Japan’s monetary and fiscal policy are at odds with each other

The Bank of Japan (Japan’s central bank) and the Japanese government seem to be moving in opposite directions with regard to monetary and fiscal policy. On the one hand you have the Bank of Japan exiting its long-running experiment with ultra-loose monetary policy (low interest rates) with a depreciating currency (yen) rising bond yields and persistent inflation. Therefore the economy is preparing for positive interest rates which is normal for monetary policy. On the other hand you have the government implementing an expansionary fiscal policy.

Japan has a headline inflation rate above 2% for many months but there could be a delay in tightening as a lot of the pressure on prices is imported with local wages still not rising to match the inflation target over the long term. Also whilst inflation can be tackled with higher interest rates Japan has little chance to cut rates if prices undershoot. Consequently it makes sense to have a tighter monetary policy with the chance of higher inflation.

Adapted from CIE A Level Revision Book – Susan Grant

What is perplexing is the government’s expansionary fiscal policy which is estimated to be 3% of GDP. It consists of large tax cuts and rebates for households which appears to be more political than economic as an unpopular government is trying to please an unhappy electorate. Over the last 30 years Japan has required huge fiscal stimulus to achieve positive economic growth and avoid the risk of deflation. A positive inflation rate means that the business cycle could be managed by using interest rates and therefore less pressure on the government budget deficit to keep the economy going – injecting money in the circular flow of the economy.

Adapted from CIE A Level Revision Book – Susan Grant

Although it remains important for the central bank to avoid tightening monetary policy too early it seems irrational that the government should implement an expansionary fiscal policy. This makes the Bank of Japan’s job even harder and also uses up fiscal ammunition in the event of a global downturn.

Source: Japan’s fiscal and monetary policies are moving in opposite directions – FT November 10th 2023

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