On Target

It looks like Bank of Japan is boarding the Abenomics train at last

Reuters reports that the Bank of Japan shook hands with prime minister Shinzo Abe’s government on a point of dispute today: inflation targeting.

Yep—after punting on the issue in their meeting last December, the central bank is backing down and agreed today to a 2% inflation target as a policy goal for monetary loosening, up from the current 1%. The bank will formalize this plan in its two-day meeting next week, which ends Tuesday.

This is a big deal. It’s good for Abe’s push to move the economy into inflationary territory, which is critical to stimulating household and business spending. Plus, the markets love it: Nikkei 225 leapt 2.8% today. Meanwhile, the yen has been hovering around the symbolic 90-to-the-dollar mark, which Abe has been shooting for in his bid to improve the competitiveness of Japanese exports.

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But it’s also noteworthy because politicians are one kind of borrower with whom bankers are never supposed to shake hands. This synch-up of the government and the central bank is controversial because, as we touched on recently, central bank independence is a check against profligate government spending made possible by “monetizing government debt.” Lifting this curb could, in theory, allow a government to spend itself into bankruptcy. In this case, Japan issues its own currency and its own debt—and has the third-largest economy in the world—making a solvency crisis, at this point, theoretical.

Theoretical for now. Abe’s scorched-earth approach to both fiscal and monetary stimulus will soon drive Japan’s government gross debt beyond 240% of GDP, by some estimates. At some point, of course, theory has to give way to the reality of having to pay all that back—and at market-set interest rates. And unfortunately for Japan, there are many things that could trigger that.

The bigger deal still, though, will be whether the BoJ announces open-ended purchasing of government and other debt on Tuesday. In its perpetual inflation-phobia, the bank has so far declined to do that—a stance that is thought to have dampened the effectiveness of a monetary policy that has otherwise been wantonly loose, as investors and businesses fear a sudden reversal in policy that could send interest rates up.

Despite the dangers of Abe-BoJ cooperation, Japan desperately needs to escape the deflationary spiral it’s been in for most of the last two decades. BoJ’s move today is a crucial step in making that happen, and a commitment to open-asset purchases will put the money where the BoJ’s 2% target-mouth is.

That means that the upshot of the growing government-BoJ cuddliness is that, increasingly, fiscal prudence and a focus on structural economic reform (e.g. privatization) will fall to Abe alone to prioritize.

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