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Japan's Economy and the Role of the Bank of Japan

Speech by Eiko Shinotsuka Member of the Policy Board, Bank of Japan,to the Japan Society of Monetary Economics on May 27, 2000

July 12, 2000
Bank of Japan

Contents

The new Bank of Japan Law, which came into effect in April 1998, has given de jure independence to the Bank of Japan and stipulates that the Bank should improve the transparency of its decision-making process regarding monetary policy and other business operations. To this end, the Bank has been making efforts to provide the public with related information through a variety of channels such as press conferences, speeches, and its Web site in addition to publishing the minutes of Monetary Policy Meetings, which are, in principle, held twice a month. Furthermore, each member of the Policy Board has actively engaged in exchanging views with people in various fields to promote an understanding of monetary policy.

Today I would like to share my thoughts with you on the conduct of monetary policy viewed from some selected, though I think quite important, perspectives. First, I will look back on the experience of the emergence and bursting of the bubble economy since the late 1980s and try to summarize the lessons learned regarding the conduct of monetary policy. Then, bearing these lessons in mind, I will discuss some points of contention regarding the current zero interest rate policy. Finally, because I specialize in labor economics, I would like to present my views on the impact of monetary policy on income distribution.

I. Japan's Economy in the 1990s

With respect to Japan's economy, the 1990s are often referred to as "the lost decade." In fact, Japan experienced a recession during most of the 1990s. Though it may be too early to draw comprehensive conclusions regarding the background to the lost decade, it appears to me that two factors are worth mentioning in the context of my speech today, namely the bursting of the bubble and the structural problem.

A. The Bursting of the Bubble

One important factor behind the recession in the 1990s was the impact of the bursting of the bubble. A variety of reasons have been given to explain the emergence and expansion of the bubble, and among them I personally think that a chain reaction of expectations played an important role. In the late 1980s, bullish expectations that Japan's economic structure was undergoing changes that would raise its growth potential prevailed among almost all economic entities including firms, households, financial institutions, and the Government. And in the final days of the bubble, it seems that such expectations led to a kind of euphoria and the loss of self-control mechanisms.

However, it turned out that there were no such changes in Japan's economic structure that would raise its growth potential, the public came to realize that the bullish expectations were unfounded, and they had to be revised downward. As a result, economic activity rapidly lost vigor, which in turn led to a classical adjustment of capital stock.

At the same time, capital stock was significantly devalued. Among the capital stock accumulated during the bubble period in anticipation of capital gains and demand expansion were facilities such as luxury resort hotels on remote islands. In the end, they lost their economic value almost completely because there was little likelihood of their being utilized and conversion to alternative use was too costly.

Such an enormous amount of negative stock had a serious adverse impact on economic activity through a deterioration in the financial intermediary function. A drop in asset prices impaired the asset quality of both borrowers and lenders, thereby reducing the value of their capital base. Since capital base is a cushion for possible losses in the future, there was a strong possibility that economic entities experiencing a reduced capital base would become cautious in their own risk taking and also find it difficult to maintain business relations when trading partners demanded a higher risk premium. In particular, the ability of financial institutions to extend credit declined substantially because of the heavy devaluation of collateral such as property and securities. This had the effect of significantly restraining the spending of the private sector.

B. The Structural Problem

Another factor was the structural problem that was temporarily concealed by the emergence and bursting of the bubble. I think one of the reasons why we still have difficulty in drawing clear conclusions about the factors behind the prolonged recession in Japan in the 1990s, is that the structural problem was intertwined with the adverse impact of the bursting of the bubble.

Here I would like to discuss the structural problem in the context that an economic system that was well-adapted to high growth has become untenable due to the decline in Japan's growth potential with the maturing of the economy.

For instance, the low productivity and profitability of Japanese firms are often pointed out as one of the economy's structural problems. This is partly attributable to the decline in the average productivity of capital, that is, a decrease in capital efficiency, resulting from the fact that capital has been accumulated while growth of the workforce has slowed down. It is also attributable to a loss of balance between labor productivity and wages. The employment system in Japan was underpinned by a belief in ever-rising economic growth and the pyramid-like corporate structure with younger workers at the bottom of the pyramid. However, as older workers have come to dominate the workforce in a situation of low economic growth, labor's share of national income has risen and corporate profits have been squeezed.

Non-manufacturing industry in particular has exhibited relatively low productivity because price competition through new entry has been restrained to a large extent. As a result, domestic service prices in Japan have been high by international comparison. This, in turn, has weakened the international competitiveness of the manufacturing industry, which has to depend on these domestic services.

