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Home > Announcements > Speeches and Statements > Speeches 1999 > Speech given by Nobuyuki Nakahara, Member of the Policy Board of the Bank of Japan, at the Capital Markets Research Institute in Tokyo on November 1, 1999 (Current Economic Conditions in Japan and Challenges for Monetary Policy)
Speech given by Nobuyuki Nakahara, Member of the Policy Board of the Bank of Japan, at the Capital Markets Research Institute in Tokyo on November 1, 1999
December 14, 1999
Bank of Japan
It is a great honor to have been invited to speak to such a distinguished group of experts from the banking and securities industries. I would like to take this opportunity to give my personal view on the following topics: developments in monetary policy since April 1998; the current state of the Japanese economy; and the downside of the zero interest rate policy. I will also explain my proposal put forward at Monetary Policy Meetings to set targets for the monetary base and the inflation rate. I will give an overall review of these topics, and hope that I will not sound overly self-righteous.
First, I would like to talk about developments in monetary policy since April 1998 and issues discussed at Monetary Policy Meetings in chronological order. I would like to make clear my opinions put forward at the meetings, taking care not to breach the code of confidentiality. This is a summary and personal reflection on the implementation of monetary policy since the new Bank of Japan Law came into effect in April 1998. My conclusion is that there is still room for additional monetary policy measures, even in the current environment of zero interest rates, and that one of the possible measures is to set targets for increases in the monetary base and the general price level.
I would like to draw your attention to Monetary Policy Meetings since April 1998. These 18 months can be divided into four periods in view of the decisions made at the meetings. The first was from April to September 9, 1998, when the target for the uncollateralized overnight call rate was lowered to 0.25 percent. The second was the period from September 9 to November 13, 1998, when the policy board decided to facilitate corporate financing by expanding the Bank's CP operations, establish a temporary lending facility, and study the feasibility of a new operation using corporate debt obligations as eligible collateral. The third was the period from November 13, 1998, to February 25, 1999. At the February 12 meeting, the guideline for money market operations was changed, leading to the adoption on February 25, 1999, of the so-called zero interest rate policy. The fourth was the period from February 25, 1999, to today. At the September 21 and October 13 meetings, no changes were made to monetary policy.
At a press conference on April 1, 1998, when I was inaugurated as a Policy Board member, I gave the following assessment of the economy. First, the economy was in an extremely severe situation due partly to restrictive fiscal measures. The public came under a burden totaling nine trillion yen as a result of a these fiscal measures, i.e., the abolition of special tax cuts worth two trillion yen, an increase in the consumption tax which amounted to five trillion yen, and a rise in medical and other charges amounting to two trillion yen. Second, business fixed investment was in a cyclical phase of decline. Third, the international competitiveness of Japanese firms was declining as a result of excessive capacity and labor. Improving the efficiency of capital was therefore an urgent task, and it was clear that corporate restructuring would be crucial over the next several years. Lastly, if the economy were to worsen, monetary policy would need to be eased further.
At that time, the economy was in a declining phase from a cyclical perspective, with real GDP falling for three consecutive quarters on a quarter-on-quarter basis from the October-December quarter of 1997. This, combined with insufficient economic policy measures and a degeneration of the financial system's credibility due to problems such as banks' nonperforming loans, made it extremely difficult to foresee economic developments.
Against this background, I started proposing from the June 12 Policy Board Meeting that the uncollateralized call rate be guided to a lower level. The Policy Board's directive for the Bank's money market operations at that time was to "encourage the uncollateralized overnight call rate to remain on average slightly below the official discount rate." I proposed that monetary policy be eased further by gradually guiding the uncollateralized overnight call rate even lower. I proposed the following target rates: 0.40 percent at the June 12 and 25 meetings, 0.35 percent at the July 16 and 28 meetings, and 0.25 percent at the August 11 meeting. All of these proposals were voted down. The debate at those meetings was centered on (1) a perception gap regarding the future of the economy--the other members were not as pessimistic as I was about the outlook, and (2) a difference of opinion with regard to how to react to the government's economic measures--whether to wait and watch the effects of the measures or whether to quickly implement monetary measures in view of the severe state of the economy. Let me expand on this. For example, at the July 28 meeting, one member expressed the view that "the risk of a double-dip decline in the economy involving a further substantial drop in production had been reduced." Even at the August 11 meeting, just before monetary policy was eased, some members expressed the opinion that "for the time being it was most important to keep a close watch on the contents and effects of the large-scale fiscal package covering fiscal 1998 and fiscal 1999, as the details of the package were gradually becoming apparent." My opinion was quite different. Many of the other Policy Board members took a mildly optimistic view of the situation, and were inclined to take a wait-and-see stance with regard to fiscal policy and its effects. In contrast, I stressed the necessity of further monetary policy easing in light of (1) slumping business fixed investment and deteriorating employment conditions, (2) the fact that the state of the economy was even worse than in September 1995, when monetary policy had last been eased, and (3) the unstable movements in the stock markets of Tokyo and New York. Finally on September 9, the target for the uncollateralized overnight call rate was lowered to around 0.25 percent. I recall that, at the beginning of that meeting, some members seemed a bit hesitant about further monetary easing. However, at the end of the meeting, nearly all of the members voted to lower the uncollateralized overnight call rate, overturning the decision reached at the previous Monetary Policy Meeting. Personally, I regret the fact that a preemptive step--a rate cut at an earlier stage--based on the Bank's internal economic forecasts was not taken.
