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Home > Announcements > Speeches and Statements > Speeches 2001 > A paper based on a speech given by Miyako Suda, Member of the Policy Board, at the Meeting on Economic and Financial Matters in Saitama on November 5, 2001 (Monetary Policy in Japan)
Based on a speech given by Miyako Suda, Member of the Policy Board, at the Meeting on Economic and Financial Matters in Saitama on November 5, 2001. It is a translated and revised version of the Japanese text released in November.
February 25, 2002
Bank of Japan
It is a great pleasure to address this meeting on economic and financial matters. I would like to take this opportunity to explain my views regarding the conduct of monetary policy, though I should stress that these are my personal views and that you should not interpret them as the position of the Policy Board of the Bank of Japan.
The Bank has eased monetary policy substantially since March 2001 in response to the growing need to halt the deflationary trend in the economy. The thrust of the measures taken is captured in the following two features.
First, the Bank changed the main operating target of monetary operations from the overnight call rate to the outstanding balance of current accounts held at the Bank, and has provided ample funds to the money market since then. As a result, short-term interest rates have declined to almost zero percent.
Second, the Bank has made a commitment to maintain the new monetary policy framework until the year-on-year increase in the consumer price index (CPI) stabilizes at zero percent or more. When ample liquidity is provided to the money market far exceeding the level required under the reserve requirement system (currently about 4 trillion yen) it follows that the overnight call rates stay at effectively zero. Therefore, the Bank's clear commitment to continue monetary easing in the future is expected to extend the easing effect to interest rates with longer terms. This effect is often called the "commitment effect" or the "duration effect."
The first feature is the ample provision of funds. I would now like to explain how the Bank's funds provision affects your economic activity.
Various transactions take place every day. Each of these transactions produces debtors and creditors. This debtor/creditor relationship dissolves when the transaction is settled. The settlement signifies the end of the transaction as a result of the debtor paying off the debt. To settle and conclude the transaction, it is necessary for the creditor to receive some acceptable medium of exchange--"acceptable" in the sense that it will enable him or her to acquire, without fail, the full equivalent monetary value of the transaction.
One of these media of exchange is banknotes1 , whilst the other is current account deposits held by financial institutions at the central bank. Current account deposits at the Bank can be exchanged for banknotes at face value at any time. The deposits in these accounts are to financial institutions what banknotes are to the general public. They are the means of settlement acceptable among financial institutions.
Current account deposits at the Bank have three main functions. First, they are a means of settlement. Here they play a role similar to that of demand deposits held by firms and individuals at financial institutions. Second, they play a role as the reserves financial institutions hold in readiness for banknote payments to individuals and firms. This is similar to firms' and individuals' practice of depositing money at banks until they need it. The third role is unique to the current accounts with the Bank. There is a law that stipulates that financial institutions must set aside at the Bank a certain amount of their customers' deposits. This is called the reserve requirements.
What causes the current account balance at the Bank to increase and decrease? Financial institutions pay banknotes to and receive them from individuals and firms. When you withdraw banknotes from a bank, the bank withdraws an equal amount of money from its current account deposit at the Bank. This is one cause. Another is payments and receipts of treasury funds to and from the Government's deposit account at the Bank. For example, let us consider the procedure for tax payments. When you make tax payments out of your bank account, they end up in the Government's deposit account at the Bank as a result of a transfer of funds between your bank's current account at the central bank and the Government's. In this way, the total outstanding balance of the current account deposits rises and falls as a result of payment and receipt of banknotes and treasury funds.
Current account deposits can be changed into banknotes at face value at any time and accordingly it is only natural that they do not bear interest. Regardless of the lack of interest income, financial institutions hold current accounts at the Bank because they need reserves for various payments and because they must meet reserve requirements. In ordinary circumstances, financial institutions will try to limit their current account balance to the minimum required amount. When the balance is below the minimum amount, financial institutions borrow funds, as a short-term measure, from other institutions with surplus funds. These transactions take place in the money market.
If the current account balances remain short of the required amount for a prolonged period of time, demand for funds in the money market increases, putting upward pressure on interest rates. Likewise, when the current account balances are in excess of the required amount, surplus funds will be placed in the market, creating downward pressure on interest rates. The Bank, in response to the market situation, uses market operations to adjust the overall balance of the current accounts by selling bills and government bonds to and buying them from financial institutions. The total amount of such transactions ranges from several billions to several trillions of yen every day. The Bank influences short-term interest rates by adjusting, in this way, the current account balances financial institutions hold at the Bank. These changes in short-term interest rates, in turn, affect the interest rates charged by financial institutions on loans made to firms and individuals, affecting in turn the level of real economic activity.
The Bank's funds provision has been extremely ample since March 2001. Exactly how "ample" has it been? In order to aid understanding, I will next give some details about developments in the overall current account balance. At present, banks and credit cooperatives together have more than 600 trillion yen in deposits from firms and individuals. Of this total, they have to deposit some 4 trillion yen with the central bank as required reserves. In March 2001, the Bank decided to conduct market operations with the objective of raising the current account balance to around 5 trillion yen. In August, the target was increased to 6 trillion yen.
