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On Recent Economic and Financial Developments and Monetary Policy

Remarks by Sakuya Fujiwara, Deputy Governor of the Bank of Japan, to the Yomiuri International Economic Society in Tokyo on December 7, 1999

December 7, 1999
Bank of Japan

Introduction

I am very honored to be invited today and given an opportunity to speak before such distinguished guests.

Since the bursting of the bubble, the Japanese economy has faced a host of structural problems and traveled a tough road toward economic recovery and financial system stability. Moreover, against the background of instability in international financial markets and domestic financial systems from 1997, the economy experienced further deflationary pressure in the course of last year. However, since spring this year, Japan's economy has gradually overcome such a critical situation and has recently shown some signs of recovery.

Let me first give an overview of the changes over the past year and discuss the challenges that lie ahead. Then, I would like to explain our thinking behind the current zero interest rate policy and the tasks we face.

1. Current Economic Situation and Economic Outlook

During the past year, views on the Japanese economy have changed significantly both in and outside of Japan. For example, the OECD's economic outlook in spring this year forecast minus 0.9 percent GDP growth for Japan in 1999 which was revised upwards to 1.4 percent last month. This increase was the largest among developed countries and the 1.4 percent figure is higher than those for Germany and Italy. Moreover, the projection for next year has also been revised upwards, from 0 percent to 1.4 percent. Such a projection may seem somewhat too optimistic in the eyes of corporate managers who are facing tough business conditions as well as households which are facing severe employment and income conditions. In fact, improvement in the economy so far owes considerably to public works and increased exports, and a self-sustained recovery led by private demand has yet to be observed. And, this is the very reason why the Bank of Japan continues to pursue its unprecedented accommodative monetary policy, namely the zero interest rate policy. Nevertheless, it should also be noted that signs of recovery are gradually being seen in the Japanese economy which at one time was on the verge of falling into a deflationary spiral.

Public investment and housing investment supported aggregate demand in the first half of this year. Also, despite the unfavorable income situation personal consumption performed relatively well which was largely due to the rise in stock prices and diminishing concern over financial system instability, leading consumers to harbor less anxiety with respect to the future. Moreover, in summer, overseas economies, especially Asian economies, picked up and exports began to increase conspicuously which led to an upturn in production. This increase in production has not only contributed to higher corporate profits but has also begun to increase household income through a rise in overtime pay. Taken all in all, Japan's economy has stopped deteriorating and is currently turning to improve.

That was a summary of Japan's economic performance from the viewpoint of demand and production, behind which there seem to exist three major underlying developments. First is the recovery of the financial intermediation function, second changes in the industrial structure, and third the interaction of economic recovery in Asia.

Recovery of the financial intermediation function

First, improvements in the intermediation function of financial institutions have begun to be observed. From 1997 through 1998 the financial intermediation function was greatly impaired because of the failure of some Japanese banks and the turmoil in international financial markets. For example, even blue-chip companies found it difficult to issue commercial paper and corporate bonds. Also, the lending stance of financial institutions became even more restrained. This not only restricted corporate activities but also made corporations and households very self-protective, all of which further accelerated the economic downturn.

However, the situation has gradually improved since spring. With the injection of public funds into financial institutions, their capital base has been strengthened. And, against the background of the ample supply of liquidity by the Bank of Japan under the zero interest rate policy, the liquidity concerns of financial institutions and corporations have largely dissipated. The enhanced credit guarantee system has also had a positive impact. As a matter of fact, various surveys show that corporate liquidity is steadily improving and the lending stance of financial institutions is beginning to be less strict compared to last year.

What I would like to especially emphasize here is that a steady improvement has been witnessed in the area of direct finance. During the 12 months up to October, the lending of financial institutions decreased by 8 trillion yen, whereas fund raising in the corporate bond market and CP market increased by 5 trillion yen. This suggests that more than half of what could have been raised by borrowing from financial institutions was obtained through direct financing. Various reforms by market participants such as the abolition of bond eligibility standards, enhanced disclosure, and the streamlining of the corporate bond settlement system are now beginning to bear fruit. The zero interest rate policy has revived risk-taking activities on the part of investors, which resulted in significantly improved environment for corporate bond issuance. For example, the share of bonds with a triple 'B' rating, which was virtually zero last year, increased to 10 percent recently.

