Bank of Japan governor Masaru Hayami announced that the central bank would increase the amount of reserves that banks are required to hold against their loans, while at the same time lending them the money to do so — basically ordering the banks to start loaning money out into the economy. Hayami also promised that the bank's key interest rate (now at 0.15 percent, compared to 5 percent in the U.S.) would drop virtually to zero and stay there — basically begging consumers and businesses to start borrowing.
And then Hayami tossed the ball into the government's court. "The Bank of Japan strongly hopes that comprehensive steps will proceed rapidly on all fronts toward structural reform under the government's decisive leadership, and the clear will of the people," Hayami said Monday night at bank headquarters. The steps will be "painful," the governor said, but without them, Japan "cannot expect to secure sustainable growth."
TIME senior economics reporter Bernard Baumohl explains what the bank is trying to do — and what happens if it doesn't work.
TIME.com: So is this the forced-inflation policy we've heard so much about?
Bernard Baumohl: Not yet, but it is a move in that direction. All the central bank has really done is allowed banks to have more money in reserve. That allows them to lend more freely, with more flexibility and less worries about the creditworthiness of the borrower.
But that doesn't mean there will be more yen floating around in the economy, which would be inflationary — it just means that there will be more yen available to the economy, sitting in those banks. But people still have to borrow it and spend it for it to have the wider effect that Japan is looking for.
Let's review. Why is Japan trying to start inflation?
BB: Right now they're stuck in a deflationary spiral. Prices are falling over the long term, so consumers — already spooked enough about the economy — have no motivation to spend on any non-essentials, because they know whatever they want is going to be cheaper in a month anyway.
Businesses then have to lower prices to attract consumers, which just speeds the whole cycle up. And then you have an economy where everybody's saving money and cutting prices, which squeezes profits, which forces layoffs, which keeps everybody saving their money. And so on.
Inflation, meanwhile, creates the incentive to spend, because prices will be going up, and to borrow, because the money won't be worth as much when you have to pay it back. That creates economic activity, and that's what Japan needs very badly right now.
And what does the central bank's move do to make that happen?
BB: They're trying to make borrowing irresistible by making it practically free. Normally, to calculate the cost of borrowing, you subtract inflation from the interest rate. In Japan, with deflation around 2 percent, you have to add that to the interest rate. But with key interest rates near zero, money is nearly free.
What happens next?
BB: Wait for the other shoe to drop — wait for consumers and business to start borrowing and spending.
And if it doesn't work?
BB: Then Japan is facing a deflationary spiral the likes of which we haven't really seen since the Great Depression, and I'm not sure that we've figured out how to beat something like that with monetary policy.