These structural problems do not necessarily have a direct bearing on the bubble. But perhaps we can say that a substantial drop in the ability of firms to adapt to changes in the management environment during the process of the bursting of the bubble may have amplified the negative impact generated by these structural problems.

C. Lessons Learned from the Bubble in Relation to the Conduct of Monetary Policy

As I have described, the bursting of the bubble was without doubt a major factor, if not the sole factor, behind Japan's recession in the 1990s. Therefore, we should conduct monetary policy paying due attention to the lessons learned from the bubble economy. In this regard, let me outline, while referring from time to time to the recent study on a similar topic by my colleagues at the Bank,1 four important lessons that I always keep in mind.

Monetary policy that incorporates risk scenarios

The first and most important lesson often pointed out is the importance of conducting monetary policy in a preemptive manner. I might rephrase this as the importance of "monetary policy that incorporates risk scenarios."

The bubble in Japan expanded based on the strong bullish expectations that asset prices would keep rising, and, in this sense, monetary easing was only one of the factors behind the expansion of the bubble. As such bullish expectations led to speculative activity, monetary easing facilitated its financing. Indeed, if we examine the yield curve at the time, it suggests that, despite growing evidence of economic expansion, expectations prevailed in financial and capital markets that interest rates would remain low and funds could continue to be raised almost without limit. Prolonged monetary easing, with the official discount rate kept as low as 2.5 percent for 27 months from February 1987 through May 1989, was definitely a necessary condition for the bubble to emerge, though not a sufficient condition. As a lesson derived from this experience, the importance of preemptive monetary policy, in other words the importance of forward-looking monetary policy, is now widely recognized.

It is by no means an easy task to conduct monetary policy in a forward-looking manner bearing in mind future inflation and the possible risk of a bubble. The emergence and expansion of a bubble have a seemingly favorable influence on an economy, and at least initially have no tangible adverse impact, though serious problems will surface when it eventually bursts. An upward shift in the expected growth rate could be triggered by either a bubble or technological innovation, and would initially bring about favorable economic conditions. In other words, when we observe the initial stage of favorable economic conditions, it is difficult to tell whether they reflect a bubble or such factors as technological innovation and changes in the economic structure.

This kind of problem of identification is not limited to the bubble period in Japan. It appears that the Fed currently faces a similar problem. It may be the case that the current expansion of the U.S. economy is based on revolutionary technological innovation as postulated in the so-called "new economy." And, it is natural that economic growth potential will rise if monetary policy is kept neutral. However, if the Fed should judge there is a bubble-like situation and tightens monetary policy, growth potential would instead be suppressed. On the other hand, the expansion might be a little bit bubble-like in the sense that asset prices in the market overestimate the rise in future productivity. In this case, if the Fed disregards this overestimation and maintains a neutral monetary policy stance, then there would be a risk that the economy might face a bursting of the bubble and severe adjustment when the overestimation is eventually rectified. How then should monetary policy be conducted?

Some may argue that a close examination of the economic situation could solve the problem by preventing such misjudgment. Though both the Bank of Japan and the Fed have been striving to systematically analyze the economic and financial situation, central banks are not much wiser than the market and I do not think close examination alone can solve the problem. Of course, we cannot go to the extreme of disregarding all information, including the impact of technological innovation, that is taken into account in the market. Therefore, at every Monetary Policy Meeting, I always try to make the best decision based on all the information available while paying due attention to the limitations. In this regard, I believe it is important in the conduct of monetary policy to focus on minimizing future risks to the Japanese economy.

Why did the Bank of Japan maintain monetary easing so long? Perhaps because the Bank might not have been sufficiently aware that the bursting of the bubble would have very serious negative effects on Japan's economy, as has been witnessed, through such channels as balance sheet adjustment and instability of the financial system. With the benefit of hindsight, we may have been slightly short on awareness of the risk scenario involved.

Changes in asset prices

The second lesson in conducting monetary policy is that we should pay due attention to changes in asset prices and their impact on the economy. This does not mean that the objective of monetary policy is to control asset prices. Even if the Bank of Japan were to attempt to control asset prices, it would most likely end up with the situation where fluctuations in the economy would be greatly amplified.

Movements in asset prices affect monetary policy in a variety of ways. Asset prices, be they a bubble or not, contain valuable information about market expectations of the economic outlook. Market expectations include various factors that will determine the future course of the economy including prospective policy actions of the Bank of Japan. The Bank should thus pay close attention to such information and the impact stemming from changes in asset prices when implementing monetary policy.

Furthermore, a rise in asset prices such as stocks and property would increase aggregate demand. It would raise the amount of funds available to borrowers by increasing the net worth of firms and the value of collateral. It would also increase spending through the wealth effect.

