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Home > Announcements > Speeches and Statements > Speeches 1996 > Speech given by Yasuo Matsushita, Governor of the Bank of Japan, to the Research Institute of Japan in Tokyo on November 6, 1996 (The Role of Monetary Policy)

The Role of Monetary Policy

This article is excerpted and translated from a speech given by Yasuo Matsushita, Governor of the Bank of Japan, to the Research Institute of Japan in Tokyo on November 6, 1996.

I. Introduction

I am greatly honored to have been invited by the Research Institute of Japan toaddress this distinguished audience.

Today, I would first like to discuss the Bank of Japan's views on recent economicdevelopments in Japan and the thinking behind the Bank's current monetary policy. Then,I would like to review some of the basic issues related to monetary policy management,such as the significance of price stability, which is the objective of monetary policy, and thepoints for consideration in achieving it.

There has been much debate since the beginning of this year about Japan'scentral bank system, and the Central Bank Study Group, an advisory panel to the PrimeMinister, is planning to publish a report in the near future. I myself have, on severaloccasions, addressed the basic issues involved, such as the status of the central bankwithin the framework of a democratic society, and the role of the central bank in maintainingfinancial system stability.1 As my previous speeches focused on the institutional framework of central banking, there has not been an opportunity to discuss the Bank of Japan's viewson the central bank's policy management.

  1. For detailes, see previous speeches entitled "The Role of the Central Bank" and "Recent Monetary and Economic Conditions and Issues Facing the Japanese Financial System" given on June 14 and April 3, 1996, respectively. Both speeches are included in the August 1996 issue of the Bank of Japan Quarterly Bulletin.

I have thus selected monetary policy as the theme of today's speech. However,there is another reason. Over the past decade, it seems that a new thinking has beendeveloping among the industrialized countries regarding monetary and fiscal policymanagement, or more broadly, the economic policy management of a country. This hasprompted heated discussions in various countries in recent years on monetary policy andcentral banking, and this new thinking will be of great significance in contemplating thefuture framework of the Japanese economy. I would therefore like to examine the role ofmonetary policy, bearing in mind this new thinking on economic policy management.

II. Domestic Economic Conditions and Current Monetary Policy

A. Domestic Economic Conditions

I would like to begin by reviewing domestic economic conditions. In spring 1995,the recovery of the Japanese economy came to a pause and, at one time, there were evenconcerns about a deflationary spiral. In view of these economic developments, substantialmonetary easing and large-scale fiscal policy measures were implemented. Since thebeginning of this year, the economy has once again been on a recovery path, owing to thepermeation of policy effects and the depreciation of the yen. The Bank currently judgesthat a moderate economic recovery continues, but there are concerns as to why theeconomy has not shown a recovery that is any stronger than "moderate" for nearly a year.

This slow recovery can be explained by the tug of war between the forcesencouraging recovery and the structural adjustment pressures constraining recovery. Therefore, to predict future economic developments, we must first understand how thesetwo factors are at work in the economy.

One of the forces encouraging recovery is the permeation of policy effects. Forexample, there is no doubt that the decline in interest rates has been contributingsignificantly to the recovery in housing and business fixed investments. At the same time,fiscal expenditures have underpinned domestic aggregate demand. However, forcesencouraging economic recovery are not limited to the supporting policy measures. As theeconomy follows a recovery path supported by policy effects, a larger number of firms withimproving profits have begun to show a more positive stance toward business fixedinvestment and employment. As a result, the risk of a deflationary spiral, which was anissue of concern last year, has been practically eliminated. It can thus be said that thecyclical forces of the economy based on domestic private demand have been slowly butsteadily at work for the past year.

However, the factors that constrain economic recovery have also been persistent. For example, while business fixed investment continues to recover owing toprogress in capital stock adjustment, it has not yet gained the full momentum seen in pasteconomic recoveries. This is because firms, in spite of improved profits, have given priorityto repaying debts in order to improve their balance sheets, or have limited their gross fixedinvestment to the amount of cash flow generated from depreciation of existing facilities.