The second critical moment was the November 13 meeting. As a result of discussion at this meeting, the following were decided and announced to facilitate increasingly severe corporate financing conditions over the end of the year and over the end of the fiscal year. First, the Bank would make active use of CP operations with repurchase agreements and, to this end, would expand the range of CP eligible for operations under repurchase agreements to include those with remaining maturities of up to one year (previously restricted to up to three months), and also expedite the process of CP eligibility evaluation. Second, as soon as necessary arrangements had been made, the Bank would establish a temporary lending facility to refinance a fixed proportion (50 percent) of the increase in loans provided by each financial institution during October-December. Third, the Bank would start a new market operation utilizing corporate bonds and other debt obligations as collateral. At the previous Monetary Policy Meeting on October 28, I had proposed that the Bank indicate clearly in the directive its intention to make active use of CP operations. This proposal was defeated at the October 28 meeting, but won majority support at the November 13 meeting. On November 13, I opposed the proposals to create the temporary lending facility and start market operations utilizing corporate bonds and other debt obligations as collateral. I was concerned that people might think the introduction of the temporary "lending" facility would pave the way for the revival of a lending facility previously used as a market operation, which was criticized as being too discretionary and was later abolished. My opposition to launching the new scheme utilizing corporate bonds and other debt obligations, which was to be installed as a permanent policy tool, was based on concern over the Bank expanding its operations into corporate financing, which is conducted essentially by private financial institutions. I believe the Bank should basically conduct monetary operations utilizing government securities, like the Federal Reserve System. If the Bank plays a role in corporate financing, it should limit such activities to its traditional operations of rediscounting commercial bills or market operations utilizing CP, which have relatively short maturities. I basically think that the Bank should not readily expand its role in corporate financing. Purely for your information, outstanding loans extended under the temporary lending facility in fact peaked at only 1,035.6 billion yen, partly owing to factors such as developments in interest rates during the period concerned.
A development worthy of special mention occurred before the November 13 meeting. On October 9, the Nikkei 225 Stock Average fell sharply below 14,309.41 yen--the low of August 18, 1992--to 12,879.97 yen, its lowest level since the bursting of the economic "bubble." Some Policy Board members had earlier repeatedly argued that an interest rate cut should be saved for emergencies such as a dramatic fall in stock prices or an intensification of deflation. However, when the emergency became a reality, no steps were taken to change monetary policy. I believe this risk of inaction still remains. For example, some members have said that quantitative easing should be implemented should the yen surge dramatically. I doubt, however, that such timely action will be taken.
After that, seeing that the economy was showing no signs of a turn for the better, I started proposing from the meeting on November 27, 1998 that the overnight call rate be lowered even further. At the November 27 meeting, I proposed the uncollateralized overnight call rate be lowered to 0.15 percent; on December 15, 1998 and January 19, 1999, I proposed a rate of 0.10 percent; and on February 12, I proposed that the Bank conduct quantitative easing (expand the monetary base) by maintaining the uncollateralized overnight call rate at as low a rate as possible. I stressed that this move was aimed at "quantitative easing" and included it specifically in my proposal because room for a further reduction in the interest rate was extremely limited. My proposal was defeated, and the chairman's proposal for the Bank to "provide more ample funds and encourage the uncollateralized overnight call rate to move as low as possible....initially aim to guide the above call rate to move around 0.15 percent, and subsequently induce further decline in view of the market developments" was adopted. I believe this proposal was approved because a perception was growing that downside risks were increasing due to pressures stemming from rising long-term interest rates and the stronger yen. I voted for the chairman's proposal because it included my contention that emphasis should be put on quantitative easing. However, the overnight call rate did not fall below 0.12 percent despite comments by Governor Hayami at a press conference on February 16 that the Bank did not rule out the possibility of zero interest rates. Therefore, at the February 25 meeting, I expressed my concern that the easing might not be effective, and urged that efforts to push the rate down be accelerated. In response to the situation, the Bank's operation unit started boosting its injection of funds into the money market in late February so that its projection of the daily excess of reserves, which is announced each morning and affected in part by the Bank's market operations, totaled 1.3 trillion to 1.8 trillion yen. As a result, the stock market suddenly started showing signs of a recovery in early March, and interest rates gradually fell close to zero. The zero interest rate policy is still in effect today. Looking back at developments in monetary policy since April 1998, I believe the monetary easing on February 25 was the most effective, largely because of its quantitative character; it substantially increased the projected daily excess of reserves. This quantitative easing had a positive effect on the stock, bond, and foreign exchange markets, and helped improve the confidence of market participants. Since the February 25 meeting, I have proposed the Bank set targets for the monetary base and the inflation rate. I will go into detail on this later.
