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Remarks by Kazuo Ueda, Member of the Policy Board

Remarks given by Kazuo Ueda, Member of the Policy Board of the Bank of Japan, at the Fed Conference on "Monetary Policy in a Low-Inflation Environment," in Woodstock, Vermont on October 20, 1999

October 22, 1999
Bank of Japan

I would like to start by congratulating the organizers of this conference for having been very successfully forward-looking. Zero interest rates have become a reality if in a small part of the world. I regret that I have not been forward-looking enough. By first having accepted the invitation to attend this conference and then having driven rates down to zero, I put myself in a very difficult position.

Anyway, let me start by spending a few moments discussing what we have been doing since last year. When I joined the Board in April last year, the overnight call rate was already slightly below 0.5 percent--not a good time to join a central bank. Since then we have cut it down successively to zero, more precisely 0.01 percent for lenders and 0.02 percent or above for borrowers. The overnight rate came down to these minimum levels toward the end of March. This was already a very extreme monetary policy stance, and we had gone to the extreme using a traditional tool, i.e., the overnight rate. I must say that we needed a lot of courage to go to the zero rate.

In April, we went further in a fairly non-traditional way. That is, our governor said we would stick to the zero rate policy until deflationary concerns were over. This commitment, we think, delivers something very close to what inflation targeting or quantitative targeting might offer, to the extent that you believe that monetary policy works through interest rates. Or, we could say that this has been like us writing a put option on short-term assets. Yet another way of explaining our position could be the following: by the commitment to maintain the zero rate for quite some time to come, we have tried to minimize uncertainties about future short-term rates, thereby decreasing the option value of long-term bonds, hence putting negative pressure on long-term interest rates. With this announcement, market interest rates came down sharply again. As of last week, three-month and one-year TBs were traded at 0.045 percent and 0.035 percent, respectively.

Do we need any further action? Obviously, it depends on where you think the economy is. After growing at negative rates for five consecutive quarters, real GDP grew at surprisingly high rates in the first two quarters of this year. We were worried that this turnaround could be short-lived because the stimulus from fiscal policy was expected to peter out later this year. However, the news we have been getting for the 3rd and 4th quarters have been encouraging. For example, the index of industrial production is expected to stay fairly strong in the second half of the year, up about 3 percent over last year. Furthermore, we are now pretty much sure that the fiscal stimulus will continue well into the next year.

Prices have stopped falling. CPI is almost unchanged relative to last year. Changes in other indexes like domestic WPI are still negative relative to last year, but are either zero or slightly positive relative to three months ago.

Offsetting this, the appreciation of the yen may exert some negative impacts on the economy in the near future. Serious corporate restructuring efforts are underway, dampening the response of investment or consumption to the expected rise in sales and profits. So, all in all deflationary concerns have not abated. That is why we have not changed our policy stance.

Assessment of the current state of the Japanese economy is certainly not the topic of the conference. But I felt that there is some misunderstanding that Japan is in the midst of a serious deflation, which is why I spent a few minutes on the question.

Now let me briefly touch upon an academic, not a real-world question of what a central bank can do beyond zero rates if it ever wanted to ease from that point on. Of course, my comments will be necessarily motivated by what I have seen in the Japanese economy during the last few months.

To begin with, back to reality for the moment. The current policy stance of the BOJ has an automatic stabilizer element in it despite the fact that we have hit the zero rate bound. That is to say, the promise to "keep the zero rate until deflationary concerns are over" puts downward pressure on long-term interest rates when people see negative signs about the economy, because they expect the zero rate to stay for a longer period of time. A similar thing would happen under many circumstances. But the current commitment seems to have strengthened the effect.

Let me now come back to academic exercises. I have not digested all of the suggestions made so far in this conference. So, let me comment on a subset of them. First, there was the idea of creating negative nominal interest rates. Second, quantity of money may matter even without changes in interest rates. Third, purchases of non-traditional assets may work through their effects on the prices of these assets.

Starting with negative rates. This is an interesting idea. But imposing a tax on banknotes seems to require some technological improvements at least. It will take time. So, it may be useful for the Fed or the ECB, but not for the BOJ. The most serious problem with this proposal, however, seems to be the effort it takes to educate the public about the meaning and necessity of negative rates on currency.

Second, let me move on to discussing money supply effects on the economy other than through interest rates. I must say they are very small once liquidity has been injected enough to maintain the zero rate. McCallum's simulation seems to support such an intuition. I hasten to add that, once the zero rate is reached and spreads over to most of the short-term interest rates, attempts to expand the money supply themselves may become unsuccessful. We have been experiencing this lately in Japan.

Hence, suggestions have been made to go beyond traditional tools of operations. The list is very long: long-term government bonds, stocks, consumer durables, real estate, foreign exchanges, and so on. There are at least two reasons for buying these assets: the purchase may reduce the external finance premium; and it may change the prices of these assets. Of course, the two mechanisms are interrelated. On the external finance premium question, I think the effects on the premium of central bank purchase of bonds would be small in a country like Japan, where the majority of bonds are held by financial institutions. Thanks to the zero rate policy among others, they are not paying high premiums nor liquidity-constrained. The story would be different if a central bank started buying stocks, or real estate.

Whether central banks can systematically affect the prices of these assets is an old question to which no one has a satisfactory answer. Let us for the moment assume that they can. Then, surely central bank purchase of at least some of these assets will affect the economy.

Just a few words on central bank purchase of foreign exchanges. Sorry to come back to the Japanese example so often, but I just wanted to note that the BOJ cannot do this because it is prohibited from buying dollars in an attempt to influence the exchange rate. The MOF can, of course, do it, and we are in no way against their doing it at appropriate timing.

There remains the question of whether intervention should be sterilized or not. As many have pointed out in this conference, sterilized and unsterilized interventions are theoretically equivalent under zero interest rates unless one wants to rely on probably non-rational market expectation that the two are different.

As a footnote to the discussion of buying non-traditional assets, I might point out that the BOJ has expanded the menu of instruments in a rather unusual way. Now we use or plan to use commercial paper, corporate bonds and asset-backed securities, but in a disciplined way. That is, we do not buy them outright but under repurchase agreements, or we use them as collateral for other operations. This way the instruments are used to supplement our operations in the money market, and the double-name principle is strictly applied. Of course, the purpose of the operations has been, in addition to providing funds in the money market as a whole, to increase the liquidity of the markets for the instruments so that the effect of money injection would have a larger impact on the economy.

Going back to outright purchases of non-traditional assets, I must say that they generate various types of costs for the central bank and for the economy, some of which we may not be aware of and most of which are not explicitly dealt with in formal models economists use. These costs certainly ought to be weighed against possible benefits of the operations before any decision is made. I hope we will not be the one to make such a risky decision.

I promise, however, to bring all the interesting ideas I have heard in this conference to the attention of my colleagues in Tokyo. Meanwhile, I must say that one of the most important messages of the conference has been: do not put yourself into the position of zero rates. I tell you it will be a lot more painful than you can possibly imagine. Thank you.