The Basic Policy on Economic and Fiscal Management and Reform (“Basic Policy”), which the government is set to compile as early as July, is expected to include a review of fiscal consolidation targets. In 2001, the Koizumi administration declared that it would target a surplus in the primary (fiscal) balance as a fiscal consolidation goal. Subsequent administrations also pursued this objective and indicated specific target dates, but the target was never achieved. Meanwhile, the government debt-to-GDP ratio has been framed as a secondary fiscal target.

If the average yield on government debt is equal to the rate of nominal GDP growth, a primary balance surplus will occur simultaneously with a reduction in the government debt-to-GDP ratio, making them consistent as fiscal consolidation goals.

In practice, however, the relationship between the average yield on government debt and nominal GDP growth tends to be quite volatile in the short term, and the two indicators do not necessarily track each other.

For this reason, previous administrations treated a primary fiscal surplus as the primary target and a falling debt-to-GDP ratio as a secondary objective. I suspect they intended to shift their attention to the latter once the former had been achieved.

The current administration, however, intends to make the debt-to-GDP ratio the main target even though it has yet to achieve a primary fiscal surplus, effectively reversing the priority of the two targets. The target of a primary fiscal surplus will not be abandoned, but the government will not view a single-year deficit as being problematic. I suspect financial markets will view this as a loosening of fiscal consolidation targets.

The current administration may be adopting the debt-to-GDP ratio as its main fiscal consolidation target because the ratio has leveled off and fallen slightly over the past several years, which means that targeting it would not raise any obstacles to proactive fiscal policy (see Figure below).

However, I believe the decline in the debt-to-GDP ratio is a temporary phenomenon resulting from the rapid inflation of the past few years. An abrupt rise in the inflation rate produces a significant increase in the denominator of the debt-to-GDP ratio (GDP), while the numerator (government debt) rises more gradually. A key reason is that even if inflation produces higher yields on newly issued JGBs, it takes time for that to drive the average yield on all outstanding debt higher as bonds mature and are refinanced.

Today's historically high inflation means the debt-to-GDP ratio is a lagging indicator of fiscal consolidation and is thus less useful than in the past.