I would like to touch last upon the September 21 meeting. At the time of this meeting, the yen--which had broken through 110 yen and was appreciating--was a focal point. However, many members of the Policy Board appeared to be surprisingly complacent about the impact of the rapid rise in the yen. I have spent most of my career in the oil industry, which is extremely sensitive to fluctuations in foreign exchange rates. My experience there has taught me that the difference in the effect on businesses with the yen staying at 120 yen to the dollar and breaking a resistance level at 108 yen is significant. Therefore, it was my opinion that preemptive action should be taken. I also believed market intervention should be unsterilized, if the markets were expected to react favorably to such a decision. At the September 21 meeting, as the minutes show, members generally shared the view that "a little more time was needed to judge the degree of the downside risk to the economy arising from the recent appreciation of the yen." My understanding is that most members were inclined to take a wait-and-see stance. I warned them that financial markets, not only the foreign exchange market, but also the Tokyo and New York stock markets, were at an extremely critical juncture, thus, grave consequences might ensue if appropriate action was not taken. On September 21, the Policy Board by majority vote decided to leave monetary policy unchanged. On the same day, the Bank issued a statement "On the Current Monetary Policy," and the chairman of the Policy Board explained at a press conference the thinking behind the belief that "additional fund provision" would not be effective. I was against issuing the statement. Members who supported the idea of issuing such a statement probably did so either because they thought financial markets were misinterpreting monetary policy and therefore should be informed of the Bank's true intentions, or because they were becoming concerned about financial markets not moving in the direction the Board members wanted them to. With the exception of when changes are made in monetary policy, I believe that the best way to explain the Bank's position is for the chairman of the Policy Board to give a detailed explanation at press conferences. I fear the issuing of the statement may well bind the Bank's future actions.
At the October 13 meeting, the Policy Board decided to start operations involving outright buying and selling of short-term Japanese government securities and announced an expansion of the scope of government bonds eligible for repo operations, both with a view to strengthening money market operations. I believe these two measures will contribute to the further improvement of money market operations.
Now let me give my view of the Japanese economy.
Since the bursting of the enormous economic "bubble," the Japanese economy has been heavily weighed down by the burden of excessive capacity, labor, and debt. Business fixed investment has slumped by an unprecedented degree, and the unemployment rate has hit record highs. The Japanese economy remains mired in an extremely unusual phase.
To sum up my view of the current state of the economy, I believe it is highly likely the economy hit bottom around April or May this year judging from the indices of business conditions for July and August. However, this development can be ascribed largely to policy measures. Although the economy appears to be heading in the right direction, the momentum of the recovery is extremely weak and vulnerable. As for the outlook for next fiscal year onwards, there are hardly any signs of the economy returning to a self-sustaining recovery. Taking these factors into consideration, I believe that preemptive action--a further monetary easing--should be taken in conjunction with the implementation of fiscal policy.
I would now like to talk about the economy from the perspective of economic cycles. According to an analytic method devised by U.S. economist Michael Boldin, which uses the composite index of business conditions, it could be said that if the coincident composite index of business conditions for September, due to be announced on November 4, is above 97.5, the economy hit a trough in May. The CIBCR method shows that a trough was hit during March to June, and the diffusion index shows that a trough was hit in July. In conclusion, I believe it is highly likely that the economy hit a trough around April to May.
These analyses point to a strong possibility that the economy is heading toward a recovery. However, the economy is still very unstable and fragile, and a slight adverse development could depress it because of the following four factors. First, it is unlikely that further positive effects will emerge from policy measures and external factors. Policy measures--including an increase in public investment, a reduction in housing taxes, an expansion of the credit guarantee system, and monetary easing--have, together with external factors such as a recovery in other Asian economies, just managed to support the economy up till now. Second, it is still hard to envisage a self-sustaining recovery in domestic demand such as business fixed investment and private consumption. Third, the problem of excessive capacity, labor, and debt--a legacy of the bubble economy--has not been resolved. Corporate restructuring is approaching a critical stage in eliminating the three "excesses." And fourth, growth in monetary aggregates such as money stock and the monetary base is slowing, and this, through the appreciation of the yen and other factors, could have a negative effect on the economy.
I am extremely concerned about the course of the economy from next fiscal year onward. Recently, the government started compiling a second supplementary budget, and plans to keep the next fiscal year's public investment at this fiscal year's levels, but I think this will probably be difficult to accomplish. The economy will therefore have to increasingly rely on private demand. Unfortunately, a number of negative factors have emerged for Japan's exports, which have been relatively firm up to now: the real effective exchange rate of the yen has risen by a monthly average of more than four percent from July to September, the sharpest rate of rise since the United States abandoned dollar-gold convertibility in 1971; and the financial sectors of some other Asian countries are in the midst of restructuring and their exports hinge on the trend of those to the United States, which is unforeseeable. With regard to private consumption, employees' income is falling as a result of the deterioration in employment conditions due to corporate restructuring and cuts in wages and salaries per hour. Hopes are pegged on an improvement in households' propensity to consume, but I believe such an improvement will be limited. Moreover, in business fixed investment, any turn for the better is likely to be from the second half of fiscal 2000 at the earliest owing to the excess in capacity. It is still too early to draw a scenario of a self-sustaining recovery led by private demand. I also fear that land prices may not bottom out for some while, and we need to be aware of the fact that this may delay corporate restructuring and cause financial institutions' nonperforming assets to increase.
