Chapter 3. Can Abenomics Overcome the Headwinds from Population Aging?

Dennis Botman, Stephan Danninger, and Jerald Schiff
Published Date:
March 2015
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Dennis Botman

The adoption of the quantitative and qualitative monetary easing (QQE) framework, together with the higher inflation target and stronger coordination with fiscal and structural policies marked a clean break from previous, more incremental attempts to end deflation and revive growth. What have been the effects of the new policies so far? What can we expect amid underlying headwinds from population aging? And what are the potential risks, including for the Bank of Japan (BoJ) balance sheet and financial stability? We discuss these issues in this chapter.

QQE and successive rounds of fiscal stimulus had an immediate impact on asset markets. The depreciation of the yen and the stock market rally boosted business and consumer confidence and growth well above potential during 2013, while inflation and inflation expectations posted multiyear highs. For the near term, the key issue is whether the recovery can gradually transition to a self-sustained, rather than stimulus-driven, recovery. This requires higher basic wages, an increase in investment, and a more substantial pickup in exports as well as progress with portfolio rebalancing among financial institutions.

We use the IMF’s Global Integrated Monetary and Fiscal (GIMF) model to assess the potential medium-term implications of Abenomics.1 We place particular emphasis on the rapid aging of Japan’s population. This demographic shift not only has implications for potential growth and fiscal sustainability, but possibly also for the ability to escape deflation in a sustained manner. Specifically, we address the following questions, based on Anderson, Botman, and Hunt (2014):

  • Under an unchanged monetary policy reaction function, what are the key channels and quantitative effects through which population aging affects inflation and the neutral real interest rate?

  • To what extent do life-cycle saving considerations neutralize the impact of aging on growth and inflation?

  • How does fiscal consolidation interact with the effects of aging on inflation?

  • To what extent can Abenomics counter the effects of aging on the economy?

We conclude the chapter by discussing the potential risks of Abenomics. In the near term, this includes the possibility that the handover from stimulus- to private-sector-led growth remains incomplete, for example because of a lack of basic wage growth or continued weakness in investment and exports. In addition, there is a risk that monetary policy will become overburdened, including from insufficient progress on medium-term fiscal consolidation and structural reforms. We also discuss the exit strategy, risks to the BoJ balance sheet, and financial stability risks from unconventional monetary policy as a prelude to a fuller discussion in Chapter 9.

Initial Effects of Abenomics

The announcement of the new policy regime in December 2012 was followed by a quick set of actions. In February 2013, the Diet approved new debt-financed spending amounting to 1.4 percent of GDP for 2013–14. In April 2013, the BoJ introduced QQE to achieve its new inflation target with a time horizon of about two years and committed to continue easing until inflation is stabilized at 2 percent. In June 2013, the government affirmed its fiscal consolidation goals of halving the primary deficit by fiscal year (FY) 2015—from the FY2010 level—and achieving a primary surplus by FY2020. The announcement also included a broad outline of a comprehensive growth strategy, which targets to raise investment, employment, and productivity. In October 2013, the first stage of the consumption tax hike in April 2014 was confirmed and, at end-2013, a fiscal stimulus package of 1.2 percent of GDP to be disbursed over two years was adopted to mitigate its effects on the economy. At the same time, the contours of potentially important reforms emerged, including framework legislation for special economic zones, the adoption of a bill to encourage farmland consolidation, and the commencement of Trans-Pacific Partnership negotiations.

Financial and exchange markets were buoyant in early 2013 and the immediate aftermath of QQE. From September 2012 to mid-April 2013, the Nikkei rose about 80 percent, with large gains for export-oriented firms and financial institutions (Figure 3.1). The rise in the stock market occurred in tandem with the strong depreciation of the yen (down 17 percent in real effective terms between end-December 2012 and end-June 2013). Upon adoption of the BoJ’s new QQE framework in April, bond yields declined briefly to historic lows, with the 10-year rate reaching 45 basis points.

Figure 3.1Equity Market Performance

(Index, July 2012 = 100)

Source: Bloomberg, L.P.

Note: TOPIX = Tokyo Stock Price Index.

