The Bank of Japan is basing its monetary policy on Peter Pan. The Financial Times reports that Governor Kuroda opened a recent conference by arguing that 'the power of conviction was among the best tools in a policy maker's tool kit':
I trust that many of you are familiar with the story of Peter Pan, in which it says, 'the moment you doubt whether you can fly, you cease to be able to do it.'
He is completely correct, although there are those who think the Bank of Japan can't possibly meet its stated aim of pushing up inflation. Indeed, we have had monetary policy-makers themselves claim that expansionary policy seems to be having little effect. But if the Bank of Japan has the conviction that it can increase inflation through engineering a boom in economic activity, it will. Why am I so confident? One reason is that we've seen this show before, although in reverse.
In the 1970s, many commentators, and indeed policy-makers themselves, doubted central banks' ability to push inflation down. In 1972, the Economic Report of the President (as cited by Christina and David Romer in an excellent paper) raised the possibility of a:
...tendency to an unsatisfactorily high rate of inflation which persists over a long period of time and is impervious to variations in the rate of unemployment, so that the tendency cannot be eradicated by any feasible acceptance of unemployment.
Federal Reserve Chairman Arthur Burns also seemed to think monetary policy was impotent. According to the Minutes of the June 8 1971 FOMC meeting, Burns thought (again, h/t to the Romers): [fold]
...the old rules were no longer working...Years ago, when business activity turned down, prices would respond with some lag, not by rising more slowly but by declining; and wages would follow. That kind of response had become progressively weaker after World War I, and of late one found that at a time when unemployment was increasing prices continued to advance at an undiminished pace and wages rose at an increasing pace...Time and again economists had hoped that the old business cycle would reassert itself in the sphere of prices and wages...However, he had now come to the conclusion that the response had changed.
This view was held in the late 1970s as well. The Economic Report of the President in 1978 stated:
Recent experience has demonstrated that the inflation we have inherited from the past cannot be cured by policies that slow growth and keep unemployment high.
This all proved to be incorrect. In the US, Paul Volker was appointed Chairman of the Federal Reserve in 1979 and subsequently, monetary policy was aggressively tightened. As a consequence, unemployment went up and inflation came down. The old rules still applied; all it required was the Fed to have the conviction to see the disinflation through. The Bank of Japan has taken some bold steps to increase inflation. It may be that they need to do more. But if they are determined enough, like Peter Pan, inflation will increase. They just need to remember some simple words from Milton Friedman:
...inflation is always an everywhere a monetary phenomenon.