Home > Announcements > Speeches and Statements > Speeches 1999 > Speech by Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, at the Japan Research Institute on October 19, 1999 (On Recent Monetary Policy)

On Recent Monetary Policy

A speech given by Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, at the Japan Research Institute on October 19, 1999.

October 19, 1999
Bank of Japan

I. Introduction

I am honored to be invited to this conference today and to be given the opportunity to speak to this panel of distinguished guests. Recent comments and criticisms regarding monetary policy underline the need as well as the importance of giving due account of our policy implementation. Allow me to take this opportunity to share with you our thinking on current monetary policy.

The principles underlying the new Bank of Japan Law enacted in April last year are independence and transparency. Naturally, the independence of monetary policy must be underpinned by accountability. In this regard, we should make continuous efforts in explaining our thinking on monetary policy, on whatever occasions available, in easy-to-understand terms, so as to gain the understanding of the public. Obviously, we should above all endeavor to implement appropriate policies to produce good results to enhance our credibility. I hope that my speech today will add to these efforts.

II. Zero Interest Rate Policy

Zero interest rate policy and "quantitative easing"

For the past several months, there has been wide ranging and active discussion of the so-called zero interest rate policy. As some elements of the historically unprecedented zero interest rate policy seem difficult to understand, such discussion has sometimes become unnecessarily complicated and the points of contention blurred. Bearing this in mind, I will first discuss our zero interest rate policy.

A good starting point is an oft-asked question why the Bank of Japan doesn't effect monetary easing by increasing the quantity of money rather than by lowering the interest rate. The current directive of the Policy Board with respect to money market operations is simply to "encourage the uncollateralized overnight call rate to move as low as possible." There are no specific targets regarding money supply or monetary base. However, as is the same in the market for goods and services, the quantity supplied and prices are closely related in the money market. Interest rates, which are the price of money, can be reduced or maintained at a low level only to the extent that the increase in funds supplied would warrant. The zero interest rate policy is a policy that supplies sufficient funds to keep the short-term interest rate at zero percent.

Let me describe this in operational terms. The statutory reserve for financial institutions which takes the form of deposits with the Bank of Japan and is called the required reserve, is currently a little less than 4 trillion yen. The Bank has been providing about 1 trillion yen in excess of this required reserve so as to maintain the overnight call rate at virtually zero percent.

Such fund provision has greatly enhanced liquidity in the short-term money market and we have seen several phenomena evidencing how abundantly funds have been provided. For example, some 70 percent of the 1 trillion yen excess funds provided by the Bank has accumulated in the accounts at the Bank of Japan of money market brokers, who have, in principle, no need to hold such idle balances. This shows that financial institutions are no longer worried about their liquidity positions and that their motive for holding excess reserves is diminishing.

Another phenomenon is that since this summer we have often observed under-subscription in our money market operations. That is, when the Bank of Japan offers funds in its market operations, the bids from financial institutions do not reach the offered amount, and thus under-subscription occurs. Even though the Bank of Japan attempts to provide ample funds at almost a zero interest rate, financial institutions no longer need the full amount.

Let me draw your attention to the fact that these money market conditions indicate that significant quantitative easing has already been achieved.

Among the various ideas regarding quantitative easing, there is a view that the central bank should set a target on a particular quantitative indicator and conduct monetary policy so as to meet that target. In my view, putting aside technical difficulties, such quantitative targeting entails the following problem. When the financial system faces a crisis and has to resort to massive public funds support, it would be very difficult to control the quantitative indicator to a predetermined level. Even if the central bank were able to control it, there would be no guarantee that stability would be restored to the market and the economy. Take for example monetary base as a quantitative indicator. Monetary base outstanding is some 60 trillion yen, 90 percent of which is the cash and the remaining 10 percent reserves of financial institutions at the Bank of Japan. The growth of monetary base was slightly less than 10 percent last year and has decelerated to about 6 percent this year until now. In the meantime, economic growth was negative last year and the government forecast of 0.5 percent for this fiscal year will most likely be achieved. As such, monetary base and economic growth have shown opposite movements. The movement of monetary base thus evidences a diminishing incentive on the part of the public to hold cash as financial system uncertainty subsides, and hence does not contradict the improvement in economic growth. It is generally known that when an economy is susceptible to financial shocks, including a financial system crisis, financial conditions can better be gauged by interest rates rather than quantity.

