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This paper examines two shortcomings--particularly relevant to Japan in the last decade--of applying simple reaction functions, such as the Taylor rule, to deflationary or near-zero inflation environments to assess the conduct of monetary policy. One is the unusually high degree of uncertainty associated with potential output in an environment of prolonged stagnation and deflation. The second is the neglect of policy expectations, which become critically important as nominal interest rates approach zero.

The authors conclude that reaction function-based assessments of Japanese monetary policy are so sensitive to the chosen gauge of potential output as to be unreliable. Using long-term bond yields, they identify five episodes since 1996 characterized by abrupt declines in Japanese inflation expectations. Policies undertaken by the Bank of Japan during this period did little to stabilize expectations, and the August 2000 interest-rate increase appears to have intensified deflationary concerns.