In line with these developments, growth started to accelerate sharply in early 2013. First-quarter GDP growth jumped to 4.1 percent (seasonally adjusted annual rate) after two quarters of stagnation in mid-2012. Wealth effects from rising equity values stimulated consumption, particularly on luxury goods. One way to illustrate the initial success of the new policies is to compare the components of real GDP growth during 2013 relative to what was predicted to happen prior to the launch of Abenomics. For the latter we use the IMF’s quarterly forecasts made in the October 2012 World Economic Outlook (Figure 3.2). As can be observed, fiscal stimulus played an important role in boosting growth, whereas investment and exports did not immediately react. Regarding trade, the forecasts made pre-Abenomics were done under constant exchange rates. Thus, the rise in exports was driven by the expectation of higher partner country growth and the rise in imports by stronger domestic demand. The actual outcomes were very close to these predictions suggesting that the weakening of the yen itself had a very modest impact on export volumes and did not dampen real imports. Although the unemployment rate declined further and the vacancy-to-applicant ratio continued to rise, this tightness in the labor market did not translate into higher basic nominal wages (Figure 3.3).2

Figure 3.2Components of Real GDP in Abenomics’ First Year

(Index, 2012:Q4 = 100)

Source: IMF, World Economic Outlook (WEO); and IMF staff estimates.

Note: Compares IMF forecasts made prior to Abenomics and actual outturns.

Figure 3.3Labor Market Developments

(Index, December 2012 = 100)

Source: IMF staff estimates.

The four transmission channels of QQE mentioned in Chapter 2 worked broadly as expected, with yields remaining stable and low amid rising inflation, pushing real lending rates into negative territory. As the yen weakened, inflation expectations among a broad range of indicators started to rise (Figure 3.4). Although market-based indicators, including from swaps, can be distorted because of relatively low liquidity, while the near-term measures of inflation expectations are affected by the consumption tax increases, longer-term measures suggest that expectations are slowly converging on the BoJ’s inflation target. Surveys of professional forecasters also confirm this. As the Phillips curve has been relatively flat, rising inflation expectations that shift the curve upward are essential to achieve the BoJ’s inflation objectives.

Figure 3.4Long-Term Inflation Expectations

(Annual percentage points)

Sources: Bloomberg, L.P.; Consensus Forecasts; Quick Survey; and IMF staff estimates.

Note: JGBs = Japanese government bonds.

Headline inflation increased to multiyear highs, and although this initially reflected higher food and energy prices, over the course of 2013 price increases became broader based. The gradual increase in core inflation, particularly for components such as reading and recreation and transportation and communication, was evidence for this. Together these comprise close to 40 percent of the index. Nonetheless, the exchange rate depreciation played an important role in pushing up both headline and core inflation (Figure 3.5) with prices of certain capital goods remaining in deflationary territory.

Figure 3.5Inflation in Abenomics’ First Year

(Year-over-year percent change)

Sources: Bloomberg, L.P.; Consensus Forecasts; Quick Survey; and IMF staff estimates.

For portfolio rebalancing, the initial effects of Abenomics were more mixed. Lending increased to small and medium-sized enterprises and large corporations, but was mainly flat to households (Figure 3.6, panel 1). Banks, particularly the large ones, have reduced their holdings of Japanese government bonds, but like insurance companies and corporate pension funds, did not significantly reduce their holdings of relatively risk-free assets. This is in contrast to households, public pension funds, and other financial intermediaries such as securities investment trust companies (Figure 3.6, panel 2; see also Chapter 9).

Figure 3.6Portfolio Rebalancing During Abenomics’ First Year

Instead, banks have mainly used the newfound financial room to accumulate excess reserves at the BoJ (Figure 3.6, panel 3). In terms of international transactions, the first year of Abenomics showed some increase in gross outflows—mainly to advanced economies—but at the same time even larger inflows, particularly into the equity market (Figure 3.6, panel 4).

Although the initial phase of Abenomics was successful, progress increasingly became uneven toward the end of 2013 and into 2014. Consumer confidence started to decline, albeit from high levels, around the summer of 2013 all the way through the April 2014 consumption tax increase. As basic wages were rising only moderately, real purchasing power started to decline, which, together with subdued export and investment growth and mixed progress on the structural reform front, implied that the transition from a stimulus-driven to private-demand-led recovery increasingly became elusive. Furthermore, the effects of the April consumption tax increase to 8 percent were stronger and longer lasting than anticipated, halting the recovery in its tracks by 2014:Q3. Progress on actual and expected inflation also stalled with the waning effects of the initial exchange rate depreciation. These developments led the BoJ to significantly scale up its monetary easing in October 2014, followed by the government’s decision to delay the second increase in the consumption tax rate to 10 percent.

