The Difficulty of Discerning What's Too Tight: Taylor Rules and Japanese Monetary Policy

Kenneth Kuttner () and Adam Posen

No WP03-10, Working Paper Series from Peterson Institute for International Economics

Abstract: Observers have relied increasingly on simple reaction functions, such as the Taylor rule, to assess the conduct of monetary policy. Applying this approach to deflationary or near-zero inflation environments is problematic, however, and this paper examines two shortcomings of particular relevance to the Japanese case of the last decade. One is the unusually high degree of uncertainty associated with potential output in an environment of prolonged stagnation and deflation. Consequently, reaction function-based assessments of Japanese monetary policy are so sensitive to the chosen gauge of potential output as to be unreliable. The second shortcoming is the neglect of policy expectations, which become critically important as nominal interest rates approach zero. Using long-term bond yields, we identify five episodes since 1996 characterized by abrupt declines in Japanese inflation expectations. Policies undertaken by the Bank of Japan during this period did little to stabilize expectations, and the August 2000 interest rate increase appears to have intensified deflationary concerns.

Keywords: Deflation; Monetary Policy; Policy Rules; Taylor Rule; Japan (search for similar items in EconPapers)
JEL-codes: E31 E42 E52 F41 (search for similar items in EconPapers)
Date: 2003-12
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Journal Article: The difficulty of discerning what's too tight: Taylor rules and Japanese monetary policy (2004)
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