However, a zero interest rate policy has more profound significance when it permeates to interest rates on term instruments. When the interest rate on financial assets such as short-term government bills (TBs and FBs) becomes zero, these assets can no longer be regarded as different from cash. In other words, since short-term interest rates became virtually zero this spring, we have witnessed an increase in financial assets which are highly substitutable with cash. This can be interpreted that quantitative easing has progressed substantially. Needless to say, this does not mean that liquidity is available to all borrowers, and the central bank itself is not in such a position as to guarantee the full availability of liquidity to all borrowers. I will come back to this issue later, but for now I would like to point out the importance of grasping the actual state of the financial market as I just described in discussing "quantitative easing."

Zero interest rate policy and interest rates on term instruments

There are some who argue that a further increase in fund provision by the Bank could lower the interest rates on longer term instruments of say, 3 months and 6 months.

The interest rates on term instruments are determined by how long the current abundant provision of funds will last rather than by how abundantly funds are provided. The time framework is more important than quantity, which is underpinned by the expectations theory of interest rate determination. The interest rates on term instruments basically reflect the market projection of future short-term interest rates. For example, the one-year interest rate is determined by the market projection of how the overnight interest rate will move over one year from now. And, since the central bank must be flexible so that it will always be able to respond appropriately to any changes in the market, it is impossible for it to announce that interest rates will never change over a certain period regardless of developments in the economy and prices.

Instead of specifically announcing for how long it will continue the ample provision of funds, the Bank has stated that the prerequisite for lifting the zero interest rate policy is not until deflationary concerns subside. Such announcement is intended to give support to the formation of market expectations regarding continuity of the zero interest rate policy. At every Monetary Policy Meeting, deflationary concerns are discussed and the resulting evaluation is presented in the Monthly Report of Recent Economic and Financial Developments and the Minutes of Monetary Policy Meetings.

As a consequence of these announcements, interest rates on term instruments have, in fact, declined to an extremely low level. For example, the rate on short-term government bills is around 0.04 percent to 0.05 percent for the maturity of 3 months through one year, while interbank interest rates are slightly higher reflecting a risk premium. The decline in short-term interest rates is surely acting as an anchor for medium- to long-term interest rates. Thus, a combination of the zero interest rate policy and the announcement that it will continue until deflationary concerns subside has been quite effective in seeing that the effects of monetary easing permeate through to the yield curve as a whole.

III. Zero Interest Rate Policy and Economic Activity

Effects of zero interest rate policy

From last autumn to the beginning of this year, liquidity concerns in the market became extremely serious due to financial system turbulence in addition to stagnant economic activity. The zero interest rate policy, through the ample provision of funds, nurtured a sense of relief among market participants because they knew that funds could be obtained whenever necessary, thus effectively dispelling concerns over liquidity. In addition, the policy has permeated smoothly to medium- to long-term interest rates, helping to bolster corporate and household confidence through favorable effects on stock prices and other asset prices.

Economic activity has gradually been exhibiting some signs of recovery. Aggregate demand led by public works and housing investment has improved, and production has begun to pick up partly thanks to an increase in exports. However, private consumption is still stagnant and business investment on a declining trend. Thus, we have yet to see an autonomous recovery of private demand.

Despite the continuation of the zero interest rate policy, why is private demand so slow to recover? Some argue that monetary easing is not enough. However, in view of the ample provision of funds to the market as I described, the background to the recent situation does not appear so simple as to justify the belief that monetary easing has been insufficient.

Let me elaborate on this from the viewpoint of the relationship between monetary easing and economic activity.

Monetary easing and economic activity

In general, monetary easing or a decline in interest rates permeates the economy through effects on the supply side, that is, bank lending, and also on the demand side, in other words, corporate funding activity. The effects of monetary easing and the development of money supply are determined by the interaction between the supply of, and demand for, funds.

For example, broadly speaking, there are three factors which affect bank lending activity. First, whether there are any uncertainties over the funding cost and the quantity to be raised. Second, whether banks are duly equipped to undertake the financial intermediary function, namely to take risks. And third, whether there is enough demand for bank loans.

The zero interest rate policy has greatly contributed to alleviating concerns over liquidity by lowering the cost as well as providing ample funds. In fact, since this spring, tightness in funding has substantially receded not only among financial institutions but also among firms.