Aging and Potential Implications for Exiting Deflation

With the initial phase of Abenomics behind us, what can be expected going forward? To address this question, we need to take into account Japan’s rapidly aging population, with implications for growth, inflation, and debt dynamics, the three areas that Abenomics attempts to tackle. Large gains in longevity and virtually no immigration imply Japan is “aging in fast forward.” Life expectancy is the highest in the world, the working-age population started to decline around the early 1990s, and the baby-boom generation (born in 1947–49) started retiring in 2007 (Figure 3.7).

Figure 3.7Working-Age Population in Selected Countries, 1950–2100

(Index, 1950 = 100)

Source: United Nations.

The old-age population will continue to increase disproportionately in coming years, while the fertility rate declined markedly during the past decades.

Population aging could impact inflation dynamics by affecting relative prices, the output gap, and potential growth, among other channels. In particular, deflationary pressures could arise from:

  • Changes in relative prices, including from land. A shrinking or aging population would lower the price of land (for example, because the elderly live in smaller houses). Land is not only a fixed factor of production, but also affects wealth and thereby consumer behavior. In addition, a decline in labor force participation affects real wages. The extent to which relative price changes occur between land, labor, and capital will depend partly on labor market characteristics—in Japan, wage growth has lagged productivity growth despite declining labor force participation and the absence of immigration. In addition, aging leads to secular shifts in consumption patterns as the elderly’s preferences differ from those of the young, with less spending on housing, transportation, communication, and education, and more spending on medical, utilities, and other consumption expenditures (Figure 3.8). To what extent this shift affects inflation dynamics depends on the flexibility of supply to adapt to these changes in demand. In turn, this may be affected by the extent to which there may be substitution from market to regulated prices and from traded to nontraded goods, although this will be difficult to capture empirically.

  • Life-cycle saving considerations could have wealth implications by affecting asset prices, including the exchange rate following repatriation of foreign assets. As the population ages, aggregate portfolio rebalancing toward safe assets is likely to occur, potentially pushing government bond yields down (see IMF 2013a).

  • Greater excess supply as a result of fiscal consolidation. In many countries, advanced and emerging market alike, aging will lead to higher government outlays on pensions and health care and a shrinking tax base. Coupled with the elevated initial deficit and debt levels, the expectation of a rising risk premium and fiscal consolidation would lead to a sustained period of output growth below potential and deflationary pressures. In contrast, unsustainable government debt dynamics could increase fears of debt monetization and, therefore, expectations of high inflation in the absence of a credible medium-term fiscal consolidation plan. It should be noted, however, that projections for aging-related fiscal expenditures are relatively modest in Japan—although new work suggests that health care spending could rise faster than previously expected (Kashiwase, Nozaki, and Saito 2014). As a result, the fiscal channel will be driven mainly by the high initial debt and deficit levels. In addition, the composition of government spending could change, with fewer outlays on human (education) and physical (public investment) capital accumulation, although the resulting effects on the output gap are not clear a priori.

  • Changes in policy objectives affected by political economy considerations. Young cohorts do not initially have any assets, and wages are their main source of income. Hence, they prefer relatively low real interest rates and high real-wage growth. Older generations work less and prefer higher rates of return on their saving and relatively low inflation (Bullard, Garriga, and Waller, 2012). The latter will depend on institutional factors, for example, the extent of pension indexation. As such, aging could affect a central bank’s perception of what its objective function should look like and thus the level of its inflation target and the speed with which it pursues it. Whether or not this is relevant for Japan is unclear, as the BoJ has recently adopted a higher inflation target to be achieved through aggressive monetary easing, to some extent defying the political economy hypothesis, or at least suggesting that this can be trumped by other economic considerations if a country has been stuck in deflation.

Figure 3.8Average Expenditure Share by Household Age, 1995–2010


Sources: Ministry of Internal Affairs and Communications; Statistical Survey Department, Statistics Bureau; and IMF (2013b).

Some of these channels have been studied in the literature. For example, in the United States, it has been observed that the elderly population spends a relatively higher share of income on health care, for which prices have risen faster than the overall consumer price index. This has led to the development of an experimental price index to track inflation for the population aged 62 and older (Cashell 2010).

