Q&A: Bank of Japan's inflation target

Shoppers at a store in Tokyo
Image caption Falling consumer prices have been a big hurdle to Japan's attempts to boost domestic consumption

Japan has an inflation problem - it does not have enough.

Instead, for almost two decades, the country has suffered from on-and-off deflation, or falling prices.

On Tuesday, in an effort to draw a line under the years of deflation, the central bank agreed to double its inflation target to 2% and to keep spending until things have turned around.

Who cares about inflation?

It is one of the most important economic indicators that a country's authorities and financial analysts look at.

Inflation indicates, in percentage terms, the rate at which prices of goods and services increase each year.

How big a problem inflation is, is a vexed question among economists.

Most agree that inflation gets out of control - as it did in most industrialised countries in the 1970s - that can create uncertainty and undermine confidence in the economy. That is why most central banks are tasked with keeping a lid on inflation.

Japan's problem is the opposite - its inflation appears to be too low.

Why is this target important for Japan?

Unlike other economies in the region, Japan has actually been battling deflation, or falling prices , for the best part of a decade.

And while that may sound good for bargain hunters, and perhaps even more importantly for Japan's ageing households receiving fixed pension incomes, if prices continue to fall for a prolonged period, it actually has a negative psychological and business effect, some economists argue.

Consumers and companies tend to put off purchases in the hope of getting a cheaper and better deal later on. At the same time, deflation eats into the value of homes, increases the cost of investment credit for corporations, reduces profits and even wage packets.

Perhaps Japan's biggest headache is that deflation makes it much harder for heavy borrowers, such as companies and the government, to outgrow their existing debts.

The total value of Japan's economic output measured in yen did not increase at all between 1991 and 2011, because increases in the volume of output during the two decade period were entirely offset by falling prices.

According to the new government, deflation is the biggest hurdle to Japan's efforts to boost domestic consumption.

In November, Japan's core consumer prices index, which excludes fresh food, fell 0.1%.

Is this the first time Japan has set such a target?

The central bank, the Bank of Japan (BOJ), had previously set a "goal" of a 1% rate of inflation in February 2012.

But it said it may only be able to achieve that in the 2014-15 financial year.

However, the new government, led by Prime Minister Shinzo Abe, called on the BOJ to set a "target" of a 2% rate of inflation.

It argued that the new, higher target would put the onus on the central bank to do more to stimulate growth.

Mr Abe had also hinted that the bank should create "unlimited" new yen, and inject it into the financial system.

The hope is that with more money sloshing around, consumers will end up with more in their pockets, and be happier to spend.

Image caption Mr Abe had suggested the bank should print unlimited yen to try and stoke inflation

Can it achieve the 2% target?

The BOJ said that it will maintain a flexible monetary policy to ensure that the target is achieved.

But it did not set a deadline by which it intends to do so.

The central bank also said that for Japan to come out of deflation, various unspecified "entities"need to work together - which most analysts take to mean the BOJ wants the government to share the responsibility.

The BOJ added that the government has shown its intention to "aggressively pursue" steps aimed at stoking inflation.

However, most analysts believe that it is unlikely that the BOJ will able to achieve the target before the 2014-15 financial year.

Why does Japan need to boost domestic consumption?

Over the past two decades Japan has relied on the success of its export sector, and on debt-financed government spending, to drive its economic growth.

However, a slowdown in key markets such as the US and eurozone has hurt the export sector and impacted its overall economy.

Meanwhile, increased competition from Chinese and South Korean firms has also dented growth, in part thanks to the yen, which has strengthened significantly since the 2008 financial crisis.

Japan's exports have now fallen for six straight months, and many analysts believe that the sector may continue to remain under pressure in the near term.

As a result, Japan has been trying to boost domestic consumption to offset the decline in foreign sales and ensure a sustained long-term growth of its economy.

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