Although the financial intermediation function in Japan has recently improved, it is still far from sufficient. We have learned from our experience of the severity of the economic downturn after the bursting of the bubble and also from recent developments that the financial sector has a profound impact on the real economy. Sustained economic growth is difficult to achieve without an efficient financial system and reasonable risk-taking activities.

Industrial reorganization

Second, we are seeing the beginning of changes in industrial structure. For the past several years, Japan's industries have been looking for potential areas to become the driving force of future growth. The difficulty in finding such areas has cast a shadow over corporate sentiment in the form of anxiety towards the future. Recently, however, some hopeful signs have begun to be seen.

One example is the stock market. During the past year, the Nikkei Stock Average has increased by about 50 percent, though performance differs greatly from sector to sector. While stock prices in such sectors as electronics and telecommunications have doubled, those in some sectors have not increased at all. Since summer, stock prices on the whole have been on a rising trend, but in terms of daily price movement, gainers have often been fewer than losers. Such a contrast is further widening and a small number of issues are increasingly responsible for pushing up the overall stock index. Market participants have focused more on promising small- and medium-sized firms. In fact, the stock index for the Second Section of the Tokyo Stock Exchange has increased 2.5 times and that for the OTC market 3.5 times while the Nikkei Stock Average has increased only 50 percent in the past year.

The information technology revolution is often cited as background to all these developments and I am encouraged to see the rise of new enterprises led by a spirit of entrepreneurship as represented by the so-called 'bit valley.' Since I am not an industrial analyst, I do not intend to predict which sector will be promising in the future. What I would like to emphasize is that a competitive framework in which promising sectors or firms can be created and nurtured is beginning to emerge in Japan.

Recovery of Asian economies

Third, we have begun to see a mutually beneficial relationship between the recovery in Japan and recovery in other Asian countries. As mentioned before, the increase in exports from Japan owes much to the recovery of Asian economies. At the same time, imports to Japan from Asia are also increasing at a considerable pace. For example, among the exports of NIEs to various countries, those to Japan have increased the most. This is due to such factors as the recovery of Japan's economy and further progress in the horizontal division of labor within the region. As such, overall intra-regional trade is also expanding. Of course, economic recovery in Japan and other Asian countries is still fragile since much of the recent recovery has been supported by the effect of macroeconomic policy and an increase in exports. And, it may take some time before financial systems are restructured and domestic demand fully recovers. Nevertheless, I believe that within the framework of the interdependent division of labor, a mechanism has been set in motion whereby recovery in one country is fed by recovery in others, thus enabling the economic expansion of the whole region.

Prospects for the recovery of domestic demand

So far I have summarized the background to the improvement in Japan's economy, but I must admit that we are not fully confident whether such an improvement will lead to sustained economic growth. This is because there are no clear signs of a self-sustained recovery in personal consumption and business investment, which are the main pillars of domestic demand.

With excess capacity and excess debt, many firms are still in the process of restructuring and cannot easily loosen the reins on their efforts to achieve efficient management and repay debt. The same applies for employment. Under such a situation, even if corporate profits increase and liquidity conditions ease, it will be difficult for firms to make additional fixed investments.

Given the pressure of restructuring put on firms, it is not easy to expect any clear improvement in either employment or the income environment for the household sector. I mentioned that recently personal consumption had performed relatively well considering the severe employment and income conditions. This is because of the rise in the propensity to consume. However, for a full-fledged recovery of personal consumption, employment and income conditions must stop deteriorating and the household sector believe that such conditions will improve.

Also, we need to carefully monitor developments in the foreign exchange market and the influence on the economy. From summer through fall, the yen appreciated rapidly and its recent movement remains somewhat unstable. So far the negative impact of the yen's appreciation on exports has been mitigated by the recovery of overseas economies and, on balance, does not seem to have had any major adverse effects on the economic outlook and business sentiment. Also, the resilience of Japanese exporting firms to fluctuations in the foreign exchange rate has been strengthened as they have made efforts to establish global production lines and make high value-added products since the 80s. Having said all this, the fluctuations since summer have been large and rapid and we will continue to carefully monitor their impact.