Konishi and Ueda (2013) suggest that negative correlations between inflation and demographic aging have been observed across developed nations recently. They analyze this phenomenon from a political economy perspective by embedding the fiscal theory of the price level into an overlapping-generations model. They assume that short-lived governments successively make decisions about income tax rates and bond issues, taking into account political influence from existing generations and the expected policy responses of future governments. Their analysis reveals that the effects of aging depend on its causes; aging is deflationary when caused by an unexpected increase in longevity, but is inflationary when caused by a decline in the birth rate. Ikeda and Saito (2012) study the effects of demographic changes on the real interest rate in Japan. Using a dynamic general equilibrium model, they find that a decline in the labor-force participation rate reduced the real interest rate, which is amplified by falling land prices in the presence of collateral constraints. Nonetheless, they suggest that total factor productivity growth is a more important source of variations in the real interest rate.

In their paper, aging affects the real interest rate by changing the demand and supply of loanable funds.3 First, household saving rises as the number of wage earners relative to the number of consumers in the household declines. This puts downward pressure on the real interest rate. This is consistent with Lindh and Malmberg (1998 and 2000) who, for a sample of Organisation for Economic Co-operation and Development countries, find that increases in the population of net savers dampen inflation, whereas the younger retirees fan inflation as they start consuming out of accumulated pension claims. Second, as firms’ demand for capital and land declines, downward pressure on the real interest rate emerges from reduced demand for loanable funds. Third, firms’ collateral falls as land prices decline, leading to a further decline in the demand for loanable funds.

A key distinction of our approach is that the GIMF is an open-economy model and therefore effects on the real interest rate occur only to the extent that developments in Japan affect the global supply and demand for saving. As a result, in the GIMF, the majority of the action occurs through changes in relative factor prices, including from fiscal consolidation. Furthermore, as in Hoshi and Ito (2012), we postulate that Japan has now entered the state in which we should start to see a decline in the saving rate as the population ages. In addition, consumption by retirees will in part be funded by running down Japan’s sizable net foreign asset position. The effect on the neutral real interest rate will then also depend on the response of the real exchange rate following repatriation of savings.

Katagiri (2012) studies the effects of aging on growth, unemployment, and inflation using a multisector new Keynesian model with job creation and destruction. Aging leads to a shift in aggregate demand from durable goods to services which, owing to various labor market frictions, increases the structural unemployment rate. In addition, productivity in the nonmanufacturing sector has been lower than in the manufacturing sector, implying that these demand shifts reduce aggregate productivity growth. Since estimates of aging have increased annually, the repeated upward revisions are treated as unexpected shocks to the economy. All considered, the author finds deflationary effects of aging in Japan through these channels.

The Effects of Aging on Inflation and Growth

Indeed, in popular debate a view appears to have emerged that exiting deflation has become more challenging because of aging. However, there is scant theoretical or empirical work on the potential relationship between these factors, with most research on aging focusing on the effects on growth and fiscal sustainability. To some extent this may be due to the monetarist doctrine: whether or not aging exerts downward pressure on prices is irrelevant as a central bank committed to do whatever it takes should remain capable of anchoring inflation expectations to the target.

Nonetheless, the extent to which aging affects the neutral rate and requires adapting macroeconomic policies to anchor inflation expectations remains a relevant and, to a large extent, unaddressed question. In this chapter we use the GIMF model to quantify the overall impact of aging on growth and to determine if the corrective macroeconomic and structural policies envisaged under Abenomics can stem the tide. The model, however, imposes limitations on the analysis. For example, in principle, monetary policy will react endogenously to any effects of aging on inflation consistent with the central bank’s objective function, although there remains the open issue of to what extent this will be effective under the zero lower bound. Therefore, to isolate the effect of aging on inflation we would need to keep monetary policy constant. However, this can only be imposed in the GIMF for a few periods, as the model would otherwise become unstable. As such, any deflationary effects from aging will be observed in the simulations through its effects on both the “shadow” policy rate and the inflation rate.4

The effects of aging on the neutral real interest rate operate through changes in inflation pressures and rising risk premiums. First, as a large proportion of the population moves into retirement, the labor force will decline, with implications for both supply and demand. Second, without labor income, retirees will draw down their savings to finance consumption expenditures. Finally, as private domestic saving declines, it has been argued that Japan will need to increasingly tap foreign investors to meet its high public financing requirement, which would likely require higher interest rates, modeled here as a rising sovereign risk premium over time. We have layered these various channels to illustrate their relative contribution to the overall deflationary effects from population aging.

