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BOJ should take it slow: Columbia University Professor Takatoshi Ito
Biz / TechFriday, January 5

BOJ should take it slow: Columbia University Professor Takatoshi Ito

2018 marks a decade since the Lehman Brothers collapse and the start of the global financial crisis. Seeking insights into the crisis and its aftermath, NHK World's senior economic correspondent Reiko Sakurai sat down with Professor Takatoshi Ito of Columbia University.

Ito has been a strong advocate of inflation targeting and is known to have influence on policymakers at the highest levels, including Bank of Japan Governor Haruhiko Kuroda.

Ito predicts a solid year for Japan and the global economy in 2018. He says the Japanese economy is fundamentally strong, with low unemployment, even though the BOJ's target of 2 percent inflation remains elusive.

Ito: I think economic risk is diminishing. It takes time to change inflation expectations. And, I think there’s a global factor, that China and other emerging markets are producing goods, which are getting better and better, at prices which are very competitive. Not being able to achieve 2 percent inflation is not Japan’s unique problem, but is also seen in the US, and also in continental Europe.

One year ago, I would have said that China is a risk and Chinese nonperforming loans and local government debt is a problem. But it seems that the management of those problems has worked, so the risk is diminishing. The European sovereign debt crisis, Greece, and others are also being managed. So maybe for the first time in a few decades, all the major economies may have full employment, and economic growth around their potential.

One risk that I do see is the tax cuts introduced by President Donald Trump. Tax cuts without tax revenue enhancement means the deficit will rise. And the fiscal deficit rising, unless there is enhancement of household savings, which is unlikely, means the trade deficit will rise. And this is called “twin deficits,” as we saw in the 1980s. I think it’s highly likely that we will see a repeat of Reaganomics. Twin deficits will rise and the dollar will strengthen. I think Donald Trump will interpret that as the trading partners manipulating the exchange rate -- which they are not -- which will develop into a trade conflict.

The Japanese economy is doing well on the real side, the real sector. The unemployment rate is low, the job-seekers-to-job-openings ratio is the best since the bubble years, and the potential growth rate is slightly moving up. The nominal side, for some reason we don’t fully understand, is weak. Wages are still not rising very fast, despite the labor shortage. And inflation is still below one percent in the case of Japan, far from the 2 percent target. So the real side is strong, the nominal side is weak.

Many experts see that the big challenge for the Bank of Japan is finding a successful exit from its aggressive monetary easing program. Central banks in Europe and the US have started tapering, but the BOJ hasn't. Ito notes, however, that the BOJ has begun what could be viewed as "stealth tapering."

In fact, the Bank of Japan has already started tapering, combined with the so-called Yield Curve Control, or YCC. They have shifted [their target] already from the quantity [of purchases] to the [long term] interest rate. And the increase in purchases of JGBs has declined from 80 trillion yen per year to around 50 trillion yen per year. In that sense, the BOJ is very similar to the ECB in that they are very gradually preparing for the first step toward an exit. It’s not walking toward the exit, but preparing for the first step. That is due to the very strong real side of the economy. But they're not rushing, because of the weak nominal side.

Ito warns that the BOJ must follow a narrow path to exit its easing program to avoid huge losses. He says policymakers will need a delicate hand in paving the way out of the effects of the global financial crisis.

Ito: Some people worry about the balance sheet of the BOJ, which may show a negative profit, or negative seigniorage. The reason is as follows: The BOJ has a large amount of long bonds, with a very low coupon rate. When the long-term interest rate rises, the valuation of these long bonds with low coupon will go down. So there will be a valuation loss on the asset side at the Bank of Japan, and on the liability side, which is mostly excess reserves, which stays as a liability. So the balance sheet may have a paper loss, losses on the asset side, which may become very large if the interest rate, the long rate goes up. But this is actually not that worrisome because the bonds with low coupon can be held by the BOJ until maturity and their full value will come back. Another kind of problem is the cash-flow problem. What does that mean? It means they receive interest payments from the government and pay existing excess reserve holders, which are the banks.

So the BOJ receives interest income on the long bonds and pays short-term liability, which is excess reserves. Right now, it’s still a positive cash flow because [the BOJ] receives interest higher than what it pays for interest on excess reserves -- because most excess reserves are currently at a zero-interest rate, and some are in the minus. But when the long rate goes up and the short rate goes up at the same time, the short rate goes up immediately. But long-rate interest income will not rise because it’s a long bond with a fixed, low interest rate. So at some point, depending on the speed of increase in short rates and long rates, it's possible that negative cash flow could happen -- negative seigniorage.

Sakurai: In that case, what's the maximum loss we should expect?

Ito: Worst case scenario, according to my calculation, is around 7 trillion yen, which is more than BOJ capital. But you could make the case that that could be replenished with future, positive seigniorage.

Sakurai: What should the BOJ do?

Ito: Follow the Federal Reserve strategy, which is to slowly increase interest rates, and slowly shrink the balance sheet, and manage those excess reserves and the asset side carefully. It will probably take 10 years to get those problems solved and get back to a normal balance sheet. It’s a narrow path, but there is a way to a successful exit. The key is to make it gradual, right? A gradual increase in, probably, long rates first...so that replaces the low-coupon bonds with higher-coupon bonds, so they can maintain a sort of positive yield on those asset and liability sides, and maintain those positive slopes on the yield curve. Then, both [start] shifting up. It depends how you simulate those scenarios, but you can contain the losses from the negative spread to maybe up to 2 trillion yen, minus 2 trillion yen, for a year and maybe sustain that for 3 to 4 years.

Sakurai: Let me just touch on former Federal Reserve chair Ben Bernanke’s idea of temporary price-level targeting. What are your thoughts on that?

Ito: First of all, how is this concept different from inflation targeting? In terms of inflation targeting, if you underachieve the 2% line, then you start from there, which means that temporarily the inflation rate needs to be higher than 2% to catch up with the long-term 2% line. Price-level targeting is actually very similar to what Governor Kuroda already mentioned..."overshooting." Overshooting is when the inflation rate reaches 2%, and you allow it to overshoot to 3% or 4% before you go back to 2%. This is identical to what I explained as price-level targeting. Whatever Bernanke was advocating, Governor Kuroda had already implemented. This was at the same time that YCC was introduced, in September 2016.

Sakurai: How do you see Japan’s fiscal health? Do you think the consumption tax hike should be implemented as scheduled?

Ito: Japan's fiscal deficit is around 6% of its GDP, and debt-to-GDP ratio is about 240%. This is the worst among the advanced countries, in history. And the only way to balance the budget is economic growth, and the tax-rate hike. If Japan wants to maintain good social security up to the European standard, then I think we need a European standard tax rate. So the plan to increase by 2 percentage points in 2019 is only the first step toward fiscal consolidation. Baby boomers will be aging, and it’s necessary to find ways to pay pensions and medical expenditures, which are rising very fast.

Sakurai: We’ve seen 5 years of Abenomics. What more is needed?

Ito: I think serious structural reform is not progressing fast enough. Yes, it’s moving in some parts, like inviting women to work. I think the participation rate has risen tremendously. But the mobility of workers is still not realized, so there is a redundant mismatch of the middle-aged and those near retirement age. That part is not moving. That is a waste. And also the usage of IT and AI is still not spreading fast enough. I think, in that aspect, Japan is lagging behind even China and US.
There’s still a lot of room for progress.