The Bank of Japan has been pumping money into the economy and has kept interest rates at almost zero (ZIRP). At the same time they have been gathering evidence that deflation is finally on the verge of being overcome. And the prognosis for the economy is that it will keep expanding too. Indeed, if forecasters are correct, fourth-quarter 2005 gross domestic product growth (to be released on Friday) will outpace the U.S. and EMU. The Bank has focused on providing banks with plentiful reserves to encourage lending - a policy known as quantitative easing - as it struggled to overcome deflation. Current policy targets reserves made available to lenders at between ¥30 trillion and ¥35 trillion.

The Bank has pledged to stick with its current policy until core consumer prices, which exclude fresh food but include energy, stop falling for at least a few months and policy makers are sure they will not resume sliding. Core consumer prices edged up 0.1 percent on the year in both November and December. This was the first time in almost eight years that core prices have increased for two months in a row. The Bank of Japan's key interbank overnight loan rate has been near zero since March 2001.

After its monetary policy meeting last week, BoJ Governor Toshihiko Fukui, indicated that the Bank would seriously consider a policy change at future meetings should consumer prices continue to rise - although the timing for a policy change is undecided. (Their next meeting is scheduled for March 8th and 9th.) The BoJ reiterated that it would end its quantitative easing only when on-year changes in core CPI are positive and no other factors warrant keeping the policy in place. Furthermore, Fukui didn't say how the BoJ would signal such a move or other future moves. And fundamental questions such as increased transparency and flexibility have not been decided by monetary board members either.

Although the country's asset bubble burst 15 long years ago, the most dominant feature of the economy for over seven years has been grinding deflation. So it is a momentous occasion to think that even minimal inflation could be returning, especially now given growing evidence the economy is pulling itself out of its long slump. And with the improving economy the Bank of Japan has been vocal in saying that soon it would stop flooding the banking system with excess liquidity. The BoJ thinks the output gap between what can be produced and actual production is narrowing fast. And this could lead to inflationary pressures. The bank is also worried that speculative bubbles might already be starting to form in some asset markets like the stock market.

But Prime Minister Junichiro Koizumi's government thinks otherwise and has been threatening the Bank with a loss of independence among other things. The Bank only became independent of the Ministry of Finance in 1997, less than 10 years ago. Heizo Takenaka, internal affairs minister and Koizumi's chief reformist ally, said recently that monetary policy was not the Bank of Japan's alone to make, but rather it should be made in partnership with government. Further, he said that should the Bank end its current easy monetary policy, the Bank's independence could be discussed in the political arena. Not to be outdone, the ruling Liberal Democratic Party (LDP) has formed a new monetary policy panel which is headed by a fierce Bank critic, Kozo Yamamoto.

There are signs that Bank policy could become a political issue as potential candidates try to establish their economic and fiscal credentials in the race to succeed to Koizumi when his term as prime minister ends in September 2006. One of the government's chief concerns has to do with burden sharing. Koizumi is committed to slashing debt issuance in order to plug a big budget deficit, and a 2007 increase in the sales tax looks increasingly likely. Plans for deregulation of the Post Office for example could weigh on economic activity. The government does not want the bank to stop its huge monthly purchases of government bonds, equivalent to about 40 percent of all debt issuance. A sudden end to those purchases would push bond yields up - as well as the government's debt service costs.

A bone of contention - inflation targeting
Governor Fukui is opposed to inflation targeting, which has been advocated by some Japanese lawmakers, saying it is difficult to calculate a 'desirable' rate of inflation. Japan's ruling party policy chief, Hidenao Nakagawa, has urged the BoJ and the government to have a policy accord that includes a 2 percent CPI inflation target once prices start rising again.

Takenaka wants the Bank to hold off until deflation is proven to be over by one of the toughest standards of measure, the GDP deflator. Hidenao Nakagawa, the LDP's policy research council chief, has demanded the BoJ link its policy to nominal GDP growth or adopt an inflation target. The gap in debate is between some government officials who are looking at the current economic climate and the Bank policymakers who are looking at possible price and growth pictures in the months ahead. Nakagawa has even threatened to alter the law governing the BoJ's independence if the bank switches too quickly to a more neutral position. In response, Kaoru Yosano, who replaced Takenaka as the minister of economic and fiscal policy in October, has warned against meddling in monetary policy.

Fearing any sign of confrontation would hurt financial markets, Tanigaki has stressed that the government and the BoJ roughly share the view that a monetary policy shift must come after a close check-up on the pulse of the economy. For his part, Takenaka has challenged the BoJ, saying it must set a clearer policy target that makes its policymakers accountable for their decisions. For its part, the Bank appears to be moving toward agreeing on an approach that would set a loose, medium-term target for the CPI. The BoJ has been telling the government that stimulus from the quantitative easing will remain and become even stronger after it is lifted because real interest rates will fall as consumer prices post gradual gains.

Bottom Line
In a time when all central banks are becoming more forthcoming about policy decisions, the Bank of Japan is under growing pressure to find a transparent and reliable target for its monetary policy before it shifts from the current ultra-expansionary quantitative credit easing sometime next year. The central bank and the government share the ultimate goal of achieving sustained economic growth under stable prices, but they are focused on different types of data in analyzing how deflation is fading in Japan after years of constant price drops.