In the first layer of the simulation exercise (blue line in Figure 3.9), the labor force in Japan declines by 1 percent a year for 30 years. This magnitude is calibrated to match the decline in the United Nations median forecast for Japan’s working age population. As the labor force declines, consumption and investment both fall. Both demand- and supply-side factors serve to decrease the overall demand for factors of production. A falling labor supply results in a higher real wage, which induces firms to move back along their supply curves, reducing demand for both capital and land. At the same time, falling demand implies that the return to all factors of production is declining, also reducing demand for capital, labor, and land. Lower demand for land causes its price to fall as well. The decline in the labor supply is similar in nature to a negative, economy-wide productivity shock, and, with less output to sell to the rest of the world, the Japanese currency appreciates. The appreciated real effective exchange rate results in increased demand for imports, as foreign goods become relatively cheaper compared to domestic goods. Declining demand for domestic output, falling land prices, and cheaper imports all exert continuous downward pressure on inflation. The calibrated aggressiveness of the monetary policy rule results in a reduction in the shadow policy rate of about 20 basis points, but this still results in inflation falling by about 10 basis points. The public debt-to-GDP ratio rises gradually over the simulation horizon owing to the trend decline in nominal GDP.

Figure 3.9Effects of Aging on Growth and Inflation

Source: IMF, Global Integrated Monetary and Fiscal (GIMF) model simulations.

In the second layer (red line in Figure 3.9), it is assumed that the Japanese saving rate declines by just over 0.1 percent of GDP a year for 30 years. Specifically, the Japanese household saving rate has been gradually decreasing since the early 1990s, from about 15 percent of disposable income at that time to about zero percent in 2011. This decline in the saving rate partially occurred because of demographic changes (aging). The importance of demographic changes was outlined by Hoshi and Ito (2012). One can use the Annual Family Income and Expenditure Survey to determine the autonomous effect of aging on this decline in the saving rate. Older households have a lower (or negative) saving rate and their share has considerably increased throughout the last 20 years.

For the decomposition exercise, we used the savings rate reported by Iwaisako and Okada (2010) (Table 3.1). Notably, the saving rate changed significantly after the financial crisis of 1997–98. The role of demographic factors assumes the same saving rate throughout the whole sample. Demographic factors accounted for about 4 percentage points (one-third) of the decline in the aggregate saving rate (Table 3.2). The role of aging has gained importance since 1998, and about 3 percentage points out of the 5-percentage-point decline was due to this factor (the change in propensity to consume added another 2 percentage points). As such, aging subtracts about 0.1 to 0.2 percentage point from the saving rate each year, and for the simulations we use the lower bound of this estimate.

Table 3.1Saving Rate for Different Age Groups
20–2930–4445–4950–5455–5960+60+ Non-employed60+ Employed
Table 3.2Demographic Factors in Declining Household Saving
Change in net saving rate (%)−13.5−8.2−5.3
Source: IMF staff calculations.Note: C/Y = consumption quote; … = not available.
Source: IMF staff calculations.Note: C/Y = consumption quote; … = not available.

Dissaving by the elderly exerts further deflationary pressures through real exchange rate appreciation. Interestingly, one might expect that dissaving by retirees would be inflationary: while aggregate supply declines owing to a falling labor supply, aggregate demand remains supported by retirees’ spending from their saving, as can be observed in Figure 3.9, panel 2. However, for Japan, dissaving by the elderly results in a repatriation of foreign saving, which in turn leads to real exchange rate appreciation. The deflationary impact from currency appreciation more than offsets the inflationary effects from higher demand for consumption goods.

As domestic saving declines while the government financing requirement remains large, Japan will need to increasingly rely on foreign investors. This is likely to exert upward pressure on long-term interest rates. This scenario is simulated through a rising risk premium, which adds further deflationary pressures (green line in Figure 3.9). The simulation assumes that the risk premium rises by five basis points per year, leading to a further contraction in output and accumulation of government debt. The combined impact of all three aging channels is to raise the public debt by 10 percentage points of GDP by 2030, relative to the baseline, and to lower inflation by about 0.3 percentage points on average during 2013–30, despite a decline in the shadow policy rate by about 60 basis points on average during the same period.