In addition, there is a possibility that large fluctuations in asset prices could significantly impair the soundness of the financial system which is the infrastructure on which all economic activity is based and which also serves as a conduit for the transmission mechanism of monetary policy. It is still fresh in our memory that concern over financial system stability in the autumn of 1997 exacerbated the disruption of the economy.

Choice of appropriate policy measures

The third lesson is the importance of appropriately choosing policy measures. In retrospect, we notice something like a puzzle in the conduct of monetary policy in the late 1980s. In the spring of 1987, the Bank of Japan lowered the official discount rate from 3 percent to 2.5 percent. And, at the same time, in its window guidance it urged commercial banks to maintain a prudent lending attitude in view of the rise in asset prices and the excessive investment in stocks and property. This suggests that people in the Bank clearly recognized the upside risk to the economy at the time when they lowered the official discount rate. Why did the Bank of Japan have to take such contrary policy actions? The answer appears to me that the Bank was forced to make a compromise under the pressure of the then prevailing policy agenda, that is, international policy coordination.

During the bubble period, international policy coordination was often used as rhetoric to force other countries to make adjustments that should have been first dealt with by macroeconomic policy at home. Furthermore, there was a strong deep-rooted feeling against the appreciation of the yen in Japan at the time. Newspaper editorials and articles repeatedly told us that as the world's largest creditor, Japan had a responsibility to maintain low interest rates and also that to raise the official discount rate might cause a worldwide recession, so it would be difficult to do so as long as stock prices were unstable. Though the Bank was becoming aware of the risk inherent in the bubble economy as early as the spring of 1987, public opinion calling for continuing monetary easing was getting stronger. Then came the Black Monday crash in October 1987. Given the circumstances, the Bank had to place priority on a policy agenda of international policy coordination, prevention of the yen's appreciation, and reduction of the current account surplus through the expansion of domestic demand. In this regard, former Governor of the Bank of Japan Yasushi Mieno said, looking back on the experience, that monetary policy should aim at equilibrium of the domestic economy, more specifically achieving non-inflationary sustainable growth over the long run, and not at exchange rate stability and the adjustment of external imbalances.2

I think there were two factors underlying the difficulty the Bank had at the time in conducting appropriate monetary policy: the weak legal foundation for central bank independence, and the nature of expectations that cannot be easily changed once embedded in society. The Bank of Japan at that time asserted that despite the absence of a strong legal basis, central bank independence was firmly respected under a tacit understanding of parties concerned. However, it seems doubtful how independently the Bank conducted monetary policy under the old Bank of Japan Law, where the Minister of Finance had comprehensive supervisory power over the Bank. For example, the public auction system for issuing financing bills, which was not realized under the old Bank of Japan Law, was finally introduced under the new Law enacted in 1998.

As I stated at the outset, the new Bank of Japan Law has given de jure independence to the Bank, but we still encounter in various forms the problem that expectations once embedded in society cannot easily be changed. For example, even though the G-7 statement of April this year only confirmed the fact that the Bank would continue the zero interest rate policy which was decided at the Monetary Policy Meeting immediately before the G-7, we saw reports saying that the inclusion of such a phrase indicated that other G-7 members disapproved of early termination of the zero interest rate policy. The G-7 meeting is a forum of finance ministers and central bank governors of seven industrialized countries for exchanging views and sharing understanding of economic developments in participating countries and the world. If, however, there is such a misconception that the future course of monetary policy is agreed upon at G-7 meetings, it would certainly be incorporated in the price formation of the marketplace. Even though such expectations would be founded on a misconception, the market would be disrupted if the expectations were somehow not fulfilled, and the Bank of Japan would be criticized for such disruption. This confusion that we observed around the time of the Monetary Policy Meeting of September last year can be understood in a similar light. How the central bank should respond to price formation based on misconception is an extremely tricky problem. The Federal Reserve Bank of Cleveland raised a similar problem that it called the "expectations trap" in its Annual Report for 1998.3

For a correct understanding of the goal of monetary policy and the thinking behind its implementation, I believe that the Bank should do its utmost to correct expectations based on misconceptions embedded in the market even if the Bank temporarily comes under strong criticism.

