homes, with the result that rental housing is more expensive. Ironically, as house prices fall, the owner equivalent rent component is surging. In September, owner equivalent rent was up by 4.0% year on year, compared with 2.1% for all items and 2.9% for all items less food and energy.

On wages, many economists have pointed out the problems in the two major wage indices for the US, the employment cost index and average compensation per worker (for example, see “Will the Real Wage Measure Please Stand Up?”, Richard Berner, Global Economic Forum, January 6, 2006). The conclusion is that both have serious sampling and formula problems, and thus that true wage growth is probably understated in the US.

Japan has similar issues with both wages and prices. The problems with the Japanese CPI are well known (see True Price Stability, Robert Feldman, April 17, 2006). Added to this is the large gap between the CPI change and other general price indicators, such as the consumption deflator, which remains in negative territory, and the CPI ex food and energy, which also remains negative.

Wage measurements are also a problem in Japan. Indeed, one of the ironies of 2006 has been the deceleration of wages per hour, despite tightening signs from other labor market indicators. The most likely explanation for decelerating wages is a change in the mix of employment back towards more part-timers. Regardless of the reason, the deceleration of wages makes it hard to argue that Japan faces an upward wage price spiral.

Policy issues

Both central banks also face policy issues. For the Federal Reserve, these include elimination of the Greenspan Put, the herd behavior of financial markets, and a potential problem in coordinating monetary and fiscal policy. For the BoJ, the fiscal/monetary coordination issue is immediate, but other issues exist, such as optimal policy indicators in an aging society.

In the US, the Greenspan Put means that the Fed cannot return to market discipline without risking a major meltdown in financial markets. (Some believe that the Fed has already eliminated the Greenspan Put, by allowing the IT bubble to burst at the start of this decade.) The standard monetary response in such situations is a gradual tightening. Surprisingly, 425bp of fed funds gradualism has not brought discipline back to capital markets. That said, any Fed tightening might be perversely stimulative, if it prompts recession fears, which lower long-term interest rates, which re-stimulate the economy, and thus prevent market discipline from working. The increasing herd behavior of markets only makes these problems more acute.

For Japan, the fiscal/monetary coordination problem is most urgent. Despite a multi-year fiscal adjustment program, there is still a deficit of about 4% of GDP in the primary balance. Some inside the BoJ are arguing for a “normalization” approach to policy. That is, as fiscal policy is normalized, so monetary policy should be normalized as well. In contrast, the attitude of the government is that fiscal deficit reduction requires monetary policy to be easier for longer, in line with a more demand-oriented approach to the economy. This debate will unfold over the coming months.

Over a longer-term horizon, demographic decline is the defining problem for the Japanese economy. The key imperative for Japan is to raise the capital-labor ratio. What should monetary policy do to help? In my view, the answer is to link interest rate policy to the return on investment. Only when investment begins to become unproductive, in the sense of generating low productivity gains, should monetary policy tighten, and cut off the unproductive use of funds. This is only natural behavior for a central bank. High productivity growth leads to price stability, so long as wage growth is within the bounds of productivity growth. At the moment, the BoJ is skeptical on whether productivity growth will be fast enough. However, it recognizes that its skepticism may not be justified. In my view, the BoJ needs to be clearer about what sort of productivity growth it expects, where it sees wages going, and when it expects unit labor costs to turn positive.  (To be fair, the Outlook notes the risk of high productivity growth continuing and wage growth staying low. The Outlook says, “On the other hand, if productivity keeps rising and wage increases lag behind in spite of the prolonged economic expansion, there may be no upward shift in the inflation rate.” Thus, the BoJ recognizes the issue, but has no time-axis attached to the risk scenario. In my view, unit labor costs will only turn positive at the end of 2007, and even then their impact on final prices is likely to be limited. See Equities, ULC, and the BoJ, Robert Feldman, June 9, 2006.) Without such clarity, investors could continue to worry that the BoJ may tighten too much, too early, and repeat the mistake of August 2000.

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