Intensified competition with other Asian countries, which has brought changesto the international environment, is also affecting the Japanese economy in various ways. The inflow of low-priced goods from other Asian countries, for example, seriously affectsfirms producing competing products. Furthermore, the relocation of production basesoverseas by Japanese manufacturers not only decreases domestic business fixedinvestment by those manufacturers, but also restrains the investment by their domesticsubcontractors, due to decrease in orders. It seems that management of firms have notbeen able to dispel uncertainties over the future, as the path toward a new industrialstructure remains obscure under the current circumstances.

B. Structural Adjustment Pressures

The Japanese economy is thus faced with two types of adjustment pressures:pressures for balance-sheet adjustment in the corporate sector; and pressures for structuraladjustment of the industries created by the intensifying competition with other Asiancountries. These are the factors that have caused the pace of economic recovery toremain moderate. These two adjustment pressures are, however, significantly different innature.

Adjustment of balance sheets is about reducing debts which accumulated duringthe "bubble" period, in other words, disposing of the burdens from the past. To that extent,this adjustment is regrettably of a negative nature.

In order to reduce the burdens, it will be necessary to enhance the functions ofthe capital markets to strengthen firms' capital bases, and to revitalize the real estatemarket to facilitate the liquidation of firms' real estate holdings. Ultimately, however, it isonly increase in profits that provides the funds necessary to write off latent losses on realestate and repay accumulated loans. In other words, the burdens from the past need tobe reduced gradually with each year's income arising from economic activity.

In this regard, although it may sound paradoxical, revitalizing economic activityand boosting corporate profits, or more fundamentally, supporting the recovery of theeconomy will be important preconditions for the smooth progress of balance-sheetadjustment. Realizing a recovery of the economy encumbered with impaired balancesheets, therefore, requires a stronger policy support than otherwise. This is one of thereasons why the Bank has implemented substantial monetary easing measures to date.

As a result, the economy has resumed recovery, although moderate, andcorporate profits have been increasing. Accordingly, balance sheets have also beenimproving gradually. Regarding debt servicing ability, the ratio of firms' long-term debts tocash flow has been declining slowly for the past two years, after rising rapidly during the"bubble" period. It can be said that firms' balance sheets have, in general, begun to showsteady improvement, although differences remain between individual sectors and firms.

While the balance-sheet adjustment is an attempt to recover from a negativesituation, structural adjustment of the industries in response to a new global economicenvironment is essentially a positive challenge in that the restructuring process itselfintroduces the possibility of creating renewed economic development.

The increasing supply capacity of other East Asian economies and theirtransition to market economies have intensified competition facing Japan's labor-intensivesectors. At the same time, however, these factors have expanded markets and businessopportunities for the Japanese economy. Therefore, if the Japanese economy can adaptitself successfully to this new international division of labor, these developments shouldbring significant benefits to the Japanese economy in the long run.

In fact, a careful look at the Japanese economy will reveal indications of suchpositive industrial restructuring. The change in Japan's trade structure is one example. Until a decade ago, the top five imports were mostly fuels and raw materials, usually crudeoil, wood, petroleum products, coal, and natural gas, although the order varied from yearto year. In 1995, however, while crude oil maintained its top position, the other four majorimports were office machinery, electronic parts, automobiles, and wood. The share ofmanufactured goods in Japan's total imports has doubled from 30 to 60 percent over thedecade. This change by itself would merely suggest that the manufacturing sector, whichhad long been Japan's mainstay, now faces severer competition with imported goods. What is notable is that the composition of exports has also changed significantly during thesame period. Automobiles, ships, and household electric appliances such as televisionsets and radios used to appear at the top of the list of export items. In 1995, however,while automobiles stayed as the number one import, electronic parts, office machinery,automobile parts, and scientific and optical apparatus ranked second to fifth, indicating thatcapital goods and parts have replaced consumer durables.

As labor-intensive sectors such as the consumer durables industry grow in otherEast Asian economies, exports of labor-intensive products from Japan have been declining,while those of capital-intensive products with higher value added, such as capital goodsand related parts, have been increasing. This is a typical illustration of the Japaneseeconomy's strong ability to adapt to changes in the global environment.

