QuickTake Q&A: Bank of Japan’s Quest for 2 Percent Inflation

(Bloomberg) -- The U.S. Federal Reserve, the Bank of England and the European Central Bank are among the world’s monetary authorities that have set an inflation target right around 2 percent. Nowhere, though, does the quest for this special number carry drama like it does in Japan, where Bank of Japan Governor Haruhiko Kuroda has vowed to do whatever it takes to stimulate prices. About midday Friday in Tokyo, Kuroda will reveal whether he has any more tricks up his sleeve.

1. What’s so special about 2 percent?

The BOJ set its current inflation target in January 2013, less than a month after Prime Minister Shinzo Abe came to power with a plan to pull the economy out of two decades of stagnation. In Japan and many other developed economies, prices rising by 2 percent a year is seen as optimal for encouraging companies to invest and consumers to spend. It’s also thought to be low enough to avoid sparking the runaway inflation that crippled Germany’s Weimar Republic in the 1920s and Zimbabwe in more recent times.

2. How close has Japan gotten to 2 percent inflation?

Not very. What Japan has had, on-and-off since the late 1990s, is deflation -- inflation below 0 percent -- with prices dropping across a wide range of goods. 

3. What caused deflation?

It began with the bursting of a real estate and asset-price bubble. Wounded banks curbed lending, companies focused on cutting debt, wages stagnated and consumers reined in spending. Households became accustomed to falling prices and put off purchases. The global financial crisis of 2008, and the devastating earthquake, tsunami and nuclear meltdown at the Fukushima Daiichi plant in 2011, entrenched what Kuroda describes as a “deflationary mindset” among consumers and companies in Japan. The nation’s aging and shrinking population is now making matters worse.

4. What is Kuroda doing to change this?

To spur prices, the BOJ has embarked on an asset-purchase program of unprecedented scale, increasing the amount of money in Japan by about 80 trillion yen ($758 billion) a year. Kuroda added an interest-rate dimension in January by charging financial institutions 0.1 percent -- a negative interest rate -- on a portion of the funds they park at the BOJ overnight. This is meant to encourage them to put the money to work more productively.

5. Why hasn’t this worked?

When Kuroda launched his program, oil was trading at near $100 a barrel. It’s now less than half that -- bad news in a country that imports most of its fuel and is trying to raise prices. The yen’s appreciation this year also hasn’t helped, since it reduced the cost of goods from overseas. But it’s not just outside factors. Kuroda’s monetary policy, along with a huge boost in government spending, was supposed to buy time for structural reforms to Japan’s tax system, its agriculture, energy, and health-care industries, and its male-centered labor market, including regulations dating from the 1960s that offer lifetime employment at large companies. These have been slow to materialize.

6. What does this mean for markets?

Stock prices are well above their levels of early 2013 and have been rising this month on expectations for more BOJ purchases of exchange-traded funds. Get ready for a drop if the BOJ doesn’t signal that. The yen would strengthen sharply if Kuroda disappoints traders with no or little action. Meanwhile, there’s a near revolt by many investors in Japanese government bonds -- the main target of the BOJ’s asset purchases. They argue that the central bank’s buying spree and negative rate are crushing the market and can’t go on.

The Reference Shelf

• Related QuickTakes on Abenomics and deflation.
• Interactive graphic showing what’s wrong with Japan’s economy.
• Bank of Japan statement introducing its new easing policy and later explanation from BOJ on the introduction of negative interest rates.
• National Bureau of Economic Research paper on the Optimal Rate of Inflation.
• Discussion paper from the central bank on the bursting of Japan’s asset bubble.
• IMF research on the risk of deflation in the euro area and IMF Managing Director Christine Lagarde’s speech calling deflation an “ogre.”

To contact the reporter on this story: Brett Miller in Tokyo at bmiller30@bloomberg.net. To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Laurence Arnold, Jodi Schneider