Even though liquidity constraints are resolved, the effects of monetary easing will not be able to permeate the economy as a supporting force for recovery if the other two factors remain as constraints.

Let me comment on the second point, the financial intermediary function. It might be safe to say that the extremely cautious lending stance of financial institutions once observed has largely retreated due to steady progress in the disposal of non-performing assets and the injection of public funds to recapitalize major banks at the end of March. According to various surveys, including our Tankan Survey, the lending stance of financial institutions has gradually shifted toward being easy since this spring. Not only the resolution of liquidity constraints but also the improvement in the capital position of banks has contributed to such a shift. In addition, financial consolidation has advanced faster than expected, as witnessed by the recent announcements of a big merger and alliance among financial institutions. If the reallocation of managerial resources proceeds parallel with the disposal of non-performing assets under more competitive market conditions, the financial intermediary function will be firmly strengthened throughout the entire financial system.

At present, the non-performing asset problem has yet to be totally resolved. Financial institutions are still working to strengthen their capital positions by improving soundness and profitability over the medium term. While such financial consolidation is expected to steadily progress, it may well take some time before it has a positive impact on the financial intermediary function.

How about the third factor, the demand for bank loans? This relates to what extent firms will conduct forward-looking activities, especially business investment. In this regard, the environment surrounding business investment has gradually improved as witnessed by the recent signs of recovery in production, exports, and corporate profits. However, the bursting of the bubble has left a lasting scar on the corporate sector in the form of excess capacity and excess debt. Therefore, we have not seen any significant moves by firms to borrow money for investment purposes. Rather, there seems to be an increasing tendency for financial restructuring. If cash flows improve even slightly, firms will use the funds to repay debt. In addition, the need to set aside emergency funds seems to have decreased reflecting diminished anxiety over the financial system, but which only encourages firms to repay debt.

Given such observations, we have seen some counter-intuitive and paradoxical developments regarding money supply. Here I am thinking of the fact that while liquidity constraints have been resolved thanks to the permeation of the effects of monetary easing and improvement of corporate profits, the resolution of such constraints has itself contained an increase in money supply, albeit temporarily.

In this connection, there are proposals suggesting that the Bank directly provide funds to the corporate sector. This appears to reflect some misunderstanding because the counterparties of the Bank's market operations are not limited to financial institutions. The Bank conducts its operations in the so-called "open" market where there is a wide range of participants, including securities companies and money market brokers. For example, since securities companies procure the financial assets eligible for the Bank's operations through their customer network, the funds created by Bank operations will also flow to the customers of banks and securities companies.

For the further permeation of the effects of monetary easing, it is important to examine the range of private liabilities that the Bank accepts as eligible for its lending and money market operations. The Bank currently designates a variety of private liabilities as eligible, including bills, loans on deeds, CP, and corporate bonds, all of which must satisfy certain credit standards. These standards are essential in maintaining the soundness of the central bank's assets, which are one of the foundations supporting the country's credit standing. The central bank should never purchase liabilities that fall short of its credit standards.

Of course, we must constantly review, in line with changes in financial transactions, the type and scope of financial assets that can be accepted as eligible in return for the Bank's credit. Such review is also important for the central bank to enhance its operational capability. From such a viewpoint, the Bank has taken various measures. This spring, it introduced new market operations utilizing corporate bonds and loans on deeds as collateral. And in September, it announced the policy of including asset-backed securities satisfying certain conditions as eligible collateral for the Bank's operations.

With a view to the recent market environment where the under-subscription of money market operations is seen from time to time, we decided on October 13 to introduce the outright purchase and sale operations of short-term government bills and to expand the range of government bonds for repurchase operations. We will make full use of these newly introduced measures to assure further permeation of the effects of zero interest rate policy.

A credit multiplier is the ratio of money supply generated to the liquidity provided by the central bank. As the term implies, if the power to generate credit is weak in the private sector, the positive effects of monetary easing will not materialize even if the central bank provides ample liquidity. What generates such credit is the risk-taking capacity of financial institutions and firms. To enhance this capacity, steady efforts should be made to promote structural reform in such areas as strengthening the financial system and increasing the innovative power of firms through deregulation. At the same time, I hope financial institutions will develop credit analysis methods that are suitable for a new economic environment, and explore and nurture firms with high growth potential that do not yet have sufficient collateral.