The emergence and expansion of new leading industries in Japan are alsoindications of industrial restructuring. The mobile telecommunications market, for example,has grown rapidly to a 3.5 trillion Yen market and the business fixed investment of this industryhas expanded to almost 2 trillion Yen, which is equivalent to the sum of business fixedinvestment by the automobile and iron-and-steel industries. Furthermore, in these threeyears when economic recovery has been unable to obtain a firm footing, some industriesachieved earnings growth comparable to or even exceeding that attained in the three yearsduring the economic boom of the latter half of the 1980s: namely, the electrical andprecision machinery industries, which have succeeded in adjusting to the new internationaldivision of labor; and the pulp and paper industry in the raw materials sector, which hasbeen able to benefit from the increased volume of information processed and distributedin today's technological age.

I have so far emphasized the brighter side of the domestic economy with thehope of further encouraging the efforts of domestic industries, but reality is obviously notso simple. During periods of transition of industrial structure, the contrast between thebright and dark sides tends to become stronger. Focusing on the dark side, the mismatchbetween labor supply and demand has become greater, and restructuring burdens havebeen particularly heavy on small and medium-sized firms.

Looking back at the postwar period, the Japanese economy successfullyunderwent several major changes in the industrial structure and shifts in leading industries. There is no doubt that during the periods of transition, management of firms faced greatuncertainties about the future, and that it was extremely difficult to accurately predict whichwould be the growth industries in the coming years. However, during the era of higheconomic growth, the rapid expansion of the economy absorbed the negative impactarising from the structural adjustment of the industries. The main difficulty that the currenteconomy faces seems to lie not in the industrial restructuring itself, but in the fact that thecurrent economic growth is not strong enough to provide a similar "shock absorber" effect.

For this reason the implementation of structural policy, such as deregulation, hasbecome an urgent issue. In order to promote industrial restructuring, it is necessary tocreate new investment opportunities and to encourage unrestricted and creative businessactivity through deregulation. It is also important to increase labor mobility and facilitateland transactions.

C. Economic Outlook and Monetary Policy Management

In order for the Japanese economy to be put firmly on a self-sustained recoverypath in the face of reduced fiscal support, it will be necessary for the structural adjustmentto continue to progress and for the virtuous circle between production, income, andexpenditure to gain further strength. In this respect, firms have been responding steadilyto the structural adjustment pressures. The decline in net exports, which had been a dragon economic recovery, has been slowing recently. In addition, inventory adjustment, whichhas been under way in certain sectors since this spring, has virtually been completed in theiron-and-steel industry.

In light of these facts, it is most likely that production will be further revitalized,strengthening the virtuous circle of the economy led by expanded private demand. However, this remains to be seen.

In view of this economic situation, the Bank will continue, in the management ofcurrent monetary policy, to monitor monetary and economic developments closely, placingemphasis on further strengthening the foundation for an economic recovery. And to repeatmy earlier point, it is also important to carry out structural reforms including drasticderegulation. In this respect, I hope that the new administration will continue to exercisestrong leadership.

III. New Thinking on Economic Policy Management

The industrialized countries today attach more importance to structural policies,such as the strengthening of the competitiveness of domestic industries and theimprovement of market infrastructure. In addition, these countries are making steadyefforts to promote fiscal consolidation, to reform their central bank systems, and morebroadly, to review national economic policy management and its framework.

This common trend among the industrialized countries is closely related to therecent changes in the global economy. The collapse of the former socialist bloc, forexample, demonstrated the superiority of a market economy over a government-controlledeconomy: that is, the superiority of a decentralized economy over a centrally-plannedeconomy. In addition, the transition to a market economy and the progress ofindustrialization of these former socialist countries and the developing Asian countries havestimulated the industrialized countries to strengthen the competitiveness of theireconomies.

Furthermore, past experiences of economic fluctuations, such as inflation andthe asset-price "bubble," and the concurrent accumulation of budget deficits have promptedcountries to closely re-examine the fundamental thinking on economic policy and theunderlying economic theories. This year happens to be the 50th year since the death ofJohn Maynard Keynes. There have recently been renewed discussions on the evaluatingof Keynes' theories and Keynesian economics, which in many respects formed the basisof postwar economic policies.

The approaches currently adopted by various countries in addressing economicpolicies have several points in common.

