Last month, the Bank of Japan (BOJ) took its first step in the ‘normalisation’ of monetary policy. It raised the Bank’s short-term policy interest rate from negative 0.1 per cent to 0–0.1 per cent and ceased most of its unconventional quantitative and qualitative easing (QQE) measures.

Lifting interest rates even by a miniscule 10 basis points certainly heralded a new era in Japanese monetary policy, as policy shifted in the direction of tightening credit for the first time in seventeen years.

After two decades of wishing to create inflation, the BOJ finally signalled that it might need to control it.

Milton Friedman famously characterised inflation as ‘always and everywhere a monetary phenomenon’. What he meant was that inflation could be sustained only when monetary accommodation was behind it. Monetary accommodation is provided by loose central bank monetary policy. If inflation is to stop, the central bank should change its policy. His view, which came to be known as monetarism, can be summarised in two words — ‘money matters’. Not all economists agreed with Friedman’s monetarist economics, but most of them accepted that there was a close link between inflation and monetary accommodation. Many believed that the opposite must also be true — that deflation was a monetary phenomenon and a stronger monetary accommodation was its cure.

Anyone familiar with the basics of logic knows that the opposite of a true statement is not necessarily true. The experience of advanced economies since the Global Financial Crisis demonstrates this. The balance sheets of their central banks, called ‘high-powered money’, expanded enormously. But inflation picked up only moderately, if at all. It was a testament to the traditional dictum that monetary policy is like a rein — pulling it slows down the horse, but pushing on it does not make it run faster.

Nowhere has this dictum been more evident than in Japan. The BOJ’s balance sheet has seen an unprecedented expansion since 2013 under its QQE measures, much more than for the central bank of any other advanced economy central bank. But it failed to ignite a surge in demand and inflation, because the money the BOJ supplied stayed idle in banks’ deposit accounts with the BOJ.

Banks did not suffer because of this as the opportunity cost of holding idle balances — short-term interest rates — was zero per cent. High-powered money turned out to have little power to generate economy-wide money growth and its impact on the economy was at best limited.

The BOJ resorted to several unconventional measures under QQE to kick-start the economy, such as purchases of exchange-traded funds, real estate investment trusts, corporate bonds, commercial paper and resort to a negative interest rate from 2016. None of these led to a clearly visible result. Inflation above the BOJ’s 2 per cent target occurred in 2022 — but this was mostly due to the weak Japanese yen, attributed not to QQE but the Federal Reserve Board’s monetary tightening.

Still, the BOJ has been cautious in normalising its policy.

Unlike money supply that proved to have very limited effects on the economy, interest rate adjustments affect firms’ and households’ behaviour. Interest rates unquestionably matter, but the change so far is a baby step. A 10 basis point increase, combined with the BOJ’s comment that accommodative financial conditions will be maintained for the time being, is unlikely to have any visible impact. In fact, instead of rebounding, the Japanese yen’s exchange rate depreciated after the policy change.

Whether the BOJ makes further policy adjustments depends on the prospect of future inflation. According to the BOJ’s quarterly outlook report, CPI inflation is expected to remain above 2 per cent through fiscal year 2024 and decelerate in fiscal year 2025.

If this forecast is to be trusted, the baseline scenario is that interest rates will remain extremely low for some time to come. There is an upside risk to this scenario. But if we recall the dictum that monetary policy is like a rein in controlling inflation, it is better for the BOJ to err on the side of higher-than-target inflation and tighten once that risk materialises.

If the BOJ adopts this strategy, it is the government, which has accumulated a staggering amount of debt, that should be the most worried. High inflation increases its tax base — nominal GDP— but it may raise its funding costs (interest rates) more, squeezing government finances. The Japanese government should prepare for this by cutting stop-gap fiscal measures introduced to appease the public who’ve cried foul over inflation.

The task of inflation management does not belong to the government, but is best assigned to the central bank.

Masahiko Takeda is Senior Fellow in the Australia–Japan Research Centre at the Crawford School of Public Policy, The Australian National University and teaches at Keio University in Tokyo.