IV. Current Monetary Policy Management

Thinking behind current monetary policy management

Let me next explain the Bank's new measures decided at the Monetary Policy Meeting on October 13.

The following two factors were taken into account.

First, the effects of the yen's recent appreciation on the economy. The 15 percent appreciation against the US dollar between July and September of this year was quite rapid.

At this juncture, let me explain our thinking regarding the relationship between monetary policy and the exchange rate since it seems we have not been able to make it completely clear so far.

In examining this issue, two important points should be borne in mind. First, the Bank should act appropriately and timely by paying due attention to developments in the economy as well as financial markets, including the foreign exchange market, since the exchange rate has various effects on economic activity and prices. Second, it is not appropriate for the Bank of Japan to conduct monetary policy with the objective of guiding the exchange rate to a specific level.

Though the Bank has repeatedly emphasized both of these points, it is unfortunate that somehow attention only focused on the second point, which led to the view that the Bank would not take heed of the exchange rate. To repeat, the exchange rate is an important factor to be considered in the conduct of monetary policy and the effects of its fluctuations are naturally incorporated in our assessment of the economy and financial markets, which forms the basis of our policy management.

From such a viewpoint, the effects of the recent appreciation of the yen warrant careful attention. The effects of changes in the exchange rate on the economy need to be judged not only in light of the exchange rate itself, but in combination with other factors. For example, one factor behind the recent appreciation of the yen is the upward re-evaluation of Japan's economy by the market reflecting the economy having stopped deteriorating and some positive signs emerging. The unexpectedly smooth recovery of Asian economies has also had a favorable impact on Japan's exports and production, which appears to have been strongly recognized as an improvement in the environment surrounding Japan's economy.

We are not yet in a position to conclude that a sustainable recovery is underway in view of the fact that business investment is declining and a recovery of private consumption has yet to be seen. Under such conditions, we consider it necessary to carefully monitor how the appreciation of the yen affects the economy. While it puts downward pressure on prices, we have observed other factors containing a price decline such as the rise in international commodity prices, including crude oil, and the progress of inventory adjustments.

The second important factor regarding the decision on October 13 was that, induced by Year 2000 problems, it is likely that precautionary demand for funds will increase toward the end of the year, putting upward pressure on interest rates. Year 2000 problems are generally regarded as occurring at the beginning of the new year, but the truth of the matter is that pressure in financial markets will emerge much earlier. If firms and financial institutions want to hold ample funds for any emergency and try to avoid settlement around the beginning of the new year, upward pressure on current interest rates would be seen. In addition, the demand for funds peaks in December due to such factors as bonuses and year-end sales. Year 2000 problems tend to aggravate the situation. In fact, 3-month interest rates which go over the year-end have already become somewhat higher. If such development results in a substantial increase in interest rates as a whole, there is the risk that the effects of the zero interest rate policy might be negated.

Under such circumstances, it is necessary to adjust the conduct of monetary policy so that financial markets remain as calm as possible. The Bank needs to be sufficiently prepared in case there is a substantial increase in the demand for funds. If credibility regarding the Bank's preparations prevails, upward pressure on interest rates will be contained to some extent.

Further permeation of the effects of monetary easing and flexible response

Based on the aforementioned two factors, the Policy Board held discussions on September 21 and October 13, and reached the conclusion that the most important task under the current zero interest rate policy was to ensure, without interruption, further permeation of the effects of monetary easing.

To this end, we decided to take some measures. First, with respect to daily market operations, we articulated our stance to maintain the zero interest rate policy by flexibly providing ample funds. We also announced our readiness to respond flexibly in addressing Year 2000 problems, for example by providing ample funds over the year end. Second, in addition to such fund provision on the macro level, we announced that we would respond in a timely and appropriate manner through our lending facility should an individual financial institution experience a temporary liquidity shortage. Third, to strengthen our policy response, we decided to enhance our operational measures by introducing outright operations using short-term government securities.

Let me elaborate on the meaning of the flexible provision of funds.

The Bank of Japan has been providing about 1 trillion yen in excess of the reserve required by financial institutions. Since this excess amount of 1 trillion yen has been observed in the market for some time, some argue that the Bank's operations have become less flexible. The Bank does not regard maintenance of this amount as an objective or a rule. As has been repeatedly stated, the current directive for money market operations is to maintain the unsecured overnight call rate at virtually zero percent. The necessary and sufficient amount of funds provided to fulfill this directive has been consistent with an excess of some 1 trillion yen over the required reserve for the past several months.