The first point is the growing emphasis placed on improving the supply side ofthe economy. The conventional approach to economic policy emphasizes the control ofaggregate demand through monetary and fiscal policies, and this remains dominant whenseeking short-term adjustments of the economy. At the same time, however, there is agrowing perception that the driving force of long-term economic growth owes much to firms'efforts to improve their productivity. It is thus necessary to strengthen the supply side ofthe economy by promoting the introduction of new technology and by improvinginfrastructures such as transportation and telecommunications.

In fiscal policy management, greater importance is being attached to the detailsof fiscal expenditures from the viewpoint of evaluating the contribution of each portion tothe improvement of economic infrastructures, rather than to their effects in generatingadditional demand. There is also a stronger awareness that, in the medium to long term,it is more desirable to curtail inefficient fiscal expenditures thereby reducing budget deficitsand to utilize economic resources more efficiently in the private sector. All this reflects thegrowing emphasis on the supply side of the economy.

The second point in common in the approaches to addressing economic policiesis the emphasis placed on the utilization of the market mechanism. Related to the firstpoint, it can be said that this emphasis calls for fully utilizing the inherent forces of themarket mechanism of promoting greater economic efficiency and of inducing technologicalinnovation, in order to achieve higher productivity.

The global trend toward deregulation and promotion of market competitionobviously originates in this common thinking. The effectiveness of the market mechanismis not limited to revitalization of industries and improvement of financial markets. Forexample, in Europe, there is a growing understanding that the main cause of the highunemployment rate, which has persisted for some time, is the lack of mobility in the labormarkets. The solution to the problem, therefore, is considered to lie in facilitating themobility in the labor markets so as to efficiently adjust labor market conditions.

The third common element is the growing emphasis placed on the public'sexpectations regarding future developments and its confidence in economic policies. Forexample, the effectiveness of fiscal policy depends significantly on the public's views on thecontrollability of the fiscal deficits in the future. In the European countries and the UnitedStates, there is a growing perception that doubts about a government's ability to controlbudget deficits could bring about an unfavorable rise in long-term interest rates. This is oneof the major reasons why fiscal consolidation is considered to be an important task.

It has also become clear that changes in expectations regarding price andinterest rate developments significantly influence the effectiveness of monetary policy.

There is a theory which even suggests that discretionary economic policy wouldnot have any effect if people always had rational expectations about the future. While thismay be an extreme example, in general it has come to be considered that the efficacy ofeconomic policy cannot be discussed without taking into account its effects on people'sexpectations.

These recent changes in the thinking on economic policy naturally have a closebearing on the fundamental thinking about central banking and monetary policymanagement. For example, even when implementing short-term demand managementpolicy, it is necessary to ensure that the policy is compatible with the objective of pricestability -- the medium- to long-term objective of monetary policy and a precondition for thesmooth functioning of the market mechanism. It is also necessary to ensure that thepublic's confidence in monetary policy be strengthened by clearly establishing theindependence and accountability of the central bank. Bearing these points in mind, I wouldnow like to move on to the other theme of today's speech, the fundamental issuesconcerning monetary policy management.

IV. The Basic Thinking on Monetary Policy Management

A. Price Stability and the Central Bank

Most people agree that the objective of monetary policy is the maintenance of pricestability. I would like to explain why it is that this particular economic policy objective,among others, is assigned to monetary policy.

Price stability, in this context, is not necessarily the stability of prices of individualgoods and services, in other words, the stability of relative prices of individual items. Infact, fluctuation of relative prices in response to changes in the supply and demandconditions reflects the most basic principle of market mechanism. Central banks aim atachieving the stability of prices in general by taking the prices of individual items in theirtotality. If prices in general increase, that is, if inflation occurs, the amount of goods thatcan be purchased for 10,000 Yen will decrease, which means that the value of 10,000 Yen willdecline. It can thus be said that "prices in general" is another way of expressing "currencyvalue." The maintenance of price stability naturally becomes one of the most importantmissions of the central bank as the issuer of the currency, together with the mission ofmaintaining the stability of the financial system.

