How does monetary policy affect economic activity and prices?

Under Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate, which was introduced in January 2016, the Bank currently conducts monetary policy by assuming the following transmission mechanism. First, the Bank's purchases of such assets as Japanese government bonds (JGBs), exchange-traded funds (ETFs), and Japan real estate investment trusts (J-REITs) will encourage a further decline in longer-term interest rates and lower risk premia of asset prices. Second, the Bank's commitment to achieve the price stability target of 2 percent at the earliest possible time and its large-scale asset purchases underpinning this commitment have been bringing about a rise in inflation expectations and a decline in real interest rates.

In addition, by applying a negative interest rate to part of the balances in current accounts held by financial institutions at the Bank, the Bank exerts downward pressure on money market rates, thereby lowering the short end of the yield curve into negative territory. By exerting further downward pressure on interest rates across the entire yield curve through a combination of a negative interest rate and large-scale purchases of JGBs, this could have a favorable impact on the economic activity of firms and households.

Through these effects, QQE with a Negative Interest Rate will support the positive developments in economic activity and financial markets, and lead Japan's economy to overcome deflation that has lasted for a long time.

In general, the effects that a rise or a decline in (real) interest rates will have on economic activity are as follows.

When interest rates decline, financial institutions can procure funds at low interest rates. This enables them to reduce their lending rates on loans to firms and households. Given the linkage between various financial markets, there is a decline in not only financial institutions' lending rates but also interest rates at which firms borrow directly from the market, such as in the form of corporate bond issuance. Firms find it easier to procure working capital (funds needed for the payment of salaries and input costs) and fixed investment funds (funds needed for construction of factories, stores, etc.), and households also find it easier to borrow funds, such as for purchasing housing.

As a result, firms' and households' economic activity picks up, and this stimulates the economy. Upward pressure on prices is also generated in turn. Such monetary policy aimed at stimulating the economy is called monetary easing measures.

On the other hand, when interest rates rise, financial institutions must procure funds at higher interest rates, and raise their lending rates on loans to firms and households. Firms and households find it difficult to borrow funds, which makes their economic activity sluggish. This, in turn, contains overheating of the economy and exerts downward pressure on prices. Such monetary policy aimed at containing overheating of the economy is called monetary tightening measures.