Can Abenomics Stem the Tide?

As aging exerts downward pressure on growth and exacerbates deflationary pressures, what are the policy options available to counter these effects? Regarding fiscal policy, space for stimulus is limited; it is an inadequate instrument given that aging affects growth persistently; and we need to consider the necessity for significant medium-term fiscal consolidation in Japan to restore debt sustainability. The latter arises not only because an aging population exerts fiscal pressures (see Chapter 4), but especially because the starting fiscal position is characterized by high deficits and debt.

To put debt on a downward trajectory, an adjustment of 1 percent of GDP is assumed to occur each year during 2016–25, over and above the adjustment that is already in the baseline, which includes the increase in the consumption tax rate to 10 percent and the waning of stimulus and earthquake-reconstruction spending in the near term (IMF 2013a). This adjustment is assumed to be divided between revenue (consumption tax increases account for 66 percent of the needed adjustment) and expenditure measures (lower public consumption accounts for 34 percent of the needed consolidation) (purple line in Figure 3.10). Even though this would avoid the rise in the risk premium, consumption and land prices decline markedly, exerting more downward pressure on the shadow policy rate and inflation. Fiscal consolidation more than offsets the decline in private saving resulting from aging, leading to a further accumulation of net foreign assets.

Figure 3.10Effects of Abenomics’ Three Arrows

Source: IMF, Global Integrated Monetary and Fiscal (GIMF) model simulations.

As illustrated in Figure 3.10, the effects of fiscal consolidation to maintain debt sustainability on the neutral real interest rate far exceed the autonomous effects of population aging, including through the real exchange rate. This may provide a cautionary tale for other aging economies that will likely experience increasing debt sustainability pressures owing to rising health care and pension spending, albeit from a better starting position than Japan.

As additional medium-term fiscal consolidation is unavoidable, the focus shifts next to whether structural reforms and the more aggressive monetary policy reaction function under QQE can overcome the deflationary pressures and maintain growth prospects. This is precisely at the heart of Abenomics. Our results indicate that combining fiscal consolidation with structural reforms and aggressive monetary easing to achieve the new inflation target can offset the effects of aging (orange line in Figure 3.10). In the simulation it is assumed that structural reforms raise potential growth by 0.25 percentage point by 2015 and 0.50 percentage point by 2018.

Provided that inflation expectations converge quickly toward the 2 percent inflation target—through aggressive monetary easing and effective forward guidance—such a policy package has substantial benefits by overcoming the deflationary effects of aging, while supporting growth and fiscal sustainability. The positive effects on growth and fiscal sustainability are mainly due to the rise in inflation expectations, which lowers the real interest rate and stimulates investment. Together with modestly higher potential growth following structural reforms, this substantially reduces the net debt-to-GDP ratio—albeit relative to a sharply rising debt-to-GDP ratio in the baseline.

Potential Macroeconomic and Exit Risks

The analysis above suggests that all three arrows of Abenomics are needed to achieve the BoJ’s inflation target in a stable manner amid headwinds from population aging. As Chapter 9 discusses, such a complete package of reforms also improves financial stability by reducing interest rate risks as financial institutions reduce holdings of Japanese government bonds and expand higher-yielding domestic and international lending portfolios instead. Not surprisingly, therefore, the key macroeconomic risks stem from incomplete Abenomics as well as the eventual exit from unconventional policies.

Specifically, much uncertainty remains concerning to what extent inflation expectations will adjust over the medium term in response to QQE. Furthermore, the effects of structural reforms on potential growth are difficult to gauge. One could thus consider a scenario in which (1) fiscal stimulus boosts activity in the short term; (2) long-term inflation expectations adjust to QQE, but in a sluggish manner; and (3) potential growth remains stuck owing to the absence of ambitious structural reforms or because such reforms have smaller effects than assumed in the simulation above. In this case, there may be an overreliance on fiscal stimulus in an attempt to close the output gap and boost inflation in the near term. However, medium-term fiscal adjustment and a rising risk premium causes output and public debt to eventually fall below the pre-Abenomics baseline (IMF 2013a).