Moreover, in the long run, it is the monetary policy of the central bank that is ableto most effectively achieve stability of prices in general. It is true that prices, in the shortterm, fluctuate due to various factors: overseas market prices, such as crude oil prices; orthe supply and demand conditions of particular goods. However, from a longer-termperspective, prices in general are determined by the amount of money relative to theamount of traded goods and services. For this reason inflation is often said to be amonetary phenomenon, and the task of achieving price stability is necessarily assigned tomonetary policy. This then explains why the monetary policy of the central bank is so vitaland why the central bank is called the guardian of the currency.

There is a question of how asset prices, such as land prices and stock prices, maybe considered in the management of monetary policy. The Bank believes that it isunsuitable to consider asset prices in the same way as it does the prices of ordinary goodsand services. For example, land is not produced by everyday economic activity. Inaddition, land prices are determined in part by the perception of earnings that will begenerated from the land, in other words, by the projection of economic activity and prices. Asset prices are therefore different in nature from the prices of goods and services that areproduced daily through economic activity and consumed. It is also apparent, however, fromthe bitter experiences of the "bubble" economy that major fluctuations in asset prices arerelated to large swings in the economy. Therefore, the Bank believes that in order toensure price stability in the medium to long term, due attention must be paid to asset-pricedevelopments. Later, I would like to discuss in more detail the meaning of price stabilityin the medium to long term.

B. The Significance of Price Stability

Let me now consider the significance of price stability. It seems self-evident thatinflation and deflation are not desirable. As large fluctuations in prices are usuallyaccompanied by economic overheating or recession, the stabilization of prices will lead toa stable economy. Furthermore, price fluctuations lead to an uneven distribution of incomeand assets, thereby threatening the stability of people's everyday lives.

In addition to the above, I would like to stress that the stability of prices in generalis the most important precondition for the smooth functioning of the market mechanism. The market mechanism adjusts production and demand according to the signals sent bythe changes in relative prices. Once inflation or deflation occurs, it becomes extremelydifficult to read the signals received from the changes in individual prices, and as a result,the price mechanism ceases to function properly. This is because it becomes impossibleto distinguish whether changes in individual prices reflect shifts in relative prices or in pricesin general. It is as if there is no reliable yardstick for economic activity. Under suchcircumstances, firms trying to formulate future business plans based on their estimation ofprofitability of investments, and households making plans for savings and consumption facegrowing uncertainties, and this impedes economic development.

In the past, some argued that inflation is desirable to a certain extent in order tofurther stimulate economic growth, or that firms' activities would become more vigorousunder inflation. The 50 years of postwar experience and the evolution of economictheories, however, have forced serious reconsideration of this argument. There is everylikelihood that a mild inflation will eventually lead to full-scale inflation. In addition, onceinflation takes root, the achievements of business activity are masked by nominal increasesin profits, and accordingly, technological innovation and improvement in productivity arelikely to be discouraged. Actual examples demonstrate that, from a longer-termperspective, countries with stable prices tend to enjoy higher economic growth.

For these reasons, the current emphasis is on the significance of price stability,which is in line with the global trend in economic policy management placing strongeremphasis on the supply side of the economy and on the utilization of the marketmechanism.

C. The Meaning of Price Stability and Assessment Criteria

How can price stability be defined? This remains a difficult question as it is not easyto draw a line between acceptable and unacceptable rate of price increase.

In theory, zero inflation would be desirable. If prices are to be the yardstick foreconomic activity, zero inflation allows the yardstick to be reliable and unchanging, and inaddition avoids the adverse effects of price fluctuations on income distribution.

I said that this is true "in theory" for several reasons. First, there are limitations tothe accuracy of price statistics in that it is difficult to exclude price increases arising fromimprovements in product quality or to reflect changes in the market share of products. Asthe statistics become biased due to such technical limitations, some argue that it isundesirable to aim at zero inflation based on a specific price indicator. In addition, if thereis a downward rigidity in certain prices and wages due to business practices andcontractual constraints, the cost of achieving zero inflation could become substantial.

In view of the significance of price stability as discussed earlier, a more practicalcriterion would be the sustainability of price stability in the medium to long term. This isbecause prices serve as a yardstick not only for deciding current production andconsumption, but also for deciding the activities that lead to future economic developments,such as business fixed investment and savings. The perception that prices influence futuredevelopments has led to an increasing tendency to view price stability as being the statein which firms and households need not consider prospective price fluctuations in theireconomic decision-making.