Challenges facing structural reform

Looking at next year, what can be done to strengthen the recovery of private demand? I believe the answer lies in this year's positive developments which I have just touched upon. To repeat, they are a recovery of the financial intermediation function and an improved competitive environment for industry. For example, although the financial intermediation function is improving, it is not yet sufficient. Let me amplify on this as an illustration.

When new firms are created, how they obtain funds differs significantly between the US and Japan. In the US, 70 percent of the funds come from own capital and most of the remaining 30 percent from venture capital and individual investors known as 'angels.' On the other hand, in Japan, own capital only amounts to less than 30 percent, and 70 percent of external funds are borrowings from financial institutions. According to a survey conducted by the Small and Medium-Sized Enterprise Agency, newly established firms find fund raising a major obstacle in starting business rather than human resource management and technological development.

Indirect financing still plays a large role in nurturing new industries and firms in Japan. Thus, it is most important that financial institutions quickly regain their strength to support such activities through the disposal of non-performing loans and the pursuit of efficient management. In this respect, we need to continue improving the financial infrastructure in such areas as asset liquidation.

At the same time, direct financing should be strengthened. In relation to the example of nurturing new firms that I just mentioned, the MOTHERS project of the Tokyo Stock Exchange, reform of the OTC market by Japan Securities Dealers Association, and a movement to establish NASDAQ Japan are part of new developments to facilitate their fund raising. There are high expectations that these developments will contribute to strengthening direct financing. As for industrial reorganization, the Comprehensive Economic Policy Package recently drawn up by the government included many measures to support the reform efforts of small and medium-sized enterprises and to promote deregulation in growth industries.

Finally, I would like to emphasize that macroeconomic policy such as monetary and fiscal policy cannot replace structural policy. Macroeconomic policy, in the present structural context, is only a measure to buy time. In addition, we should remember that the fiscal deficit has expanded to a considerable extent and that monetary policy is being conducted when the short-term interest rate is virtually zero. Of course, the Bank of Japan will strongly support economic recovery by continuing the zero interest rate policy. However, while such macroeconomic policy measures have a supportive effect, it is necessary that various structural policy measures be implemented expeditiously to encourage forward-looking activities on the part of the private sector.

2. On Current Monetary Policy

Features of the zero interest rate policy

Now let me turn to the conduct of monetary policy.

Since February, the Bank of Japan has been pursuing extraordinary monetary easing through its zero interest rate policy. But because we have elaborated on the content and basic thinking behind this policy on various occasions, here I will only mention three features that have relevance to today's discussion.

The first is that the zero interest rate policy is a powerful monetary easing tool even when viewed from a quantitative aspect. In order to encourage the uncollateralized overnight call rate to move down to zero percent and maintain it at that level, ample funds need to be supplied. However, the provision of these funds by the Bank of Japan to the interbank market does not automatically lead to an expansion in bank lending and money supply. For such a process to work, financial institutions and the securities market must effectively discharge the function of financial intermediation and firms need to actively seek funds. While current financial markets can adequately respond to any positive developments in the real economy, it is important to strengthen the financial system and revitalize corporate activity through the structural measures I mentioned earlier.

The second feature is that the Bank has made a commitment to continue the zero interest rate policy "until deflationary concerns subside." As a result of this commitment, the effects of the zero interest rate policy have smoothly permeated to longer term interest rates. Except for the rise in over the year-end interest rates due to Year 2000 problems, interest rates with a maturity of up to one year have declined to the zero percent range.

In addition, such commitment has also given some flexibility to the zero interest rate policy. For example, let us assume that the economy receives an adverse shock. The market would naturally anticipate that lifting of the zero interest rate policy would be postponed. This would result in a swift decline in longer term interest rates with the overnight rate remaining at zero, thereby reinforcing the effects of monetary easing. We may call this "the time framework effect" of our zero interest rate policy.

The third feature is that the Bank has been strengthening its money market operations so as to assure permeation of the effects of monetary easing. For example, the Bank is prepared to continue the provision of ample funds and maintain the zero interest rate policy in the event of increased fund demand in the short-term money market due to the year-end factor or Year 2000 problems.