Alternatively, monetary policy could become overburdened in such a scenario to support activity and prevent yields from rising. With greater uncertainty about fiscal and financial stability, this may trigger capital outflows and exchange rate depreciation, undermining not only Japan’s recovery, but also adversely affecting trading partners—especially in the region.

Additionally, tail risks could be triggered under an incomplete Abenomics scenario. Given high debt, a self-fulfilling sell-off of Japanese government bonds remains a possibility, in the event that a convincing medium-term debt reduction strategy is lacking, and markets could shift their perception of BoJ bond purchases toward debt monetization. Yields could spike, undermining domestic and global financial stability, increasing the risk of a reversal in emerging market capital flows and putting pressure on the BoJ to maintain an accommodative stance for longer, possibly at the cost of its credibility and ability to efficiently manage inflation.

Finally, even if Abenomics is successful in ending deflation and raising potential growth, important risks could stem from the eventual exit from QQE amid elevated BoJ balance-sheet exposure. As noted in Yamaoka and Syed (2010), in theory, exit from unconventional easing involves a number of seemingly straightforward central bank operations to maintain activity close to potential and ensure price stability: (1) halting extraordinary interventions; (2) downsizing and normalizing the central bank balance sheet; (3) selling purchased assets, if necessary; and (4) raising short-term interest rates.

However, in practice, the exit is more complicated. Yamaoka and Syed (2010) argue that uncertainties about the outlook for economic activity and inflation and the precise transmission mechanism of unconventional policies complicate the timing, pace, and sequencing of an exit strategy. In addition, to return to a positive policy rate, central banks usually need to eliminate the excess bank reserves accumulated through their unconventional operations, or at least neutralize the potential undesirable effects on credit growth and inflation as activity picks up. Some portion will contract automatically, as exceptional liquidity facilities are terminated and short-lived assets mature. However, the rest necessitate selling assets acquired by the central bank or other ways of sterilizing excess reserves to facilitate the necessary rate hike, such as by paying interest or issuing central bank bills.

The BoJ has experience with exiting from quantitative easing: it signaled the start of its exit strategy in March 2006 by announcing that it would gradually drain liquidity while keeping the overnight rate at virtually zero. By July 2006, it had smoothly transitioned to a more normal monetary framework, having downsized its balance sheet before raising the policy rate. Clear communication, transparent conditions governing future actions, flexibility, and market confidence about the adequacy of tools and underlying strategy for absorbing excess liquidity helped the BoJ manage an orderly exit. A revival of risk appetite through a restructuring of financial sector and debtor balance sheets, together with prudence and safeguards introduced during the entry stage of its unconventional operations, was also important (Yamaoka and Syed 2010).

Japan’s experience during 2006, albeit premature in hindsight, as noted in Chapter 2, was successful and smooth in its technical aspects, practicalities, and associated communication strategies. After the BoJ officially announced the termination of quantitative easing, it reduced its balance sheet and excess bank reserves within a few months, although not all the way back to their late-1990 levels. Moreover, the exit did not result in any obvious disruption to financial markets. There was also no evidence of abrupt portfolio shifts or heightened volatility in both safe and risky assets (Yamaoka and Syed 2010).

As the BoJ’s purchases are now skewed more toward longer-dated Japanese government bonds and private sector assets compared with the past, balance sheet risks may be commensurately higher, which may make the exit more complicated this time around. As noted in IMF (2013a), balance sheet risks could stem from implicit or explicit valuation losses as a result of a rise in interest rates, declines in operating income when central banks increase their holdings of long-dated securities with low coupon interest rates, and possible impairment losses on assets with credit risk.


Abenomics had a strong start, but, along a number of indicators, progress stalled toward the end of 2013 and, following the consumption tax increase to 8 percent in April 2014, uncertainty has increased about whether a successful handover from a stimulus-driven to a more self-sustained recovery is in the cards. This transition needs to occur against various structural headwinds, with population aging being a common thread that could hamper higher investment, rising wages, greater domestic rather than overseas production, and portfolio rebalancing away from safe assets.