As for financial markets, as I said earlier, the foreign exchange market and stock markets in Tokyo and New York have just passed through a critical period, and at present, stocks in the United States appear to have entered an unstable phase while the rebound in Tokyo stocks has been feeble. In the foreign exchange market, the yen appears to be gathering upward momentum.
Thus, various aspects of the Japanese economy remain extremely vulnerable, and it is necessary to secure an economic recovery by preemptive monetary easing synchronized with fiscal policy, bearing in mind Article 4 of the Bank of Japan Law.
There are many formulae to calculate the deflationary gap; the one giving the largest gap--in the most severe case--produced a figure of eight to ten percent of GDP. The inflation rate is zero or slightly below zero, and I therefore believe there is no doubting the need for further monetary easing. Moreover, with the effects of the zero interest rate policy appearing to have waned, I believe it would be advantageous to change the monetary policy regime by introducing targets for the monetary base and the inflation rate.
Next, I would like to talk about the problems of the zero interest rate policy in this unusual economic environment.
Based on my understanding, the following can be said of the zero interest rate policy: (1) the policy targets solely an interest rate and does not aim at a quantitative easing with a concrete numerical target; (2) the effects of the policy seem to have dissipated between March and the present; (3) the objectives of the policy are abstract and unclear; (4) the policy has exposed the inconsistency of the technical methods used by the Bank of Japan in money market operations; and (5) the policy is symbolic and does not allow further action--the only options are to continue it or to stop it. Furthermore, ending it will give rise to various problems.
To expand on the first point, the zero interest rate policy targets only the uncollateralized overnight call rate; it does not target an increase in reserves or monetary aggregates. It differs clearly from quantitative easing that sets a target for monetary aggregates such as the monetary base. Under the zero interest rate policy, ample funds will be provided so that the interest rate falls to zero. However, the logic of the policy implies that, after the zero interest rate is attained, there is no need to supply additional funds. Moreover, with the current money market operations, the provision of funds to achieve a daily excess of one trillion yen in reserves is deemed necessary and sufficient, except for when firms need to procure funds for the end of their business terms. Therefore the provision of funds is not increased, and additional positive effects of quantitative easing are unlikely. If the Bank, in the current zero interest rate environment, conducts market operations so that the daily excess of reserves significantly exceeds one trillion yen, a quantitative target should be set and such a decision should be made by the Policy Board.
The second point reflects my view that the effects of the zero interest rate policy have dissipated since March. Although the phrase "further permeation of the zero interest rate policy" is reiterated, the foreign exchange, stock, and bond markets, which react instantaneously, are unlikely to show further positive response and the likelihood of a favorable impact on the real economy, via low interest rates stimulating business fixed investment, is remote.
On the third point, this policy is abstract and many difficult phrases are used to explain it. Such expressions as "abundant and flexible provision of funds" and "provision of ample funds" mean only necessary and sufficient funds will be provided purely for the purpose of pushing the overnight call rate to zero, and thus additional increases in the provision of funds cannot be expected after the rate reaches zero. The phrase "(the zero interest rate policy) will be continued until deflationary concerns are dispelled," does not make clear whether the deflationary concerns are mainly related to developments in prices or in the economy. If they are related to the economy, it should be made clear which indicators are being watched, how long the policy will be continued, and what conditions need to be satisfied to end the policy. For the public, all of these are unclear. Of course, if the public is happy with the overall judgement by the Policy Board based on various indicators, that is fine, but I do not think that is necessarily the case. Furthermore, on price stability--an objective of the Bank--I personally believe the Bank should stop using abstract phrases, such as "a situation that is neither inflationary nor deflationary" to describe price stability. The Bank, to ensure its accountability, should set a concrete numerical target in its policy.
My fourth point is that the zero interest rate policy has exposed the technical problems of the Bank's money market operations. These are evident in the large discrepancy between (1) the Bank's projection of the daily excess of reserves made at 9:20 a.m. on weekdays--which market participants interpret as a quantitative signal, and (2) the actual amount of the excess at the end of the day. Before the zero interest rate policy was implemented, the gap between the projection and the result was not that significant. For example, the monthly average of the daily projection for January was an excess of 180 billion yen (this figure and those which follow have been rounded to the nearest 10 billion yen) while the actual amount was 140 billion yen, and in February the projection was an excess of 320 billion yen against an actual 270 billion yen. In March, just after the introduction of the zero interest rate policy, the projection was for 1,540 billion yen but the actual excess was 900 billion yen lower at 640 billion yen. In April, the projection was 1,300 billion yen and the actual excess 180 billion yen; in May the figures were 1,080 billion yen and 330 billion yen. The discrepancy between the forecast and the actual result has thus sometimes been of the order of one trillion yen. In September, the projection was an excess of 1,100 billion yen and the actual result was 190 billion yen, a difference of almost one trillion yen. Furthermore, in September, of six of the 20 business days, actual reserves fell below the amount of "remaining required reserves" (the daily average of reserves that should be deposited in the remaining days of the reserve maintenance period). That is, for almost one third of the business days in September, the Bank tried to create an excess of reserves through its market operations, only to find that funds did not flow to institutions that are required to hold reserves and as a result the amount of remaining required reserves did not decrease. This discrepancy between the projection and the outcome can be attributed to the fact that (1) the forecast for the supply and demand of funds in the money market, which is used to calculate the projection of the daily excess of reserves, is always very different from the actual result, and (2) the formula used to calculate the projection of the daily excess of reserves is based on the assumption that, as in the past, there will be no excess reserves at the end of a reserve maintenance period. Considering the meanings of the words "forecast" and "projection," I think it inappropriate for the Bank to announce "forecasts" for funds demand and supply and "projections" of reserves that deviate greatly from the actual results. The words "forecast" and "projection" should be used only when they are likely to be relatively accurate, otherwise the Bank's accountability is at stake. If the Bank has no plans to immediately adopt quantitative easing, the Bank should change the term "projection" of the daily excess of reserves or the formula used to calculate the amount as soon as possible in favor of a more accurate term or formula. Moreover, the injection of funds into the money market, which should be adjusted carefully in line with market conditions, has been fixed to achieve a daily excess of reserves of about one trillion yen, and the amount has become a psuedo target. It is my opinion that the current policy framework is not working properly, and therefore, the Policy Board should decide a target for excess reserves or the monetary base, present this to financial markets, and change the policy stance to attain this target. In this case, I do not think the Bank necessarily needs to use the concept of the daily excess of reserves.