Since the zero interest rate policy is unprecedented both historically and worldwide, there have been a variety of suggestions and criticisms. For example, there are views which emphasize the negative side effects of the policy such that it distorts the income distribution of the household sector or delays structural reform. Such side effects certainly cannot be ignored. We recognize that the zero interest rate policy is an option that could, with these negative side effects in mind, barely be justified under the current situation. What is most important at this juncture is to support the economic recovery through extraordinary monetary easing, and, if successful, the favorable effects will surely spread to the household sector as well.

In contrast, there have been criticisms that the degree of monetary easing has been insufficient despite the zero interest rate policy. For example, the call for further quantitative easing is one such criticism. In this regard, as I stated earlier, the zero interest rate policy is in itself a powerful monetary easing measure from the quantitative aspect.

Some have suggested further monetary easing through unsterilized yen-selling foreign exchange intervention. If 'sterilized intervention' means 'the Bank absorbing all yen funds provided by individual yen-selling intervention through daily money market operations,' then the Bank is not implementing such operations. Under the zero interest rate policy, the Bank has been flexibly providing ample funds to the short-term money market in an amount more than necessary for financial institutions, taking account of factors including yen liquidity arising from foreign exchange intervention. On December 1, Governor Hayami issued a statement referring to this point and clarified once again the relationship between the Bank's money market operations and foreign exchange intervention.

In addition to these arguments, discussions on inflation targeting have recently gained momentum, and I would next like to give my views on that subject.

Two views of inflation targeting

Put simply, inflation targeting means setting a specific target inflation rate and conducting monetary policy aimed at achieving that target. This policy was adopted by countries such as New Zealand, the United Kingdom, and Canada in the early 90s. These countries had been suffering high inflation and through each respective central bank exhibiting strong commitment to containing inflation by adopting inflation targeting, they were successful in reducing inflation to some degree.

However, in recent discussions in Japan, there seem to be two different views on inflation targeting. One holds that inflation targeting is a measure for further monetary easing under the zero interest rate policy whereas the other regards it is a medium- to long-term framework for the conduct of monetary policy.

As a measure for further monetary easing, inflation targeting is utilized to escape from a deflationary situation. A somewhat high target inflation rate is set and all possible measures are mobilized until it is achieved. This line of thinking tends to suggest, in its extreme form, that a central bank should purchase all kinds of assets including long-term government bonds, stocks, and even real estate until it achieves the set target. This is a kind of 'reflation theory' disguised under the name of inflation targeting. On the other hand, inflation targeting can be regarded as a longer term policy framework that can be utilized to effect both monetary easing and tightening by putting emphasis on the long-term stability of market expectations and enhanced accountability of the central bank.

Problems with "reflation theory"

In the past, there were occasions when reflation theory was put forward as a way out of a stagnant economy. It is argued that the revitalization of economic activity through moderate inflation would be good for the nation as a whole. In Japan, there are views that focus on the cost reduction effects of inflation since firms are suffering excess debt and the fiscal deficit has become quite large. However, to resolve economic problems by inflation is an extremely dangerous option and an unacceptable method for a central bank.

First of all, is it possible to realize "moderate inflation"? Once inflationary expectations arise, more often than not they multiply themselves. And, once inflation emerges, we need to rapidly put the brake on the economy to combat inflation. Such a response runs the risk of a large swing in economic conditions. When people become uncertain about future prospects due to large swings in the economy and prices, their economic activities become defensive. Firms will suppress business investment and there is a high risk of economic dynamism being lost.

Second, we cannot neglect the negative impact of inflation on financial assets. The value of household financial assets, currently amounting to some 1,300 trillion yen, would be eroded in real terms by inflation. The depreciation of financial assets due to inflation would only aggravate the distribution problem, which is pointed out as a negative side effect of the low interest rate policy.

Third, is it possible to alleviate the debt burden by inflation? This question should be examined by taking account of the development of financial and capital markets as well as the trend toward globalization. For example, if people start worrying about future inflation, in an efficient financial market, such concern would be immediately translated into an increase in interest rates. In this case, while inflation might lessen the burden of past debt it would increase the burden of new debt. There is no guarantee that we could complete the clean-up of the aftermath of the bubble and achieve fiscal consolidation.