Even when price indexes remain stable during a certain period, price stability in themedium to long term could be at risk if the economy is overheating and creating potentialupward pressures on prices. Monetary policy must thus be managed not only to minimizecurrent fluctuations in prices, but also to contain the potential risk of price fluctuations in thefuture. This is why price stability is said to be a medium- to long-term objective of monetarypolicy.

The maintenance of price stability does not conflict with the achievement of stableeconomic growth and employment conditions. For example, measures to preventoverheating (or recession) of the economy can at the same time contain inflation (or avoiddeflation), and provide medium- to long-term price stability; and this price stability, in turn,is a prerequisite for achieving sustainable growth of the economy, as I mentioned earlier.

D. Features of Monetary Policy

I would now like to examine the important elements in managing monetary policy.

There are two features of monetary policy that differentiate it from other economicpolicies. The first feature is that monetary policy uses market-oriented measures totransmit policy effects to market participants and therefore the efficacy of monetary policydepends on the market's reaction to the measures taken by the central bank. In thisrespect, monetary policy differs significantly in nature from the government's economicpolicy, which aims to achieve its objectives through administrative means such as laws andregulations.

Specifically, monetary policy affects the supply and demand of funds in the financialmarkets through the implementation of the Bank's daily operations, such as bill and bondtransactions. The mechanism is initiated in changes made to the money market interestrates, or in technical terms, changes to the overnight rates in the interbank market, whichcan be referred to as the wholesale market for cash and reserves. Changes in these ratesaffect other short-term interest rates and longer-term rates through arbitrage in the markets,which in turn influence changes in the deposit and lending rates offered by banks. Thesechanges in interest rates as a whole then influence the economic activities of the corporateand household sectors.

With the completion of the deregulation of interest rates, use of the marketmechanism is currently the most effective way of transmitting policy effects throughout thefinancial markets and the economy. However, in order to effectively utilize this mechanism,public and market confidence in monetary policy is of decisive importance. Unless thepolicy intentions of the central bank are fully understood and considered to be credible, theeffects of interest rate policies will not permeate adequately, and market interest rates mayfluctuate independently of the intentions of the central bank, affected by unnecessaryconjecture and rumors.

The second distinct feature of monetary policy is that considerable time is requiredbefore its effects materialize, in other words, there is a long time lag before policy effectspermeate throughout the economy.

The mechanism through which changes in interest rates are transmitted to economicactivity is complicated. Interest rate changes may have a relatively rapid influence on firmsplanning to make an investment in the near future. Theoretically, the effect of interest ratechanges should be swiftly transmitted to fluctuation in asset prices.

On the other hand, it takes a considerable time for the effects of interest ratechanges to appear in actual corporate profits and household income levels. One reasonis that there are various types of borrowing and investment with short and long maturities. As new interest rates are applied to these instruments only at the time of maturity,considerable time is required before the overall interest rate level changes and before thenew level takes effect throughout the economy. In addition, changes in corporate profitsand income levels will only bring about a gradual change in the confidence of firms andhouseholds in their investment and consumption, and after some delay in time, newdecisions will be made on investment and consumption. Further time is then neededbefore these decisions materialize as actual spendings.

It has been said that preemptive policy responses are necessary to ensure pricestability. This is because, as mentioned earlier, price stability must be achieved in themedium to long term, and because there will always be a considerable time lag beforepolicy effects permeate throughout the economy. As this time lag in permeation of policyeffects has become more widely recognized, greater emphasis has come to be placed inthe management of monetary policy on assessing the potential risks in the economy, toenable preemptive policy responses.

E. Considerations in Monetary Policy Management

The requirements for monetary policy are thus "maintenance of market confidence"and "preemptive response." It is, however, extremely difficult to achieve these tworequirements simultaneously.

Let me explain how the two requirements conflict. In order to make timely policyresponses, it will be necessary for the central bank to act based on its projections of theeconomic and price situations one or two years ahead. However, considering the difficultyof accurately predicting economic developments, such action may not necessarily resultin market confidence in the Bank's policy. Nevertheless, it would be impossible to actpreemptively if the Bank waited until a consensus was reached on future economicdevelopments and desirable policy actions.