As I said earlier, the forecast and results of funds supply and demand differ greatly. On a monthly average, the disparity for January this year was 70 billion yen and for February 80 billion yen. After the introduction of the zero interest rate policy, the disparity grew to 680 billion yen for March, 930 billion yen for April, and since then, the gap has ranged from several hundreds of billion yen to one trillion yen. The reason for this large gap is that the forecast for funds demand and supply is based on the assumption that funds held by institutions that are not required to hold reserves at the Bank--such as money market brokers-cum-dealers called tanshi companies--will flow to financial institutions that need to hold reserves. However, in reality, funds do not flow in that direction, and remain in the hands of such institutions as tanshi companies. The Bank's forecast of funds supply and demand from "others" (included in the item "Net fiscal payment and others") has recently been almost always below the actual result because "others" includes the flow of funds from such institutions as tanshi companies. If the Bank is to continue to release its forecast for funds supply and demand, I think the breakdown of the flow of funds, e.g., the flow to/from tanshi companies, should be made clear so that market participants get an accurate idea of market conditions.
I am also worried about the fact that some signs of moral hazard are emerging, i.e., some money market participants appear to be depending on the Bank's current policy. The Bank announces its daily forecast for the demand and supply of funds and its projection for the daily excess in reserves, and therefore, money market participants need not bother to analyze or forecast the market's funds demand and supply themselves. Some participants are said to base their outlook for interest rates entirely on the Bank's quantitative signal, i.e., the projection for the daily excess of reserves. I have been told that, for the past few months, as soon as the Bank announces its projection at 9:20 a.m. of an excess of one trillion yen in reserves, some market participants stop watching the market for the rest of the day and that they think all they need to do is to seek help from the Bank if they encounter problems. If this situation continues, the money market will cease to function properly, and will not be able to respond instantaneously to various factors that affect the market.
My fifth point is that the zero interest rate policy is not a policy that sets a numerical target for interest rates or monetary aggregates, and a further easing of policy is impossible. This policy is symbolic and does not allow further action--the only options are to continue it or to stop it. One cannot implement a slight easing or tightening, i.e., flexible adjustments to policy are impossible. In other words, it can be said that the most crucial point of the policy is how long it remains in place. If expectations grow that the policy will be ended, there will be a large impact on the bond market. In the case of monetary base targeting, which I will explain later, the degree of monetary easing is indicated by specific figures, therefore it cannot give rise to the above concerns.
If the Bank is aware of the time element of the zero interest rate policy, it should use concrete figures to make clear the economic environment it is aiming for, or forecasting, and the timeframe to achieve that goal. An example would be the United Kingdom, which aims to achieve inflation of 2.5 percent at a two-year horizon. What the Bank needs to do when an unexpected development changes the course of the Japanese economy is to adjust its forecast and explain the change to the public.
I would next like to explain my proposal to set targets for the monetary base and inflation. My proposal has already been outlined in the minutes of the Monetary Policy Meeting. It aims for an annual increase of 0.5 to 2.0 percent in the consumer price index (CPI) excluding perishables in two years' time, while increasing excess reserves by about 500 billion yen over one reserve maintenance period, and continuing to increase the amount thereafter to produce annual growth of about 10 percent in the monetary base. Inflation targeting would be employed as a framework to achieve the objectives of monetary policy, with a certain growth rate of the monetary base as the intermediate target. In the minutes, I have added a note explaining the need for the Bank to increase outstanding reserves from present levels, assuming a certain amount of growth in banknotes, by about three trillion yen by the end of March 2000 so that markets can get an idea of the volume of funds the Bank provides.
In case the adoption of targets for the monetary base and inflation is insufficient, I suggest the Bank take measures, such as directly buying assets that cannot be substituted with base money, in order to expand the money supply. The Bank could, for example, buy long-term government bonds with remaining maturities of over one year from the market.