Indeed, aging is expected to reduce the labor force participation rate and thereby impact potential growth. At the same time, it affects other factors of production, such as the rate of return to capital accumulation and land prices. Through these factors, aging affects potential growth, permanent income, and inflation, with implications for the neutral rate. Furthermore, aging tends to be associated with higher government outlays for health care and pensions, exacerbating already high fiscal consolidation needs in Japan. The prospect for sustained fiscal consolidation may dampen inflation dynamics by widening the output gap. In addition, while dissaving by the elderly during retirement could possibly support aggregate demand at the time when aggregate supply is declining, this needs to be weighed against possible exchange rate effects from repatriation of foreign assets, both with possible implications for underlying inflationary pressures.

Our findings suggest that aging tends to exert deflationary pressures through changes in relative prices. These include changes in nominal wages as labor force participation declines, triggering adjustment in the price of capital and land as well. Furthermore, dissaving by the elderly affects the neutral rate and also the real exchange rate through repatriation of foreign saving. Finally, as Japan’s financing requirement remains large under baseline policies, while aggregate saving declines owing to life-cycle dynamics, the risk premium starts to rise gradually. In combination and under an unchanged monetary policy reaction function, this reduces inflation persistently, despite a decline in the shadow policy rate.

In addition, fiscal consolidation needs are large in Japan, mainly because of the high initial deficit and debt levels and, to a more limited extent, as a result of further increases in aging-related government expenditure (such as health care). We found that medium-term fiscal consolidation that puts the debt-to-GDP ratio on a downward trajectory through a combination of revenue and expenditure measures exerts substantial downward pressure on the neutral rate. In fact, the effect is larger than the combined direct effects of aging. This is a channel that is not only relevant for Japan, but likely also for other countries that experience fiscal pressure from population aging.

We also showed that these pressures can be overcome with a full package of reforms that includes, besides medium-term fiscal consolidation, bold structural reforms, and a sufficiently aggressive monetary policy reaction function, which at the zero lower bound should include unconventional monetary easing and strong forward guidance. Such a package of reforms generates powerful economic synergies, particularly as rising inflation expectations push down the real interest rate, stimulating capital formation, whereas bold structural reforms raise permanent-income expectations, thereby stimulating aggregate demand and helping to close the output gap.

Structural headwinds from aging justify the aggressive approach the BoJ has taken to strengthen the credibility of its policy rule. On the structural front, measures that directly address the effects of population aging are likely to be most effective. These include stimulating female and elderly labor force participation as well as greater opportunities for immigration, particularly in areas with labor shortages (see Chapters 6 and 7 for further discussion). Prior to the launch of Abenomics, a comprehensive and coordinated approach to exit deflation and revive growth was lacking and it is likely that the declining working-age population since the mid-1990s contributed to the mild deflation, on average, observed during the last two decades.

Although Japan is ahead of the curve in the pace of population aging, it is not unique. Many other advanced economies will experience rapid population aging in coming years (although not necessarily declining working-age populations) amid elevated debt-sustainability concerns in light of rising health care and pension outlays and high initial debt levels. Disinflation risks are also rising in a number of advanced economies (Moghadam, Teja, and Berkmen 2014) and are generally above the pre–global financial crisis average (IMF 2014). In this regard, while some of the findings in this chapter are Japan specific (such as the starting point of two decades of entrenched deflationary expectations and high net foreign assets), broader lessons for aging economies with low inflation and rising fiscal outlays owing to health care and pension spending are that ambitious structural reforms and an aggressive monetary policy reaction function are needed to reduce the risk of falling into a deflationary trap.

An incomplete package of policies will put financial stability at risk (Chapter 9), including by potentially overburdening monetary and fiscal policy. These risks are not just relevant for Japan, but also for the broader global economy through implications for the exchange rate, global financing conditions, and trade flows (see Chapter 10 for more on Japan’s role in the global economy). An additional risk stems from the eventual exit from unconventional easing. Although past experience provides a useful marker, both the size and composition of asset purchases will present new challenges for the BoJ when the time comes to exit.


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See Kumhof and others (2010) for a detailed description of GIMF.

See Chapter 7 for a detailed discussion on labor market developments.

Other studies that use computable general equilibrium models to study the effects of aging on the aggregate saving rate include Miles (1999) for the United Kingdom and western Europe, and Chen, İmrohoroğlu, and İmrohoroğlu (2007) and Braun, Ikeda, and Joines (2009) for Japan.

The “shadow” policy rate is defined as the rate that would be observed in the absence of the zero lower bound.

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