Remarks by Kazuo Ueda, Member of the Policy Board of the Bank of Japan, at the Meeting on Economic and Financial Matters in Kagoshima, on July 1, 1999.

July 6, 1999
Bank of Japan

Today I would like to discuss recent developments in the Bank of Japan's monetary policy by focusing on its forward looking aspects. It sounds obvious that a central bank ought to be looking far out into the future in setting current monetary policy. This is, however, easier said than done. Moreover, attempts to be forward looking constrain many aspects of monetary policy making.

1. Given my academic background, in everyday policy discussions I have tried to assess the usefulness of various schools of economic thought for actual policy decisions since I took the current position in April last year. One provisional answer I have obtained is the following: the single most important claim of the monetarism, i.e., to keep the growth rate of the money supply constant is hardly acceptable. On the other hand, the reasoning that supports such a conclusion seems to merit tremendous respect. Among others, long and variable lags in the effects of monetary policy are a key component of the monetarist thinking and should also attract the attention of policy makers.

2. A brief review of the recent Japanese experience about the relationship between monetary aggregates and the economy is provided. Long and variable lags in the effects of monetary policy are easy to see in the data. Thus, the BOJ cut the discount rate five consecutive times starting in January 1986 with the economy bottoming out 10 months later. Monetary tightening started in the spring of 1989. It took about a year for assets prices, and about two years for the economy to start declining. Similarly, the easing starting in July 1991 had to wait until October 1993 before exerting a strong impact on the economy.

Long and variable lags led monetarists to recommend constant money growth policy as a way to avoid creating unnecessary instability from the policy side. This proposition does not seem to stand up to the recent Japanese experience. The growth rate of M2+CD remained very stable between 3.0-4.0% since sometime in 1994. Yet real GDP growth fluctuated between -2.8% and 5.1%. Even the claim that high growth in monetary aggregates delivers strong real growth seems not to hold. In addition to the fairly high growth rates of M2+CD, the monetary base expanded at more than 7% for about 3 to 4 years until the fall of last year. Despite this last year saw the most serious recession since 1950.

The reason for the failure of the monetarist propositions is well known. Unstable money demand breaks the link between monetary aggregates and the real economy or inflation. In addition to the creation of many new financial products, unstable movements in the precautionary demand for money triggered by fear for financial system stability have been the major reason for the instability of money demand in Japan over the last few years.

Consequently, stable money supply does not mean stable monetary policy. This is why most central banks today use interest rates rather than monetary aggregates as instruments of policy. Moreover, the majority view is to move the instrument rather than holding it fixed, in order to achieve the goal of price stability. In using the instrument one needs to pay attention to the existence of the lag in policy effects. Hence, the importance of being forward looking.

3. The BOJ's monetary policy board made two important decisions this year. First, on the 12th of February the board decided to decrease the overnight call rate down to the lowest possible rate. (Henceforth, the zero interest rate policy.) The minutes of the meeting indicate this was a forward looking decision. Many members realized that "the economy has stopped declining, but going forward, significant downside risks remain."

Second, board members reached an agreement on April 9th as reflected in Governor Hayami's statement on April 13th that "the zero interest rate policy will be maintained until deflationary concerns are over." At the time, we were keen on maximizing the impact of the zero rate policy by making clear that the policy would remain unchanged for quite some time.

4. The above decisions have exerted critical impacts on money and financial markets. Put simply, many risk premiums and hence interest rates have declined sharply. Assets prices have risen. The effects are most salient in the term markets, the long-term government bonds market and the stock market. Even the notorious Japan premium has almost disappeared. The explanation for such developments is straightforward. The zero interest rate policy has forced investors to accept more risks.

5. We are now waiting for the rise in the assets prices to start stimulating the demand for goods and services. It is only five months from February. The claim for further easing at this stage that we hear from some circles seems unjustifiable given that the effects of the policy on the real side of the economy are yet to manifest themselves so far.

6. Going more specifically into the call for further easing, we realize that such requests are often based on serious misunderstandings on the current stance of the BOJ's policy. Many such claims involve recommendations for using monetary aggregates as either instruments or intermediate targets of monetary policy.

Before criticizing such recommendations, I would like to comment on the current operations of the BOJ. At a daily level, we carry out operations, mostly during the morning, in order to inject enough reserves consistent with the target for the call market rate. However, the relationship between the two, reserves and the call rate, is a very unstable one and changes from time to time according to the market's perception about the rate to prevail in the near future. Apart from the role reserves play in guiding the call rate to the target at a daily level, we do not have any targets for reserves or the monetary base. In fact, existence of such targets would be inconsistent with our target for the call rate. Of course, the growth rate of the monetary base has increased from around 3% earlier this year to around 7%. This is, however, not because we are targeting money growth, but because the zero rate policy has increased the demand for the monetary base. The growth in the base may slow down again in the near future due to further subsidence of fears for financial system instability or to the expected slowdown in summer-time bonus payments. But this would in no way be due to a change in the stance of our policy.