Allow me now to explain the details of the framework of monetary base targeting. To practice monetary base targeting as a policy, the degree of growth in the monetary base and the instruments used to measure growth should be decided by methods that are objective not discretionary. The outline of the quantitative easing I have proposed is based on the McCallum Rule devised by U.S. Professor Bennett McCallum. This rule is used to calculate the growth rate of the monetary base needed to achieve the potential rate of GDP growth using such economic information as the rate of change in the velocity of money and the differential between the potential and actual rates of nominal GDP growth. According to this rule, when the growth rate of nominal GDP is below potential GDP growth, the growth rate of the monetary base should be increased to make the differential smaller. Let us assume that the potential growth rate of Japan in real terms is two percent and that the targeted inflation rate is one percent. To achieve GDP growth of about three percent, calculations using recent GDP data and the rate of change in the velocity of money show that the necessary growth rate in the monetary base is about 11 percent. I would say that around ten percent growth in the monetary base would be adequate.
I will next give my personal opinion on how positive effects from quantitative easing are transmitted to the economy. I would like to add that the transmission mechanism of the zero interest rate policy is not entirely clear.
The first kind of effect is transmitted through a decline in interest rates on term instruments with relatively long maturities. Japan is now in a situation where the overnight call rate has fallen as low as possible, and it can no longer be said that interest rates and the amount of liquidity are "two sides of the same coin." However, there is still some room for the rates of longer-term instruments to fall. It is my opinion that a further easing of monetary policy through quantitative measures would, therefore, trigger a fall in the interest rates of term instruments and stimulate the real economy. I would like to add that, if the economy were to improve as a result, the expected rate of inflation would rise in the medium to long term, and nominal interest rates would also rise. In the short term, however, real interest rates would ease, and a favorable impact would be likely.
The second effect stems from financial institutions changing their portfolios. When quantitative easing is adopted, funds become abundant in the short-term money market. There is a limit to the amount of funds that tanshi companies can accumulate in their accounts at the Bank. Therefore if the Bank's supply of funds were increased further from current levels, the excess reserves of financial institutions would be likely to eventually grow larger. I will explain this point later. Financial institutions might then choose to shift their funds away from reserves to the bond and stock markets or increase their extension of loans. To facilitate this flow of funds, it is necessary to combine quantitative easing with inflation targeting and change the expectations of economic entities.
The third is the effect from a rise in the expected inflation rate lowering real interest rates. A fall in real interest rates below the expected rate of return will stimulate business fixed investment.
In addition to these direct effects on the real economy from the monetary side--transmission down the main stream--there are two more transmission mechanisms. These two mechanisms were at work when the zero interest rate policy was temporarily exerting the same effects as a quantitative easing.
One is the effect from a weaker tendency in the value of the yen. For example, it is widely known that institutional investors such as life insurers and hedge funds watch the ratio of base money between Japan and the United States as a major factor determining their foreign exchange trade.
The other is the effect from a rise in stock prices. As of the end of September, the aggregate value of shares listed on the first section of the Tokyo Stock Exchange amounted to 400 trillion yen, up more than 100 trillion yen compared to 288 trillion yen as of February 25. It is hoped that firms will use their increased unrealized gains on stocks to further restructure business.
I will now move on to explain the feasibility of quantitative easing. Opponents of monetary base targeting have criticized my proposal on the following grounds: first, that it is not clear whether annual growth of 10 percent in the monetary base and an increase of 500 billion yen in excess reserves are consistent; second, that a further increase in the supply of funds would only accelerate the flow of funds to institutions that are not required to hold reserves at the Bank, and will not lead to an increase in reserves; third, that the Bank does not have extra capacity to expand its money market operations; fourth, that with interest rates at almost zero, bids received in the Bank's money market operations have sometimes fallen short of the offered amount, and this shows it would be difficult to increase the provision of funds; and fifth, that the monetary base is unsuitable as a target for monetary policy because methods to deal with wide fluctuations in the monetary base, caused by exogenous factors such as uncertainty over the financial system, have not been spelt out.
I would like to present my arguments in response to these criticisms. First, I will explain why growth in the monetary base of 10 percent and an increase in excess reserves of 500 billion yen are consistent. The logic used to come up with the figures I proposed at the September 21 Monetary Policy Meeting is as follows. To achieve year-on-year growth of 10 percent in the monetary base in the January-March quarter of 2000, the outstanding average monetary base of January-March 2000 should be 63.8 trillion yen. This means the monetary base, using data from August 1999, needs to be increased by more than 860 billion yen each reserve maintenance period starting from that beginning in mid-September. Banknotes in circulation, which account for more than 80 percent of the monetary base, have grown by about six percent year on year in recent months, and based on this, banknotes in circulation will continue to grow by about 390 billion yen per month. The difference between 860 billion yen and 390 billion yen is 470 billion yen, which is close to the 500 billion yen I have proposed. By filling this gap with an increase in reserves, annual growth of 10 percent in the monetary base would be achieved. I have ignored seasonal factors for the purpose of simplicity. I believe the size of the increase in reserves can be determined at Monetary Policy Meetings based on the thinking I have just explained, and by using data on the growth rate of banknotes in circulation and the monetary base.