Disclosure of information

The fourth lesson is the significance of improving transparency with respect to the conduct of monetary policy, in other words, the importance of information disclosure. Though I have just said that the Bank must correct misconceptions embedded in the market even if we are temporarily criticized, it is certainly better to communicate with the market without causing unnecessary disruption. Under the new Bank of Japan Law, independence has certainly been enhanced, but it does not mean that the Bank can go its own way in conducting monetary policy without paying any attention to public opinion. The highest body of national sovereignty is the legislature, which is the Diet in Japan. The legislative body in many industrial countries, including Japan, has given independence to the central bank because of historical experience that teaches that significant harm would be done to society in the long run if monetary policy decisions were affected by various political interests. In this sense, central bank independence can be regarded as discipline that society has imposed on itself.

Central bank independence as the self-discipline of society should not be taken lightly. It is, therefore, indispensable that the Bank should explain to the extent possible central bank independence and the decision-making process of monetary policy so that the public has a correct understanding. At the same time, each member of the Policy Board has the responsibility to disclose his/her judgment on economic and financial conditions as well as his/her thinking on the conduct of monetary policy.

Currently, the Bank discloses discussions at Monetary Policy Meetings through the minutes and other publications. Unlike the Fed and the Bank of England, whose minutes mostly describe the majority view, the minutes of the Bank of Japan give a detailed description of not only the majority view but also the minority view. Such disclosure, I believe, would not have been possible without the revision of the Bank of Japan Law. It is a big "if," but if in 1987 the Bank had enjoyed strong independence as it does today and the minority view of the Policy Board had been disclosed under the principle of transparency, it might have been the case that the public would have been aware of the risk of a bubble and its expansion would thus have been prevented at an early stage.

II. On the Zero Interest Rate Policy

A. Overview

The zero interest rate policy, which the Bank of Japan has maintained since February 1999, consists of two elements. First, the unsecured overnight call rate has been guided to virtually zero percent through monetary operations. Under this policy, the Bank is prepared to provide as much liquidity as needed and to satisfy all demand for short-term funds so as to drive the overnight call rate down to zero percent.

Second, the Bank has made clear its commitment to maintain the zero interest policy until deflationary concerns have been dispelled, implying that the policy will continue beyond the following Monetary Policy Meeting if necessary, so that the effects can thoroughly permeate financial markets.

Some economists have criticized the phrase "until deflationary concerns have been dispelled" as being ambiguous and unclear as to how long the policy will continue. It is, however, extremely difficult to make a commitment to specify how long the current policy will continue when there exists much uncertainty regarding future economic and financial developments. Indeed, neither those central banks that have adopted inflation targeting nor the Fed and European Central Bank have gone so far as to make commitments about policy interest rates beyond the next monetary policy meeting.

Others have called upon the Bank to specify the condition that has to be satisfied for deflationary concerns to be dispelled. In this regard, as you can see in the minutes of recent Monetary Policy Meetings, the condition has been gradually boiled down to whether a self-sustained recovery of private demand can be seen. Since we had grave concerns over a variety of serious downside risks when we adopted the zero interest rate policy in February 1999, it was impossible for us to specify the condition needed to dispel deflationary concerns at the time.

In retrospect, it seems that the zero interest rate policy was adopted when the economy and financial markets were affecting each other in an extremely negative manner. In financial markets at the time, there was a strong possibility that the very pessimistic view of Japan's economy falling into a crisis would become widespread. Had the view spread to households and firms, such economic activity as household consumption and business fixed investment would have been excessively depressed and the economy would have fallen into a vicious circle. In response to this situation, the Bank of Japan announced its strong commitment to monetary easing by adopting the zero interest rate policy. The Government injected public funds into 15 major banks at the end of March 1999 under the Law Concerning Emergency Measures for the Reconstruction of the Function of the Financial System and the Financial Function Early Strengthening Law, both of which were enacted in October 1998. The combined effect of these policies has drastically reduced concern about financial system stability. I believe that we, as the central bank, made the maximum possible commitment required at the time when we adopted the zero interest rate policy in February 1999.

B. Termination of the Zero Interest Rate Policy

When making a decision regarding monetary policy, we always weigh the positive and negative effects in analyzing economic and financial conditions. The zero interest rate policy is no exception. Though the majority of the Policy Board maintains that the zero interest rate policy should continue, they do not totally ignore the negative effects of the policy. Indeed, the Policy Board as a whole has decided that priority should be placed on supporting economic activity through low interest rates in view of the deflationary concerns still remaining, while paying due attention to the negative effects of the current policy. I am a proponent of the minority view that the zero interest rate policy should be lifted and the overnight call rate raised to the level before the change on February 12, 1999. But, I do not focus solely on the negative effects. I fully appreciate that the current zero interest rate policy has greatly contributed to financial market stability and the economic recovery. I do not think that my view of the basic framework for the conduct of monetary policy is significantly different from that of the majority. The difference in opinion arises because of increasing uncertainties regarding the economic outlook. It would thus seem only natural that the evaluation of economic conditions currently differs to a certain extent among the members of the Policy Board.