In contrast, the policy to target the growth rate of the money supply would, for example, set a target of 10% growth in the monetary base. Even such a policy normally operates through interest rates. How would it differ from a policy to cut the call rate? A once and for all cut in the call rate will not create additional stimulus until the rate is cut again by a policy decision. The policy to increase the money supply would first create some decline in the call rate, but automatically create further rate declines if the economy worsens and the demand for money declines. In this sense the commitment to avoid deflationary forces is stronger with money supply targeting.

If properly interpreted, the current policy stance involves the same degree of commitment to easy policy as does money supply targeting, but by using different semantics. We have lowered the call rate to the minimum and promised to keep it there until the economy is back on track. This means that we have promised to do everything using interest rates. To the extent that the money supply works through interest rates, the commitment money supply targeting delivers is already contained in the current policy stance. Put differently, our stance is close to the one advocated by Paul Krugman. He argues in one of his recent articles that to achieve his recommendations, all one needs is to promise not to raise rates even if the economy starts to recover so long as the recovery is weak. The major difference, of course, lies in the implicit inflation target. Whilst Krugman presumably has a target like 5% in mind, we do not have the intention to keep the zero rate until that point.

Consequently, shifting to an explicit money targeting policy from here would not create much value added in terms of further easing. To believe in strong additional effects of such a policy shift, one needs to believe that an increase in the money supply creates a stimulus without working through interest rates. Large amounts of excess reserves currently exist in the banking system. Not a single bank has said that a further increase in the reserves would increase their lendings. One might argue that money may affect other asset prices such as the exchange rate. But even here the mechanism is normally through interest rates. Apart from it, exchange rates may move in response to our attempts to directly buy foreign currencies or to inflation expectations. But the latter runs into a circular argument unless one can show there is a mechanism to create inflation. The former does not require an increase in the money supply.

The argument that an increase in the growth rate of the money supply increases inflationary expectations and stimulates aggregate demand by lowering real interest rates sounds attractive. It is unclear again, however, how this mechanism works when the nominal interest rate has been already driven down to zero.

One could still say that if the current stance and the money supply target produce the same result, why not the latter? The major counter-argument to this would be the difficulty of setting appropriate money growth targets. As pointed out at the beginning, the demand for the monetary base has been extremely unstable due to movements in people's psychology toward the soundness of the financial system. Year over year growth rate of the base has fluctuated between 3% and 10% over the last ten months or so.

How about a policy of letting the monetary base grow at 20 or 30% then? Inflation does not seem to be on the horizon. One can tighten after the inflation rate reaches 1 or 2%. We think such a policy would have a small chance of success for reasons already mentioned. When it does succeed, it will probably generate a much higher rate of inflation than 1 or 2%. Because of lags in the effects of policy, the 20-30% money growth will continue to generate inflationary pressure even after the tightening starts.

7. The similarity of the current stance to inflation targeting is easier to see. Some have criticized, however, that the current BOJ's policy stance is too non-transparent. According to them, the expression that "we keep the zero rate policy until deflationary concerns are over" does not make clear when the policy will be lifted. We think that at least partially the criticism is based on misunderstandings about the workings of monetary policy.

The intent of the policy stance would be clearer under a directive to "keep the zero rate policy until the CPI inflation rate reaches x%." It should at once be apparent, however, that such a policy stance cannot be adopted. Given lags in the effects of monetary policy, the directive ought to read like " we will stick to the zero rate policy until the expected CPI inflation rate one or two years from now reaches x%." The expectation of future inflation rates for the policy decision is formed by the central bank. It would be almost impossible to come up with a simple relationship between observable variables and the expected inflation rate formed by the central bank. Hence, even the approach that makes clear the inflation target necessarily involves some discretion to say the least. I gather that most of the inflation targeting approaches currently adopted by other central banks fall into such a category.

I hasten to add that many important price indexes such as CPI, WPI, GDP deflator and CSPI have been showing divergent trends in Japan. Hence, we have been reluctant to use a particular price index as the variable on which to set a target of policy.

The expression to "keep the zero rate until deflationary concerns are over" reflects our determination to be forward looking. We do not want to respond to short-run fluctuations in the economy. Rather, our intention is to keep the zero rate policy until we are sure that serious downside risks are over when we look ahead a period like half a year to two years. Our judgement on this point will continue to be stated clearly in the minutes, governor's press meetings and the monthly reports on the economy.

8. The economy has stopped deteriorating for the moment as shown by the recently published first quarter GDP numbers. Our concern, however, is that the stabilizing tendency is maintained mainly by the stimulus from the fiscal side and that significant uncertainties remain as to the possibility of sustained recovery when the fiscal stimulus starts to run out later this fiscal year. Of course, the current easy monetary policy attempts to maximize such a possibility. Many pieces of new information on the economy will continue to be published. Most of such data, however, contains more information on the current state of the economy than on its future behavior. We will maintain our forward looking approach by avoiding to respond carelessly to short-run news about the economy and yet by trying to discover long-run trends in the economy from the totality of the small pieces of information we accumulate. In any case, I think it will take us quite a few more studies of new data before we can declare that deflationary concerns are over.