Therefore, to resolve problems by way of inflation is not only accompanied by extremely large side effects but also entails a high degree of uncertainty as to whether the desired effects can be achieved.

Inflation targeting and accountability

Inflation targeting, in its original concept, is a measure that emphasizes a central bank's strong commitment to its policy objective, price stability, thereby enhancing the transparency of monetary policy management. Since we have been making efforts to enhance accountability under the new Bank of Japan Law, we can thoroughly understand this concept. However, it is true that there are many issues that need to be addressed.

First of all, there are a host of problems in defining "price stability" by using a specific price indicator and setting a target. For example, which price indicator is desirable? How should we take account of external shocks? Is it possible to set a meaningful target rate when the quality of such products as personal computers and cellular phones improves or prices decline as a result of the rapid pace of technological innovation? One might say these problems are a matter of judgment, and there are indeed some such aspects involved. However, it seems to me that the problems pose a serious challenge involving a fundamental question like "what is price stability?"

In addition, the relationship between inflation targeting and the transparency of monetary policy management is, in fact, not that simple. While it is true that monetary policy management would become easier to understand if numerical targets were introduced, since a relatively long time is needed before the effects of monetary policy permeate the economy, it is almost impossible to set a current rate of inflation as a target. It thus becomes necessary to conduct monetary policy by assessing the target rate with a forecast of the future inflation rate. For example, in the United Kingdom, the target inflation rate for two years ahead is set at 2.5 percent. The Bank of England recently tightened its monetary policy despite the recent inflation rate being only 2.1 percent. This episode typically illustrates that, in order to assure medium- to long-term price stability, policy judgment should be made taking account of various factors including potential inflationary pressures.

What we have discussed so far tells us that an overall judgment taking account of the future state of the economy and price developments is essential for the conduct of monetary policy, regardless of whether inflation targeting is adopted or not. If so, it is equally important to clearly explain policy decisions and the thinking behind them.

At present, the Bank of Japan is explicitly stating its stance to "continue the zero interest rate policy until deflationary concerns subside." This can be regarded as having the same effect as inflation targeting while avoiding difficulties in setting a numerical target. Having said this, we will continue to study methods and frameworks regarding the conduct of monetary policy paying due attention to various opinions both at home and abroad.

Thinking behind "deflationary concerns subside"

Finally, let me explain what we mean by "we will maintain the current zero interest rate policy until deflationary concerns subside." The following questions are often put to us: Haven't deflationary concerns yet dissipated since the economy has begun to recover? Aren't the criteria rather unclear as to when such concerns are expected to subside?

Regarding current price developments, CPI and WPI are almost level. For example, CPI declined as much as minus 0.5 percent on a-year-on-year basis in September 1998, but is now around zero percent. According to this movement, we are not in a deflationary situation. However, in the framework of inflation targeting, what monetary policy should focus on is whether such price stability is sustainable for the future. Hence, what matters is not the current movement of price indices but the judgment regarding various risks concerning future price developments.

From such a viewpoint, in the situation where the sustainable recovery of private demand has yet to be seen and the risk of recession lingers, we cannot conclude that potential deflationary pressures have been sufficiently contained. Thus, it is too early to say that we have reached the stage where deflationary concerns have subsided. This is the majority view in our Monetary Policy Meetings up until now.

At Monetary Policy Meetings, policy board members will continue to carefully examine price developments taking account of such factors as whether the risk of the output gap further widening is judged to have become sufficiently small, and whether the probability of recovery exceeds that of recession. I would add that we will thoroughly explain our decisions and the thinking behind them to the market as well as to the public through our monthly economic reports and minutes of Meetings.

Concluding Remarks

Today, I firstly summarized the development of Japan's economy and the conduct of monetary policy during the course of this year. Then, I explained the challenges that lie ahead and our thinking behind the current conduct of monetary policy.

I hope that the positive developments outlined today will lead to a sustainable recovery of the economy and that the new millennium will usher in a truly new beginning for Japan's economy. In this regard, it is vitally necessary to revive the dynamism of the Japanese economy through not only macroeconomic policy such as monetary and fiscal policy but also structural policy and the innovative power of the corporate sector. To this end, the Bank of Japan will continue to make the utmost efforts.

Thank you for your attention.