Bearing in mind the most recent judgment that the improvement in Japan's economy is becoming more marked with a recovery being observed in some areas of private demand, let me talk about three issues relating to the termination of the zero interest rate policy.

Have deflationary concerns been dispelled?

The first and most important issue is whether we have come to the point where we can say deflationary concerns have been dispelled.

Let me digress a little by briefly discussing what deflationary concerns are and what is really meant by price stability. Though there are a variety of points to discuss regarding price stability, which is the target of monetary policy, I would like to take up three that I think important. First, price stability is a precondition for sustainable growth, and such stability is required not temporarily but over the long run.

Second, theoretically the Bank should aim at zero inflation, since inflation would cause a deterioration in the allocation of resources through changes in relative prices, the distortion of income distribution, and increased uncertainty that would prevent economic entities from efficiently conducting their activities. However, given that price indices such as the Consumer Price Index and GDP deflator have biases, price stability compatible with sustainable growth does not necessarily mean a zero percent increase in terms of particular price indices.

The third point is how to deal with supply shocks. One view is that it is not persuasive to talk about price stability while excluding particular products whose prices have changed due to a supply shock since monetary policy aims at stability of the general price level. It would be difficult for monetary policy to control the impact of supply shocks. If monetary policy were to try to control such impacts, it is likely that sustainable price stability would be impaired as production swings became larger and uncertainty regarding investment increased. Therefore, we should accept change in prices due to supply shocks to a certain extent. At the same time, we should closely monitor the risk that a drastic change in the relationship between costs and prices due to supply shocks might affect corporate profits, subsequently leading to large swings in economic activity.

Again there is the problem of identification in that it is not easy to clearly tell supply shocks from demand shocks. Though we do not have a perfect solution to this difficult problem, we do our best by combining macroeconomic analysis and information on the microeconomic level that is collected by both the Head Office and branches.

Now let me return to the zero interest rate policy. The Bank has clearly stated that it will continue the current zero interest rate policy until deflationary concerns have been dispelled. The term "deflationary concerns" refers to concerns about the economy falling into a deflationary spiral, that is, a vicious circle where a decline in prices suppresses economic activity through lower corporate profits and wages, which in turn causes a further decline in prices. If a decline in prices reflects technological innovation and improved efficiency of corporate management that increase production without unduly squeezing profits, such a decline would not give rise to deflationary concerns since a positive momentum is working on economic activity.

In judging whether deflationary concerns have been dispelled, we need to accurately assess the momentum of economic activity or the strength of the self-sustained recovery behind price developments. Specifically, we need to check three points regarding the self-sustained recovery of private demand: First, is corporate activity gathering positive momentum? Second, to what extent is the improvement in corporate activity leading to an improvement in household income and employment? And third, how smoothly is the improvement in household income and employment leading to increased private consumption? With these three questions in mind, the Bank has been carefully examining economic data to confirm whether deflationary concerns have been dispelled. Currently, the Bank is examining private consumption. To be more specific, we have been trying to judge whether household income and the propensity to consume, both of which are underlying factors of private consumption, have stopped deteriorating and are beginning to show any signs of improvement. As firms will continue squeezing labor costs over the medium term, a conspicuous increase in household income can hardly be expected. Nevertheless, we expect that the environment surrounding private consumption will improve if firms become more active, corporate profits increase, and the expected economic growth rate rises. Such a view is shared by a majority of Policy Board members, including myself.

Assuming that the recovery has become more distinct, we should pay more attention to the development of money supply to judge whether it is still appropriate to continue providing ample liquidity. Let me elaborate on this.

Since a change in money supply usually precedes one in economic activity, I take money supply as an information variable. The most important feature of money supply is its comprehensiveness. Though a change in money supply does not correspond to changes in any specific economic variables, it generally reflects the development of overall economic activity. According to empirical research by the staff of the Bank,4 there is a long-term stable relationship between money supply and such variables as the general price level and nominal GDP. Another feature is that since a change in money supply precedes one in economic activity, significant fluctuations in money supply most likely signal an underlying change of economic activity.

It is difficult to predict how such an underlying change will reveal itself--it may be a fluctuation in economic activity, a change in prices, or volatility of asset prices as evidenced in the bubble period. In some cases, it is hard at an early stage to detect signs of an underlying change of economic activity that has already occurred. Furthermore, since it is not easy to predict the impact of a change in money supply on economic activity, it is rather misleading to assume a strict relationship such as that prices will change if the growth rate of money supply diverges from its long-term equilibrium trend for more than a year. In conducting monetary policy, we need to be on the lookout for any underlying changes of economic activity every time monetary aggregates show volatile movement.