The second criticism is that an increased provision of liquidity would only lead to an increase in the accounts at the Bank of institutions that are not required to hold reserves, such as tanshi companies, and would therefore not boost the level of excess reserves. I do not agree with this view. Tanshi companies act only as brokers for uncollateralized call transactions between financial institutions, that is, a borrower financial institution--which is subject to reserve requirements--always exists for each transaction. Considering this, it must be through collateralized call transactions that tanshi companies, as dealers, borrow funds from financial institutions and then accumulate the funds in their accounts at the Bank. As the amount of collateral tanshi firms have is limited to about 1.5 trillion yen, if the Bank were to raise its injection of funds to aim for excess reserves of three to four trillion yen instead of the current one trillion, I believe the bulk of the increase would end up in the reserves of financial institutions, which create money. In this context, one solution would be to encourage tanshi companies to act as brokers in the collateralized call market instead of dealing on their own account.
On the third point, the new market operation decided at the October 27 Monetary Policy Meeting--outright purchases of short-term government bonds--together with traditional operations such as repo operations, purchases/sales of TBs and FBs under repurchase agreements, and CP and bill operations should suffice. At present, the overall amount of funds the Bank can provide with these operations and other measures is said to total more than 30 trillion yen. These operations should make it possible to supply the amount of funds needed to realize my proposal, even if the need arose to boost supply to meet strong fund demand, e.g., that at the end of the year. If these operations are inadequate, one option for the Bank would be to buy instruments with longer maturities such as government bonds. Another possibility would be to follow the example of countries such as Switzerland and Australia and supply funds through foreign exchange swaps as a supplementary measure. I am sure the Bank could draw on its wealth of wisdom and produce many other viable measures.
On the fourth point, the shortage of bids in money market operations, my proposal would solve this problem because inflation targeting would somewhat raise the expected rate of inflation in the medium to long term. Theoretically, there are two measures that could be taken in the meantime. One would be to push interest rates below zero and the other would be for the Bank to buy long-term instruments. I personally think the adoption of negative interest rates would give rise to various problems and that the Bank, if necessary, should buy long-term instruments. For the time being, I plan to watch and assess the efficacy of the new money market operation--outright purchases of TBs and FBs--decided by the Policy Board on October 27. The TB and FB market has developed and its outstanding value is forecast to grow to 63 trillion yen by the end of this fiscal year. There are certain issues, such as the 26th, 27th, and 28th, that market participants strongly want the Bank to buy outright. By responding to the market's needs and actively using market operations such as TB and FB operations, the problem would be likely to be more or less solved, even though bids might still occasionally fall short of the offered amount.
The fifth criticism is that monetary base targeting is not a realistic practice because it is difficult to control the amount of banknotes in circulation, which account for the bulk of the monetary base, as demand for banknotes tends to show large fluctuations due to factors such as uncertainty over the financial system. I am fully aware of this risk and that is why I added the following in my proposed directive, which you can read in the minutes of the Monetary Policy Meeting on September 21: "Regardless of the above target for the monetary base, the Bank will expand money further should the financial markets destabilize, for example, should the uncollateralized overnight call rate rise substantially." Monetary Policy Meetings take place at a relatively frequent rate of twice a month. The Policy Board can assess the state of the economy at each meeting, and change the directive in line with the economic conditions. If necessary, extraordinary meetings can be convened. What is important is to clearly explain the changes in the directive to the public. I also think it is worth considering the idea of instituting a lending facility similar to that of the ECB that allows financial institutions to borrow funds when they want to.
Other than the criticisms I have just mentioned, I often hear the argument that the Bank's balance sheet would be impaired if it were to buy a large amount of long-term government bonds as part of a quantitative easing. I have discussed this topic with prominent U.S. and European economists, and most of them have said they cannot fathom why a central bank, which has its seigniorage enshrined in law, is so worried about damaging its balance sheet. Even if one viewed the Bank of Japan as a private enterprise, the probability of the Bank collapsing is extremely low, according to an ALM model, as Mr. Hideya Kubo at NLI Research Institute has previously said. The view that the Bank's balance sheet is very sound and that the Bank has the capacity to acquire a sizable amount of assets is shared widely. Ultimately, the Bank exists to facilitate the sound development of the economy. Considering this, what is the point of keeping the balance sheet of the Bank healthy when the economy is suffering? It would be problematic of course if the Bank were to underwrite a massive amount of government bonds and as a result its holdings of long-term government bonds ballooned. Such a scenario, however, can be avoided by the restrictions provided by setting targets for the monetary base and inflation.
