Home > Announcements > Speeches and Statements > Speeches 2001 > Speech given by Kazuo Ueda, Member of the Policy Board of the Bank of Japan, at Council on Foreign Relations in New York, May 11, 2001 (Japan's Economic Outlook & the Bank of Japan's Monetary Policy)

Japan's Economic Outlook & the Bank of Japan's Monetary Policy

Speech given by Kazuo Ueda, Member of the Policy Board of the Bank of Japan, at Council on Foreign Relations in New York, May 11, 2001

May 12, 2001
Bank of Japan

In Japan we now seem to have a pro-reform cabinet. Many people, both within and outside of Japan, are waiting anxiously for the new prime minister to start delivering on his promises. Structural reform will be the talk of the country for months or years to come. Looking backwards, however, we notice that serious restructuring efforts in some areas and/or absence of needed reforms in some others have been one of the major determining factors of the course of the economy for the last few years. Today, I would like to talk about some salient features of the Japanese economy during the last couple of years with particular attention to the point I have just mentioned. I would also talk about the backgrounds for, and implications of the recent monetary policy decisions of the Bank of Japan (BOJ) in the light of the discussion of the economy.

When I became a member of the BOJ's policy board in April 1998, output was falling and the rate of inflation was around zero. The economy was headed to a liquidity crunch generated by a concern over the health of the financial system. Yet, the overnight call market rate, our policy instrument at that time, was already below 0.5%--a great time to be a central banker. We overcame the liquidity crisis by re-capitalizing many of the top banks and by adopting a rather non-conventional monetary policy stance. The latter was named a zero interest rate policy by someone outside the BOJ and was a combination of a near zero overnight rate and the commitment to maintain it "until deflationary concerns are over." It was non-conventional in the sense that the policy rate was set at zero, an extreme level, and that the near-term future policy stance was explicitly made clear. No other central banks have done something similar except for those who are fixing the exchange rate.

As a result of the containment of liquidity concerns, investment and consumption stopped declining in early 1999. Since then, the economy has been on a slow recovery path. In order to understand why the recovery has been slow, it is useful to use a rather stereotype dichotomy of new versus old economies. In Japan, the new economy consists of electronics and some related industries. The old consists of most of the others.

Since the middle of 1999, the new economy had been hit favorably by an acceleration of US economic growth and the worldwide IT boom. A virtuous cycle among exports, production, and business fixed investment started to develop and became a major driving force of the recovery in 1999-2000. For example, the electronic machinery industry expanded at an annual rate of more than 10% during the recovery. The boom in the new economy, however, did not quite spread over to the old, resulting in an average annual RGDP growth rate of about 1.3% between 1999-2000. Incidentally, this number, 1.3%, is about the same as the average growth rate for the period of 1991-2000, which was 1.4%. People call the period a lost decade. But the economy has grown at a positive rate, if small-which may explain the lack of the sense of crisis on the part of the general public and may have been a cause of the slow pace of restructuring.

The weakness of the old economy has been deeply connected with many structural problems plaguing the economy. The spending binges of the late 1980s along with other inefficiencies have left Japanese firms with very low rates of return on capital. The return on assets is currently around 3% in Japan as against 8 to 9 % in the US. Efforts to increase the return on capital have resulted in low growth of wages and consumption. The old economy has traditionally shown high correlation with consumption-one of the reasons for its stagnant behavior.

To be sure, there have been some serious efforts on the side of the old economy to restructure itself. For example, years of direct foreign investment into Asia, and the associated growth of the region, especially that of China, have enabled many innovative firms to produce there and sell in Japan a variety of goods at low prices. One of the leaders in this area, uniqlo, who sells in Japan casual clothes manufactured in China, is generating above 20% return on assets. But they are bypassing not just Japanese producers of competing goods but also traditional retail and wholesale firms thanks to modern technology such as SCM. Thus, their activities are creating serious deflationary impacts on more traditional firms. Many have gone under. Others are not expanding investment.

The lingering bad loan problem has also been a source of deflationary pressure. The unhealthy state of the balance sheets prevented banks from extending loans to new, but risky projects. It has also slowed down the process of restructuring of problem borrowers.

Downside risks to the Japanese economy have increased sharply since the fall of last year as both the US economy and the IT boom turned downward. The downturns have hit the new economy hardest. The production of electronic goods contracted at 7.3% in the first quarter of this year relative to the previous quarter due mostly to a decline in exports. Depending on the course of the US economy in the 2nd half of this year and beyond, the virtuous cycle of the new economy may turn into a vicious cycle. The old economy has remained stagnant.

I hasten to add that GDP may have expanded at a reasonable rate in the second half of last fiscal year, which ended in March. But going forward, the downside risks I have just characterized are the major concern. Such was the background for our monetary policy decisions in the last quarter.

Given time limitation, I would like to avoid discussing the technical details of monetary policy changes we have carried out since the beginning of the year. But let me just briefly touch upon the measures decided on March 19th. You could call it a return to a zero interest rate policy or adoption of quantitative easing, whichever you like. Through a massive supply of liquidity to the market, the overnight rate has effectively come down to zero--1 or 2 basis points. It is like the zero rate policy that was in place until August last year, but is a stronger one at that. It is stronger because we have committed to injecting large amounts of liquidity until the rate of inflation as measured by core CPI becomes positive for a sustained period. Previously, the commitment was more vague and hence was weaker. We are now watching carefully at how this new set of strong measures is going to affect the markets and the economy.

Our monetary policy framework can be combined with a variety of policy options in other areas. For example, it can be combined with serious efforts at structural reforms by the government. Such efforts may produce deflationary forces in the short run, but will generate a much more efficient economy after a while. Even in the short run improvements in confidence due to the announcement of the reform plan may produce favorable impacts. Our framework will go a long way towards supporting such reforms. The maintenance of near zero rates will mitigate possible deflationary forces. Liquidity provided will be put to efficient use as reforms progress.

Of course, the government has other policy options to be combined with our monetary policy. If I were to talk about an extreme, hypothetical example, the fiscal authority might decide to increase expenditures or cut taxes on a very large scale. Possible upward pressures on interest rates will be mostly contained by our commitment of liquidity provision. The policy mix would stop deflationary forces after a certain point. Of course, we will not allow a runaway inflation because our commitment to provide large amounts of liquidity is effective only so long as the rate of inflation is below zero. Thus, what the policy mix would achieve is to affect the time it would take for the economy to end a period of deflation. With this policy mix the time to a positive inflation rate may be shorter than with the previous example. But the structure and the efficiency of the economy at the time we will be able to terminate our commitment will also be different. For example, this mix may end up in preserving the high share of the old economy. The fiscal situation will surely worsen.

We feel that the BOJ has come up with fairly bold measures to stimulate the economy. To repeat, our measures can be combined with a variety of options in the hands of other policy makers in the country. Policy choices by other authorities will affect the time it will take to end deflation and the shape of the economy at that point. In this regard we cannot but hope that efforts will be made to choose the configuration that best meets the preference of the public.