Why Has Japan Failed to Escape from Deflation?

• DOI: http://doi.org/10.1111/aepr.12197
• Date: 01 January 2018
• Published date: 01 January 2018

Why Has Japan Failed to Escape from

Deflation?

Kota WATANABE

1

and Tsutomu WATANABE

2

†

1

Canon Institute for Global Studies, University of Tokyo and

2

University of Tokyo

Japan has failed to escape from deflation despite an extraordinary monetary policy easing over

the past 4 years. Monetary easing undoubtedly stimulated aggregate demand, leading to an

improvement in the output gap. However, since the Phillips curve was almost flat, prices have

hardly reacted at all. Against this background, the key question is why prices were so sticky. To

examine this, we use sectoral price data for Japan and seven other countries including the USA,

and use these data to compare the shape of the price change distribution across the eight coun-

tries. Our main finding is that Japan differs significantly from the other countries in that the

mode of the distribution is very close to zero for Japan, while it is near 2% for other countries.

This suggests that while in the USA and other countries the “default”is for firms to raise prices

by about 2% each year, in Japan the default is that, as a result of prolonged deflation, firms keep

their prices unchanged.

Key words: deflation, inflation expectations, inflation norms, menu cost models, Phillips curve,

sectoral price data

JEL codes: E31, E5

Accepted: 12 July 2017

1. Introduction

From the second half of the 1990s, Japan has suffered a period of prolonged deflation,

in which the consumer price index (CPI) has declined on a trend. During this period,

both the government and the Bank of Japan (BOJ) have tried various policies to escape

from deflation. For instance, from 1999 to 2000, the BOJ adopted a “zero interest rate

policy”in which it lowered the policy interest rate to zero. This was followed by “quan-

titative easing”from 2001 until 2006. More recently, in January 2013, the BOJ adopted

a“price stability target”with the aim of raising the annual rate of increase of the CPI

to 2%. In April 2013, the BOJ announced that it was aiming to achieve the 2% inflation

We would like to thank Kosuke Aoki, Christian Broda, Ippei Fujiwara, Hideo Hayakawa, Kazuo

Monma, Roberto Rigobon, Shigenori Shiratsuka, Kazuo Ueda, Hirohide Yamaguchi, Hiroshi

Yoshikawa, and David Weinstein for valuable comments on earlier versions of this present

paper, and Takuto Murase for preparing part of the dataset used in the present paper. This

research forms part of the project on “Understanding Persistent Deflation in Japan”funded by a

JSPS Grant-in-Aid for Scientific Research (No. 24223003).

†Correspondence: Tsutomu Watanabe, Graduate School of Economics, University of Tokyo,

7-3-1 Hongo, Bunkyo-ku, Tokyo 113-0033, Japan. Email: watanabe@e.u-tokyo.ac.jp

© 2018 Japan Center for Economic Research 23

doi: 10.1111/aepr.12197 Asian Economic Policy Review (2018) 13, 23–41

target within 2 years and, that in order to achieve this objective, the BOJ introduced

quantitative and qualitative monetary easing (QQE), which sought to double the

amount of base money within 2 years. Furthermore, in February 2016, the BOJ intro-

duced a “negative interest rate policy,”in which the BOJ applies a negative interest rate

of minus 0.1% to current account deposits held by private banks at the BOJ. This was

followed in September 2016 by the introduction of “yield curve control,”in which the

BOJ conducts operations using Japanese government bonds (JGB) so as to keep the

10-year JGB yield at 0%. Table 1 contains an overview of recent policy decisions made

by the BOJ between 2013 and 2016.

However, these efforts by the BOJ to escape from deflation have not been successful.

That is, while the annual rate of change in the CPI (excluding fresh food) did initially

turn positive, price developments have subsequently weakened again. Specifically, after

leaving negative territory and returning to zero in May 2013, the annual rate of change

in the CPI turned positive in June 2013 and rose to 1.5% by April 2014 (excluding the

effects of the consumption tax hike in April 2014). This was a direct consequence of the

depreciation of the yen in 2012–2015 when the yen depreciated about 40% vis-á-vis the

US dollar from 78 yen/dollar in 2012 to 125 yen/dollar in 2015), a depreciation which

was induced by the BOJ’s monetary easing. However, since then, inflation has gradually

slowed as consumption demand declined. If the effect of the consumption tax hike is

excluded, inflation has fallen to under 1% since October 2014. Given this, it looks

unlikely that the BOJ’s 2% target will be achieved in the foreseeable future.

This present paper investigates why it has been so difficult for Japan to escape from

deflation. To do so, we focus on the fact that Japan’sdeflation since the mid-1990s has

consisted of an extremely mild decline in prices. The largest annual decline of the CPI

for any month during this period was only around 2%, and for the period as a whole

the average annual decline was slightly less than 1%. Therefore, even though it was

deflation, it was very mild and did not turn into the kind of severe deflation one might

Table 1 Monetary policy decisions made by the Bank of Japan in 2013–2016

January 22, 2013 Joint statement by the Government and BOJ on overcoming deflation

and achieving sustainable economic growth was released. BOJ set an

inflation target of 2%

April 4, 2013 BOJ introduced Quantitative and Qualitative Monetary Easing (QQE)

BOJ decided to double the monetary base to achieve the 2% inflation

target with a time horizon of about 2 years

October 31, 2014 BOJ expanded QQE by increasing its annual net purchases of JGB from

50 trillion yen to 80 trillion yen

January 29, 2016 BOJ decided to apply a negative interest rate of minus 0.1% to part of

BOJ current account balances

September 21, 2016 BOJ decided to use yield curve control with the target level of 10-year

JGB yields set to zero

BOJ, Bank of Japan; JGB, Japanese government bonds.

Escape from Deflation Kota Watanabe and Tsutomu Watanabe

24 © 2018 Japan Center for Economic Research