In 1999, the year-on-year growth rate of nominal GDP was minus 0.6 percent while the growth rate of money supply was 3.6 percent and that of the monetary base 7.3 percent. Thus, we cannot say that the supply of money was insufficient relative to economic activity. Since 1997, Marshallian k, which is the ratio of M2+CDs outstanding to nominal GDP, has been significantly above the long-term trend calculated from the 1970s. Both broadly-defined liquidity and modified Marshallian k that uses "divisia money supply" have also shown similar movements.

Marshallian k surged from 1997 onward because precautionary demand for money at firms and households increased, reflecting concern over possible funding difficulties against the background of financial system instability. Since the increase in money supply due to precautionary demand is not related to economic activity, such an increase should be discounted when evaluating the movement of Marshallian k.

As a recovery becomes pronounced, there will be less incentive to hold money for precautionary reasons and the opportunity cost of holding money will increase along with interest rates. As a result, Marshallian k will decline. Though it may sound paradoxical, when economic conditions become such that termination of the zero interest rate policy is warranted, money supply outstanding adjusted for inflation needs to decline to a certain extent. Also, the money multiplier may increase as the financial intermediary function recovers. In the process of economic recovery, there will eventually be a turning point with respect to the movement of money supply. This should be always borne in mind, as we might otherwise make a serious mistake. For example, if we continue to believe, without much evidence, that the increase in Marshallian k reflects greater precautionary demand for money, we might miss the turning point, and excessive fluctuation in economic activity would likely occur.

I do not maintain that inflationary risks are in the offing. The zero interest rate policy is very powerful in the sense that theoretically there is no limit to the provision of liquidity. It will become even more powerful as concern over financial system stability recedes and the economy recovers further. So, if the Bank continues to provide liquidity in the same way as it does now, economic activity might be excessively stimulated and there may be a risk of impairing stable growth over the medium to long term. In today's uncertain environment, the Bank must adopt a preemptive and gradual approach in the conduct of monetary policy by taking stock of our past experience as well as the experience of foreign central banks.

Having said all this, some may criticize me strongly, saying that what matters is that there had not been enough monetary easing. It seems that those in favor of further monetary easing argue that Japan has already experienced, or has been on the verge of falling into, severe deflation similar to that during the Great Depression in the United States in the 1930s. As I have repeatedly stated, Japan's economy is clearly on a recovery path, and I do not think current economic conditions call for further monetary easing.

Can we lift the zero interest rate policy in a persuasive manner?

The second issue regarding the termination of the zero interest rate policy is how we can avoid shocks to financial markets, or at least, minimize them. Some economists argue that the zero interest rate policy could continue as long as there are no signs of inflationary risks. I fear that if we terminate the zero interest rate policy after observing some signs of inflationary risks, say for example raising the overnight call rate to 0.25 percent, strong expectations would arise in financial markets that the overnight call rate would be raised further from 0.25 percent, which would increase uncertainty regarding the future movement of interest rates.

On the contrary, if the Bank comprehensively explains its judgment that the economy has definitely improved since February 1999 when it was on the verge of falling into a deflationary spiral and that no signs of inflationary risks have been observed, and if it terminates the zero interest rate policy in line with the pace of recovery, I suspect that the shock of policy change will be relatively small.

In this regard, we may be able to draw a lesson from U.S. monetary policy in the early 1990s. In February 1994, the Fed raised its target for the federal funds rate from 3 percent to 3.25 percent for the first time in five years, thereby terminating the zero-percent real interest rate policy. As there were no clear signs of inflation at the time, and lingering concern over unemployment, the Fed released a statement saying that the decision had been taken to move toward a less accommodative monetary policy stance in view of the expansion of the economy.

After the increase in the federal funds rate in February 1994, long-term interest rates in the United States, which had been declining substantially, started to surge. But we should not jump to the conclusion that termination of the zero interest rate policy in Japan would give a serious shock to the market, including a surge in long-term interest rates. In general, the impact on the market of a change in monetary policy differs greatly, depending on how well market participants understand and share the central bank's thinking behind monetary policy and its judgment of the economy. There were strong expectations at the time in U.S. financial markets that the Fed would not raise the federal funds rate in the near future in light of the level of unemployment, which was a hot issue politically and socially. It seems that the policy stance of the Fed, to preemptively move toward a less accommodative stance before inflation arose, was not sufficiently understood in the market. Bearing in mind this experience of the Fed, it is quite important for the Bank to explain to the public, to the fullest extent possible, its judgment regarding the outlook for economic activity and prices as well as the relationship between monetary policy and such economic conditions.

