The Bank of Japan's inflation dilemma

Column by Sébastien Lechevalier, Professor at Ecole des Hautes Etudes en Sciences Sociales (EHESS, Paris) and International Senior Fellow at the Canon Institute for Global Studies (CIGS, Tokyo).

Japan, faced with a (weak) surge in inflation, is reluctant to wield the weapon of higher interest rates, analyzes Sébastien Lechevalier in his column.

Column. After more than two decades of moderate deflation (prices fell by an average of 0.5% a year), Japan, like all OECD countries, is experiencing the return of inflation, albeit at a much lower level (around 2%, compared with around 5.5% in France since April 2022). In the Japanese context, this is good news - for macroeconomic equilibrium, less so for individual consumers - since the 2% inflation target had been at the heart of monetary policy objectives since the early 2000s.

But this return has consequences for the dynamics of public debt, which today represents over 250% of gross domestic product in Japan, compared with around 110% in France and 66% in Germany. Against this backdrop, how should economic policies evolve? Should the Bank of Japan (BoJ) end its ultra-easing monetary policy? Should the Japanese government embark on a process of fiscal consolidation?

These questions were at the heart of a conference organized in Tokyo on Monday December 11, 2024 by the Canon Institute for Global Studies in collaboration with the Banque de France, "Inflation and public debt dynamics in a new environment: EU-Japan perspectives", at which Japanese and French economists and policymakers debated these issues.

Over 90% of debt held domestically

Since the economic slowdown of the early 1990s, Japan has accumulated public deficits, leading to record levels of debt. But unlike France, over 90% of this debt is held by domestic players. Today, it is the BoJ that owns more than 50%, after a decade of extremely flexible monetary policy that saw the BoJ finance the issuance of this debt.

As a result, a problem clearly identified by Waseda University economics professor Junko Koeda has emerged: the return of inflation will eventually be accompanied by a rise in interest rates, leading to an increase in the debt burden. The BoJ and the Japanese government have thus linked destinies. In particular, the BoJ has contributed to debt sustainability, even though in theory its mandate is limited to price stability.

However, as Takeo Hoshi from the University of Tokyo reminded us, the key factor is the relationship between the interest rate (r), which determines the cost of new debt issues, and the growth rate of the Gross Domestic Product (g), which impacts tax revenues. When r-g is negative, as has been the case in Japan for over twenty years, there is no problem of debt sustainability.

What lessons can we draw for France and Europe?

But this is no longer the case. And since raising the growth rate is far more difficult and uncertain to achieve than keeping interest rates low, it's easy to understand the BoJ's current dilemma when it comes to deciding whether or not to raise key interest rates. What lessons can we draw for France and Europe?

The first is that inflation is not the magic wand that will allow governments to stop worrying about deficits and public debt. The second, and more important, is the need for coordination between two independent economic policy bodies: the government, responsible for fiscal policy, and the central bank, responsible for price stability.

The issue is complicated for several reasons. Firstly, the dynamics are not independent of each other, as we have seen. Secondly, better coordination should not mean subjugation of one to the other. Finally, the caricatured opposition between rigorous central bankers and governments overly sensitive to public opinion needs to be overcome: the work of the newly-formed OECD expert group on the acceptability of reforms shows that coordination between the two helps to limit the influence of populism.