Put differently, the Bank is ready to flexibly provide funds depending on the state of the market. In fact, around September 9 when the market focused on the possibility of computers malfunctioning and from the end of September to the beginning of October when the demand for funds related to the interim closing of accounts increased, the Bank provided more than 2 trillion yen excess funds to prevent the call rate from rising. Current operational measures possess flexibility to promptly respond to changing market conditions. The decision regarding operational measures on October 13 reinforced such flexibility.

For the immediate future toward the year-end, there might arise upward pressure on market rates. In addition, we must always be vigilant as to whether substantial changes in asset prices such as the exchange rate, long-term interest rates, and stock prices might affect the financial market. The Bank of Japan will flexibly respond as needed if there is any anxiety that turmoil might spread to the financial market.

Dialogue with the market

Lastly, I would like to touch upon the issue of communication between the central bank and the market. This is in response to the frequently heard criticism that the decision on September 21 to go against market expectations was a mistake, and which resulted in the yen's appreciation and stock price plunge.

When considering our response to market expectations, we face two difficult issues.

First is how to preserve the price formation mechanism. For example, if the central bank begins reacting to short-term market expectations, there is the possibility that the market will come to place an overly strong emphasis on the reaction of the central bank, which runs the risk of distorting the price formation mechanism that is supposed to evaluate economic fundamentals. "Dialogue between the central bank and the market" is an oft-cited phrase. I understand this is the process of checking each other's thinking based on a solid analysis of current economic conditions and the outlook. Should such a process deviate from checking economic fundamentals and turn into a guessing game of "who wants what," there is a risk that overshooting and misalignment might ensue.

The second issue is that it is extremely difficult to find a truly effective policy response that works on people's psychology. In some cases, it may at first appear that the policy has been effective, but the effect will diminish as the market regains calm. In other cases, policy announcement or implementation may have a significant impact when the market is temporarily paralyzed by large external shocks or when market expectations swing to one side. In the end, the Bank should make a decision based on thorough examination of the objectives and effects of its policy measures and the situation at hand.

To have constructive dialogue between the central bank and the market, it is important that the Bank's thinking on monetary policy and its evaluation of economic conditions is shared by market participants. To this end, the Bank must explain its thinking on monetary policy in easy-to-understand terms and in a consistent manner. The Bank also needs to produce good results in its policy implementation, which will enhance its credibility.

V. In Closing

Today I have explained our thinking on recent monetary policy from various aspects.

Let me reiterate that the Bank of Japan will continue its zero interest rate policy until deflationary concerns subside and make efforts to ensure further permeation of the effects of such a policy. Under this policy, we will flexibly provide ample funds.

In relation to "flexibility," let me comment briefly on the time framework effect of our zero interest rate policy. Should concerns over the future economic outlook and prices emerge, the market would expect that the timing for lifting the zero interest rate policy would be deferred. If the market incorporates such an expectation, medium- to long-term interest rates will decline more rapidly. When the yen appreciated rapidly in September and the market perceived that the appreciation had gone too far, long-term interest rates actually dropped. The financial market intrinsically has an automatic adjustment mechanism. A combination of the zero interest rate policy and our announced commitment to its continuation, in my view, has a positive effect in maximizing such an adjustment mechanism.

Here I would add that it is not realistic to think that all problems relating to the financial system and structural reform, such as reorganization of the industrial structure in the context of a globalized world, can be solved by monetary policy alone.

Looking back on the eight years since the collapse of the bubble, Japan's economy has faced recurrent deflationary pressure as well as pressure for structural adjustment. The Bank faced the dilemma that while monetary policy alone could not solve structural problems, and at times it might even delay structural adjustment, it had to make a policy response as long as pressure for structural adjustment exerted a deflationary impact on the economy. These thoughts finally led to the adoption of the zero interest rate policy.

Let me close by saying that the Bank of Japan will continue to firmly support the Japanese economy from the monetary side so that some positive signs now being observed in the economy will, this time, lead to a self-sustained recovery. At the same time, we strongly hope that structural reform such as the restructuring of corporate management and the strengthening of the financial system will bear fruit and lay the foundation for renewed development of the Japanese economy.

Thank you for your kind attention.