On March 19, Bank of Japan (BOJ) Governor Fukui’s term expired, with Prime Minister Fukuda and the upper house of the Diet unable to agree on a successor. In the interim, Masaaki Shirakawa, an able and respected former BOJ official who has been confirmed as deputy governor, will serve as acting governor. This political stalemate, if it were it to continue, would be most unfortunate because Japan, not to mention the global economy, needs the BOJ to continue to build on the engaged and dynamic role it has played under Governor Fukui.

Japan has just begun, in the past two years, to emerge from a ‘lost decade’ that included three recessions and debilitating deflation. While deflation in Japan may appear to have been defeated, it is too soon, we believe, to predict an enduring victory. Sound BOJ policy choices by the next Governor, in what is proving to be a turbulent and challenging global financial environment, will be required to put Japan on a sustainable path of well-anchored inflationary expectations. Similarly, while the Japanese economy has grown at or above trend for each of the past five years and appears to be better diversified away from its historical reliance on U.S. exports as an important source of domestic demand, the jury is still very much out with regard to how much Japan and the global economy can and will decouple as the U.S. economy stumbles into a recession. Under these circumstances, decisive BOJ leadership will be required to steer the Japanese economy away from recession with very limited room available to maneuver, given the current policy rate of 0.50% and zero lower bound constraint that the BOJ faces.

The BOJ’s primary focus during Governor Fukui’s tenure was to pull Japan out of a debilitating deflation. Clearly, it was impossible as a practical matter for the BOJ to anchor material, positive inflation expectations so long as actual prices continued to fall, as they did from 1997 through 2005. Since 2005, CPI inflation has been positive, but just barely, averaging just 0.1% per year.

How did the BOJ bring deflation to an end?
Governor Fukui played a significant role in stepping up monetary policy easing and financial system stabilization and helped the economy eventually exit from deflation. Although the BOJ’s unconventional Quantitative Easing Policy (QEP) was initiated back in 2001 under former Governor Hayami’s regime, it was enhanced by Governor Fukui’s leadership and became a very effective monetary policy tool when the policy rate was already at zero. The most powerful and innovative instrument in QEP was the BOJ’s pre-commitment to future monetary policy. The so-called “policy duration effect” of this pre-commitment strategy was observed in financial markets as a lower term premium and credit risk premium. The bank’s pre-commitment statement originally started in 1999 under Governor Hayami’s regime and became more explicit, and therefore more powerful, when Governor Fukui’s regime clarified necessary conditions to exit from QEP in October 2003. While it is debatable whether excess liquidity provided by the BOJ itself had a significant portfolio rebalancing effect, it probably had some signaling effect on market participants, which helped reduce the risk premium in the financial markets.

The BOJ’s challenge was not only monetary easing under the constraint of non-negative policy rates, but also to stabilize a financial system that was non-functional because of a capital crunch. Though the size was insignificant, the BOJ’s purchases of equities from banks were a kind of back-door capital injection that effectively re-capitalized the troubled banking system as it helped reduce banks’ risk assets. Outright purchases of asset-backed securities were also meant to supplement the poorly-functioning banking system.

Challenges for a New BOJ Governor
The new BOJ Governor is likely to face a number of significant challenges once appointed. First, the new Governor will need to sustain and enhance the credibility of the BOJ’s monetary policy. The BOJ can take much credit for stopping Japan’s deflationary spiral with aggressive monetary easing and financial stabilization initiatives, and delivering the innovative and transparent post-QEP framework. Nonetheless, it is hard to disagree that current levels of inflation statistics and financial markets suggest that Japan faces a continued risk of mild deflation. Excluding food and energy prices, core inflation is still negative in Japan, and expectations inferred from the inflation linked bond market in Japan confirm that the public and the financial markets currently do not expect inflation over the next 10 years to average even 0%. After adjusting for the risk and term premium, underlying expected inflation in Japan is actually negative.

 While the new post-QEP policy framework is revolutionary in terms of its transparency with the numerical definition of price stability, it relies heavily on the bank’s ability to forecast future inflation statistics and therefore gives the bank much discretion in policy making. It remains questionable whether the BOJ has fulfilled its obligation of  accountability on its post-QEP policy decisions to hike rates. It seems to us that rate hike decisions were driven more by the bank’s strong bias to “normalize” its monetary policy, rather than by its forecast (regardless of how accurate it turned out to be). To preemptively normalize monetary policy, the BOJ needs to have its own inflation forecast for the next few years clearly well inside the price stability range and needs to communicate it with the market.

Second, the new Governor will likely face two different states of the economy in his five-year assignment, in our view, and therefore will need a high level of maneuverability to cope with different types of risks in each state of the economy.

If our current assessment that the Japanese economy still remains at risk of a mild deflation is right, the BOJ’s near-term policy will need to be focused more on downside than upside and to be more reflationary. With external and internal demand both likely to slow materially, we forecast that Japan’s GDP growth will remain well below its potential on a cyclical horizon. As a result, with the output gap remaining deflationary, the core-core CPI (excluding fresh food and energy) will not rise much. A “tail-risk” for the BOJ in the cyclical horizon therefore is that Japan’s economy will remain stuck in mild deflation for a prolonged period and even the current monetary policy stance will become too restrictive. It is the BOJ, not any other central bank, which should best understand from its own experience how large deflation costs can be when the policy rates are at or close to zero bound constraint.

Over the longer horizon or towards the end of the new Governor’s five-year term, we think that the global economy will be inflationary rather than disinflationary and that Japan’s economy should also be rather inflationary because of that. We believe that the global economy has the potential to grow at 4-5% on average, much of which will be led  by high growth in emerging economies. Domestic demand in emerging economies, particularly infrastructure investment, can be a new source of global inflation. The Chinese labor force, too, will have a less disinflationary impact than the last decade as it becomes more integrated with the global labor market. With this backdrop of global secular inflation, the BOJ may finally see a much better chance of normalizing its monetary policy. Yet, careful examination and open communication of Japan’s neutral rates will become more critical, given that demographic and fiscal challenges will then become more intensified.

The BOJ improved its transparency under Governor Fukui’s regime, and these efforts need to continue under the new Governor. The bank’s efforts to improve transparency started with its clarification of necessary conditions to exit from QEP in 2003 and became more evident in their post-QEP framework with a so-called “two-pillar” approach and a numerical definition of “price stability.” The two-pillar approach has a risk-management nature in a forward-looking manner and conceptually fits with global trends in central banking. Numerically defining price stability should be recognized as a major achievement in the BOJ’s history, as doing so was once rejected under Hayami’s regime in 2000.

Who Should Be the Next Governor?
There are several key considerations that should inform the decision of who will be the next BOJ Governor. These include: Who will be able to credibly reflate the Japanese economy? Who will be able to communicate BOJ policy to financial markets in a way that has a maximum impact on the economy? Who will be able to absorb, distill, and navigate the many and varied complex international linkages in trade, investment, and financial markets that are certain to impact and complicate monetary policymaking in Japan in the coming years? Fortunately, Japan is blessed with a number of individuals, including Mr. Shirakawa himself, who have the background and experience required to achieve these crucial tasks.

The next BOJ governor must have (or quickly earn) the credibility to continue the process of monetary reflation undertaken by Fukui. This will require not only skill, but also understanding of and recognition by workers, firms, and financial markets not only in Japan but globally. It is time for the political battles to cease. Japan, not to mention the global economy during these turbulent times, needs a Governor at the BOJ.