Weakened awareness of risks

The third issue is the possibility that the awareness of risks among economic entities might be greatly weakened if the zero interest rate policy persists for a long time.

In fact, some market participants link deflationary concerns to structural adjustment and argue that the zero interest rate policy should continue as long as there are pressures for structural adjustment. I understand that pressures for structural adjustment would slow the pace of a self-sustained recovery of the economy. However, as I mentioned earlier, policy measures should be appropriately chosen for the objective that it is intended to achieve. Monetary easing has the side effect of alleviating the pain in the process of structural adjustment, but at the same time it makes economic entities delay adopting radical solutions to structural problems. If the zero interest rate policy continues while the economy is recovering, it may be natural for firms to fall into comfortable belief that they should postpone painful structural adjustment based on a short-sighted and false assumption that economic recovery can be supported solely by monetary policy. I feel it is vital we remind ourselves that the protracted monetary easing amid economic recovery was one of the major factors behind the expansion of the bubble.

III. Monetary Policy and Income Distribution

I have long supported the view that distortion of income distribution is one of the side effects of the zero interest rate policy. A textbook theory teaches us that the goal of monetary policy is price stability and that any distortion of income distribution should be corrected by fiscal policy and other income redistribution policies, though the influence of monetary policy on income distribution cannot be denied. I understand this theory, but still I cannot help feeling that the impact of monetary policy on income distribution has been taken too lightly.

The Bank explains the impact of the extremely low interest rate policy on households as follows. The extremely low interest rate policy reduces the interest income of households, while it improves employment and household income conditions through larger corporate profits. Statistically speaking, employee income accounts for about 80 percent of household disposable income, whereas interest and other income accounts for only about 5 percent. Therefore, on a net basis, if one compares employee income and interest income, households enjoy a positive effect from the extremely low interest rate policy.

This explanation by the Bank of Japan is based on a macroeconomic approach in the sense that various types of households with diverse interests are represented by employees' households, or the "average" households. This view is reasonable to the extent that monetary policy is a macroeconomic policy. However, household conditions are now very diverse, and they are expected to become even more so in the future. In light of this trend and the fact that the Bank has pursued an extremely low interest rate policy for the past five years, currently in the form of the zero interest rate policy, I fear that the Bank's explanation, which seems to give the impression that the impact of monetary policy on income distribution has been taken lightly, is unlikely to be fully accepted by the public.

In the conduct of monetary policy, the situation in which each household is placed must be taken as a given condition, including wages and salaries, assets and liabilities, and their ratio to annual income. Monetary policy has a different impact on different households, and it is impossible to conduct it in such a way as to adjust such asymmetry. Of course, it cannot be used to influence such factors as education and employment opportunities as well as risk taking. I do not agree to a priori arguments that income distribution should always be equal. Nor do I think that equality in results should be guaranteed.

Having said this, it is true that increasing attention is being paid to income differentials as can be seen in the controversy regarding this problem among young Japanese labor economists: many of them argue that the conventional approach of monitoring only the average household should be reconsidered. Recently, there is a microeconomic view of labor economics that holds that the zero interest rate policy is deeply related to the income distribution between winners and losers. As a specialist in labor economics, I tend to have sympathy with these views. Nevertheless, I can assure you is that I have, and for that matter the Bank has, never made a monetary policy decision based on weighing the opinions of winners and losers. This dilemma can be regarded as an example of the large gap between the macroeconomic approach, which is the basis of the conduct of monetary policy, and the microeconomic approach featured in labor economics.

Let me briefly describe how a foreign central bank explains the impact of monetary policy on income distribution. In the United States, the Federal Reserve Bank of Kansas City held a symposium in 1998 focusing on income inequality.5 In March this year, Mr. Greenspan, Chairman of the Federal Reserve Board, referred to income distribution in a speech entitled "Economic Challenges in the New Century" to the effect that the remarkable performance of the U.S. economy in recent years has not reversed the wage inequality that occurred during the 1980s but has brought benefits to minorities as seen in the increase in their asset holdings and the rise in home ownership. I think that we should be aware that the Fed, as the central bank, has been paying careful attention to such problems as the impact of monetary policy on income distribution and the change in national income distribution. Such an approach may be based on the fact that the United States is a multi-racial country and its public authorities always have to pay careful attention to problems like the difference between the rich and the poor to preserve social stability. Nevertheless, we can certainly draw a lesson from such an approach.

