BOJ's Kuroda's policy guided by ‘Adaptive’ inflation expectations

Kuroda subscribes to a hypothesis that inflation expectations are 'adaptive', rather than 'rational', meaning that people form future inflation expectations based on past or current actual inflation. From his speech on 19 April 2015:

"In a recent study, Mr. Jeffrey Fuhrer, Executive Vice President and Senior Policy Advisor at the Federal Reserve Bank of Boston, using U.S. time series data, finds that past inflation accounts for 40 percent of the variation in four-quarter inflation expectations. Looking at data for Japan, similar reduced form regressions tend to find that past inflation accounts for a significantly larger part of variations in inflation expectations. These contrasting results suggest that inflation expectations may be better anchored - that is, less susceptible to developments in past inflation - in the United States than in Japan."

This is important. A central bank can look through short-term fluctuations of actual inflation if inflation expectations are rational rather than adaptive and anchored to the central bank's inflation target. Otherwise, or in Japan's case where inflation expectations are not anchored and are influenced heavily by actual (declining) inflation, the central bank will likely respond to it.

Kuroda's economic belief of the adaptive nature of inflation expectations in Japan and his legal mindset with the anticipated possibility argument probably explain the BOJ's surprise decision to ease policy further in October 2014 as a response to falling oil prices.

In his view, any second-round effect of falling oil prices to lower inflation expectations should be the BOJ's responsibility, and the chance of that effect materializing was high given the adaptive nature of inflation expectations in Japan. Going forward, any major shock (for instance, an equity sell-off or currency appreciation) deemed significant enough to depress inflation expectations would likely be a trigger for the BOJ to ease further.