It is no exaggeration to say that the key to monetary policy management is in findinghow these two requirements can be fulfilled simultaneously.

Central banks have tried to meet the two requirements through various techniques. For example, many central banks in the past adopted "money supply targeting," in whichmonetary policy is aimed at achieving an intermediate target of money supply growth. Thisis a method based on the causality that fluctuations in money supply influence realeconomic activity with some time lag. However, it has been pointed out that financialinnovations have made it difficult to discern the relationship between money supply andeconomic activity, and that although the relationship between the two is stable in the longterm, it may be unsteady in the short term. Accordingly, many of the central banks whichset a money supply target today mainly use it as a general guideline for monetary policyor refer to it as one of the major indicators in making policy decisions, rather thanattempting to adhere rigidly to it.

Some central banks now adopt "inflation targeting," in which a certain target rangeis set for inflation rate. This method aims to secure the confidence of the market bydeclaring beforehand the central bank's commitment to a specific target. For those centralbanks employing inflation targeting, another challenge besides setting the target range isdevising how to take appropriate, individual policy actions under the price target. Countrieswith high inflation rates have succeeded in containing these rates by employing inflationtargeting. However, the fact that the method has been effective in curbing a high inflationrate does not necessarily indicate that it will also be effective in sustaining already stableprices.

Recently, some academics in the United States have suggested evaluating thepotential risks of price and economic fluctuations based on such concepts as the outputgap and the expected inflation rate, and then utilizing these evaluations as guidelines inmanaging monetary policy.

Unfortunately, it is difficult to establish rules or other convenient guidelines which areby themselves sufficient to ensure optimal policy response. It is for this reason that theBank of Japan has never adopted stringent targeting or specific rules to date, but instead,has consistently emphasized the judgment of the overall economic conditions and hasmade efforts to improve underlying research and analytical skills.

Learning from the bitter experiences of the emergence and the bursting of the"bubble" economy, the Bank attaches utmost importance to realizing price stability andthereby economic stability in the long run, and, to this end, identifying and assessing thepotential risks within the economy. The Bank has also been making increased efforts toexplain its actions and policy in detail in order to gain the better understanding of the public.

One of the aims of last year's series of monetary easing measures was to eliminatethe possibility of a deflationary spiral, in other words, a potential risk of excessive pricedeclines. The Bank also made efforts to provide a clearer explanation of the details ofpolicies implemented and the thinking behind these policies. Announcements on theBank's stance on money market operations and improvements in the monthly and annualreports of the Policy Board are results of these efforts.

The Bank intends to continue investigating ways of fulfilling simultaneously the tworequirements of preemptive policy responses and of the maintenance of market confidence,by learning from theoretical and empirical studies and from the experiences of other centralbanks.

I would like to emphasize that, in order to maintain market confidence in the centralbank which is an essential task for achieving price stability in the medium to long term, theinstitutional independence of the central bank becomes very important. Accordingly, it willbe necessary to enhance the transparency of policy decisions and to establish a frameworkto ensure the Bank's accountability.

V. Conclusion

The review of the central bank system in Japan is likely to develop into a revisionof the Bank of Japan Law after the Central Bank Study Group submits its report.

When seen from the vantage point of reconsidering the broad framework ofeconomic policy, I believe that the revision of the Bank of Japan Law is significant not onlyto the Bank of Japan itself or to the financial sector, but also to the overall economy. Nowthat Japan's industries are making steady efforts to adapt to a new era, it is also requiredthat the economic policy management of Japan be reformed to suit the times.

The Bank of Japan Law is to be reviewed as the first concrete step in the reformprocess of Japan's economic policy management. The law, stipulated in 1942, has beenone of the rules and regulations constituting the basis of the old regime which has affectedthe country's economic policy management for the past 50 years. This is why muchinternational attention is now focused on the reform of the central bank system in Japan.

In order for the central bank to achieve its missions, improvement of the institutionalframework is necessary, but what is more important is that the Bank manages its policy andoperations with due responsibility. We at the Bank are very conscious of this and will exertourselves to the utmost to ensure that the Bank fulfills its responsibilities amid the ongoingglobalization and shifts to market-oriented economies. I would like to conclude byexpressing my hope for your continued support and understanding.

Thank you very much for your kind attention.