I would next like to explain the framework of inflation targeting, which I believe should be used as a tool to achieve the objectives of monetary policy. The combination of inflation targeting and monetary base targeting forms the core of my proposal. First, I would like to make clear that my proposal differs from the inflationary policy advocated by Professor Paul Krugman, which aims for a relatively high rate of inflation, but is similar to the framework adopted by a number of countries that aims for price stability. At present, a number of countries including the United Kingdom, New Zealand, Canada, and Sweden practice inflation targeting. It is difficult to evaluate the performance of inflation targeting as it has not been practiced over a long period of time, but I believe it has yielded satisfactory results so far. Academic research on this topic has developed quite rapidly around the world. I have been told that at the Federal Reserve Bank of Kansas City conference in Jackson Hole in August, Professor Ben Bernanke of Princeton University and Professor Mark Gertler of New York University presented a paper on the effectiveness of inflation targeting in achieving macroeconomic and financial stability even in an environment of volatile asset prices. I have also been told that discussion on inflation targeting at that conference was profound and enlightening. It is my understanding that the majority has a positive view towards inflation targeting, and its opponents are limited to several central banks. The inflation targeting I have proposed would be an embodiment of the Bank's philosophy stipulated in Article 2 of the Bank of Japan Law--"Currency and monetary control shall be aimed at, through the pursuit of price stability, contributing to the sound development of the national economy."--by providing a concrete number. Among the many price indicators, I have chosen the CPI because it is closely connected with the daily lives of the public. Perishables have been excluded as their prices tend to be volatile due to factors such as the weather, and thus their inclusion makes it difficult to judge trends. Some of you may be wondering why I have proposed setting an inflation rate of 0.5-2.0 percent while at the same time I have talked about aiming for zero inflation. The reason for this is that Japan's CPI is said to overstate inflation by around 1 percentage point, and I have factored this into my calculations. The upward bias in the CPI in the United States was verified in 1996 by the Boskin Commission appointed by the U.S. Senate Finance Committee. The Boskin Commission's report proved the CPI in the United States did not fully reflect the improvement in the quality of goods, such as personal computers, or bargain sales by discount stores, and thus, CPI data give a higher level of prices than prevails in reality. In a rare study on Japan's CPI, Mr. Shigenori Shiratsuka of the Bank of Japan estimates an upward bias of 0.9 percentage point. My estimate is an upward bias of about one percentage point, which includes an allowance for accidental errors. Then, allowing 0.5 percentage point room for maneuver below and 1.0 percentage point above, my target for the CPI (excluding perishables) becomes a rise of 0.5 to 2.0 percent.
I did not equally balance the range above and below an increase of 1.0 percent in the CPI because I concluded that a smaller range downward would strengthen the probability of a recovery in the dismal economy. I think it is possible for Japan to achieve the target in about two years' time--the same timeframe as the United Kingdom's target--which would be around October-December 2001. If I am able to study the matter further, I may be able to suggest inflation targets for Japan, of say, one to three percent, or 2.5 percent as is the case for the United Kingdom, that are consistent with the potential rate of economic growth.
I will next talk about the advantages of inflation targeting.
The first is that it gives monetary policy discipline. Many people claim that excessive quantitative easing leads to a high rate of inflation, but my proposal avoids such a situation by calculating the level of the monetary base that would be adequate before deciding a monetary policy objective that aims for 0.5 to 2.0 percent inflation.
The second is that it uses concrete figures, not ambiguous phrases such as "a situation that is neither inflationary nor deflationary." This would test the true accountability of the Bank. The Bank would need to explain its actions and also take responsibility for the results.
The third is that, as a result of adopting inflation targeting, the monetary authorities would need to be more conscious of the course of the economy. This would oblige the Bank to apply preemptive and truly forward-looking policies, instead of reacting to developments after they occur. The Bank of England (BOE) raised interest rates by 25 basis points on September 8 even though the inflation rate was below the targeted 2.5 percent. This was because BOE Monetary Policy Committee members recognized the need to take action to keep prospective inflation in line with the target as inflation could accelerate in the second half of the year against the background of strength in the housing market, a tightening of the labor market, and a sharp increase in consumption. As this example shows, central banks that practice inflation targeting need to analyze and forecast the course of the economy and this enables them to take preemptive action.
The fourth is that inflation targeting would facilitate dialogue between the central bank and the financial markets. Some market participants appear unable to foresee how long the zero interest rate policy will continue, or unable to find clues to make a forecast. If a concrete inflation target and target date are set, market participants can analyze the path that the economy will take and this is likely to improve communication between the Bank and the market. Numerical targets may also have a direct impact on market expectations, and this may prompt active dialogue.
The fifth is that it would shield the Bank from political pressure. The Bank of Japan Law stipulates price stability as one of the objectives of the Bank, but there is no clear definition of what level of inflation is accepted as stable and thus there is room for discretion on the interpretation. Furthermore, the Bank is truly independent in its policy making. I believe the Bank should adopt inflation targeting to achieve its objective of price stability, and take the initiative to announce a targeted inflation rate. The Bank's independence would be fortified by making all efforts to achieve the target. Where the target cannot be achieved, the Bank should explain the reasons and, if necessary, reprimand those responsible.
The adoption of inflation targeting is of vital importance for the Japanese economy and for the implementation of monetary policy. I am confident it will be adopted in the not so distant future.
The next few years will be critical for the Japanese economy. If Japanese industry comes successfully through this harsh era and improves capital efficiency through restructuring, the Japanese economy will revive, and from the perspective of long-term economic cycles, I believe the economy has the potential to reach a new peak around 2010. To this end, it is crucial that the Bank demonstrates its strong resolve to contribute to the economy by adopting targets for increases in the monetary base and inflation. I am sure such steps would free Japan from deflation and pave the way for a sound development of the economy. Courage and action--to adopt new monetary policy and pull the Japanese economy out of this extremely difficult phase--are what are required of the Bank.
I hope to continue to contribute to monetary policy to ensure the prosperity of Japan in the 21st century.
Thank you very much for your kind attention.