Japan's Monetary Policy in the 1990s and Implications

It can be seen that the lingering slump and deflation that gripped Japan in the 1990s were basically triggered by the failure to deliver appropriate policies to support its weak demand. Based on optimistic views on economic conditions in the early days of the recession, the Japanese government chose to continue to respond with laid-back policies, and as a result, it failed to prevent long-term slump and deflation from arriving. Its policy authority did miss the early signs of deflation, and underestimate the risks to be caused by misjudgement. The monetary policy, in particular, was deemed to have remained somewhat idle in the effort for economic and price stability and apparently overlooked the impacts to be caused by drop in inflation expectations among economic agents. The Bank of Japan at that time was not fully conscious of core objectives of monetary policy, and thus it failed to make timely preparations with regards to clear criteria and operating system for price stability. Korea as well has witnessed a continuation of slow growth and falling inflation for a considerable period and the possibility of deflation cannot be ruled out. Inflation continues to hover around 1%, running far below the targeted goal over the past several years, while GDP deflator growth rate recently plunged close to 0%. It is now essential for the monetary authority to present strong commitment and take appropriate actions to comply with the inflation target so that continued low inflation will not lead to downward anchoring of inflation expectations among market participants. Given that falling inflation expectations might attenuate the stimulus effect of the cut in the nominal interest rate, it is important for the monetary policy to make a very strong commitment to complying with the inflation target. Once deflation is fixed, it will cause severe negative impacts on financial debts and fiscal situation and also limit the use of available policy methods, implying that responsive measures to remove the possibility of deflation need to be developed in advance as a preparation. Lessons learned from Japan’s experiences are the necessity to prepare for asymmetric risk in inflation and deflation and the need for monetary easing policy that could be initiated promptly in the case of a deflation scenario. Above all, it should be noted that when the monetary authority fails to reflect the downward trend of ‘natural real rate of interest’ resulting from a drop in potential growth rate or implements interest rate policy without noticing a decrease in inflation expectations, deflation risk might loom large