Let me turn the focus back to Japan. Among the general public, there seems to exist in some quarters an illusion that households have nothing to do with macroeconomic policy. For example, when the Tokyo Metropolitan Government introduced a plan for a new tax on selected large financial institutions operating in Tokyo, many Tokyo residents agreed with it. However, it is doubtful whether many fundamental issues related to the tax plan had been thoroughly examined, for example, the impact of the plan on the profitability of banks operating in Tokyo, especially major banks that have received public funds, and the impact on the international competitiveness of the Tokyo market and on financial system stability. Should this policy decision lead to a deterioration in the international competitiveness of the Tokyo market and instability of the financial system, it might be that Tokyo residents would have to bear the cost as taxpayers.

I think it is the household sector that ultimately bears risks in any country.6 Therefore, the people are entitled to appropriate information to enable them to make a correct assessment of a variety of problems, the risk attaching to which they have to bear or will have to in the future, including the financial system problem, the management of fiscal policy, and other economic policy issues. The central bank also has a responsibility to provide the public with an adequate explanation regarding the conduct of monetary policy. It should pay more careful attention to the impact of monetary policy on income distribution. I personally would like to study further how to make the best use of the microeconomic approach in labor economics in conducting monetary policy.

IV. Conclusion: The Bank of Japan in the 21st Century

Today, dialogue with the market is essential to the conduct of monetary policy. To me, the market here means the public. As the financial market expands in depth and breadth, the distinction between professionals and laymen in financial activity has become blurred. I believe that to enhance public confidence in monetary policy, the Bank should become a central bank that can share its various concerns with the public.

Recently, inflation targeting has received much attention from the viewpoint of the framework of monetary policy. It is pointed out that it would improve communication between policy makers and the public, and strengthen discipline and accountability.7 The new Bank of Japan Law has firmly established a basic principle of transparency that is inseparable from independence. And, under this principle, the Bank has been maintaining accountability that is totally comparable with the Fed and other central banks that have adopted inflation targeting, through publication of the minutes of Monetary Policy Meetings and the Monthly Report of Economic and Financial Developments.

I hasten to add that I do not think the current style of conduct of monetary policy is faultless. For example, we should be open to learning what we can learn from countries that have adopted inflation targeting. For example, we could examine the possibility of disclosing our inflation forecast or the economic outlook behind this forecast. A comprehensive study on price stability that includes this issue is currently under way.

The central bank can only earn credibility through daily implementation of appropriate monetary policy. In June 1943, Mr. Keizo Shibusawa, the then Deputy Governor and later the 16th Governor of the Bank, stated in his speech at the inaugural meeting of the Japan Society of Monetary Economics that: "When tackling a new problem, it is vital to properly understand how it has emerged. A correct fundamental theory is essential to appropriate policy and its implementation."8 More than fifty years have passed, but this message is still valid today. I hope all of you will continue to give us candid advice and criticism with respect to monetary policy.

References

  1. Okina, Kunio, Masaaki Shirakawa, and Shigenori Shiratsuka, "The Asset Value Bubble and Monetary Policy: Japan's Experience in the Late 1980s and the Lessons," IMES Discussion Paper Series, No. 2000-E-13, Institute for Monetary and Economic Studies, Bank of Japan, 2000.
  2. Mieno, Yasushi, Nihon keizai to chuo ginko (Japan's Economy and the Central Bank), Toyo Keizai Inc., 1995, p.41.
  3. Federal Reserve Bank of Cleveland, "Beyond Price Stability: A Reconsideration of Monetary Policy in a Period of Low Inflation," Annual Report 1998, 1999.
  4. Bank of Japan, "M2+CDs to keizai katsudou no kankei ni tsuite: chouki kinkou kankei wo chuushin to shita ken'kyu (M2+CDs and Economic Activity: Studies with a Focus of Long-term Equilibrium)," Nippon Ginko Chousa Geppo (Bank of Japan Monthly Bulletin), June 1997.
  5. Federal Reserve Bank of Kansas City, Income Inequality: Issues and Policy Options, 1998.
  6. Ikeo, Kazuto, "Baburu houkai to kakei bumon no sakkaku (The bursting of the Bubble and Misunderstanding of the Household Sector)," Weekly Toyo Keizai, November 13, 1999.
  7. Bernanke, Ben S., and Frederic S. Mishkin, "Inflation Targeting: A New Framework for Monetary Policy?" Journal of Economic Perspectives, 11, 1997.
  8. Japan Society of Monetary Economic, Kin'yu gakkai no souritsu to shoki no katsudo (Establishment of the Japan Society of Monetary Economics and its Activities in the Early Days [40th anniversary]), Toyo Keizai Inc., 1984.