In September, the target was further raised to "above 6 trillion yen." This measure was taken to prepare, first, for any unpredictable effects on the global economy and financial markets from the terrorist attacks in the United States, and second, for a possible increase in cash in hand before interim book closings for the first half of the fiscal year. As a result, financial institutions have been able to maintain the necessary amount of funds in their current accounts. In October, the daily outstanding balance fluctuated in the range of 7.5 trillion to 10.9 trillion yen, with the daily average at slightly below 9 trillion yen. 2
With regard to interest rates, since the beginning of September the overnight call rates have been at record low levels of 0.001-0.003 percent, which is less than one tenth of 0.02 percent, the record low for the zero interest rate policy period between February 1999 and August 2000. 3 Thus, the current period may be termed the period of "ultra-near-to-zero interest rates."
Next, I would like to explain another aspect of the current monetary policy: the significance of the Bank's commitment to maintain the current monetary policy until the year-on-year increase of the CPI stabilizes at zero percent or higher.
Firms and individuals decide on their investment and consumption, taking into consideration not only the present state of the economy but also their views of the economic outlook and economic policies that may influence the future. Interest rates on longer-term instruments, such as three-month, six-month, and one-year rates, as well as long-term interest rates are important. At present, such interest rates essentially depend on how long the current abundant provision of funds will last rather than how abundantly funds are provided. The "policy duration" effects are underpinned by the "expectation theory" of interest rate determination. Pure expectation theory tells us that long-term interest rates today should basically reflect the future course of short-term rates.
In general, because economic conditions vary and must be accommodated in practice, the central bank cannot make definitive statements about the movements of short-term interest rates over any given period of time. For the same reason the Bank is unable to give a definite time frame for the termination of the current monetary easing measures. However, it is able to make its commitment to the continuation of monetary easing as clear as possible: specifically, in terms of policy duration, the Bank has made a commitment to maintain the current monetary easing measures until the year-on-year increase of the CPI has stabilized at zero percent or more.
In addition, the Bank has made clear its views on the outlook for the economy and prices in the relatively long run in the latest "Outlook and Risk Assessment of the Economy," a publication which is released twice a year (in April and October). As you see in this latest report released in October 2001, Policy Board members expect the CPI to fall by about 1 percent in both fiscal 2001 and 2002. This outlook has strengthened the views of market participants that the current quantitative easing will continue for some time. The more such views are shared by market participants, the stronger will be the tendency for relatively long-term interest rates to remain at extremely low levels. I believe this commitment by the Bank has enhanced substantially the effectiveness of the monetary easing.
I have so far talked about the basic thoughts behind recent monetary policy. At present, however, it is unlikely that the effects of the monetary easing will spread throughout firms and households--entities outside the financial system--and trigger positive momentum in investment and consumption.
Why does Japan's economy remain stagnant? Some market participants argue that economic activity would be rejuvenated and general prices would rise if the Bank increased the monetary base even after short-term interest rates reach zero. This argument is based on the assumption that financial institutions cannot lend as much as they want to because there is an overall funds shortage in the markets. Thus, if the central bank provided funds far in excess of reserve requirements, financial institutions would increase their loans, which in turn would stimulate the real economy.
So how effective at present is this traditional mechanism of monetary easing? In my view, this mechanical "multiplier" model of money creation is too simple to provide much insight into the current state of Japan's economy. I believe that the problem Japan's economy currently faces is not a shortage of funds in financial markets, but a failure to distribute funds properly: both within the money market itself, and also between the money market and other markets, such as the stock and debt markets. Recently households have started to place importance on the "safety" and "liquidity" of financial assets, so both institutional investors and financial institutions, the entities that invest on behalf of households, are seeking safe havens. In this situation, stock prices slump due to a lack of buyers. Even in the money and bond markets, the normal destinations for safe investments, the desire to avoid the risks related to liquidity, credit and price fluctuation has become evident, despite plentiful funds overall, in a high degree of selectivity. As a result, the yield spreads between bonds with high and low credit ratings have widened in the secondary market.
The reasons for this heightened averseness to risk are found in the circumstances of both lenders and borrowers. Looking first at borrowers: corporations, for example, have been unable to obtain the returns expected by investors in their businesses. In order to increase demand for stocks, the corporations concerned need to present convincing business models that would enable them to achieve the sustained profit increases demanded by many investors. At present, the Government is making strong efforts to deregulate. I believe the aim of this deregulation is to make it easier both for existing firms to employ innovative methods in the provision of goods and services, and also for new and innovative firms to be created.
With regard to lenders such as financial institutions, it has been pointed out that they have less scope for risk-taking due to the fall in stock prices. They are also under pressure because of structural adjustments, including pressures arising from the nonperforming-loan problem; and at the same time they are faced with uncertain prospects in overseas economies (in particular that of the United States) as well as an equally uncertain adjustment phase in the information technology sector. The growing uncertainty about the future has made investors, including households, more risk-averse. With higher premiums on credit and price-fluctuation risks, the expected return on investment (in other words, the reward for risk-taking) is even lower.
If this situation continues, the provision of additional reserves is unlikely to lead to expansions in loans, deposits, or even in the narrow and broad measures of the money supply. For this reason, the Bank has been paying close attention to changes in investors' risk-taking attitudes.
As mentioned, the current easing measures are very strong in nature. At present, however, Japan's economy remains in an adjustment process, and prices of goods and services continue to fall. Given these circumstances, some observers have sought to justify further easing, suggesting specifically that "monetary policy should be conducted in such a way as to achieve a 1-3 percent annual rate of increase in consumer prices within two years." This type of policy is known as "inflation targeting." 4 Several central banks, notably those of the U.K., Canada, and New Zealand, make use of inflation targeting. Central banks in these countries establish a standard by which to judge whether an inflation rate is high or low; i.e. they clarify the definition of "price stability" in terms of a specific percentage rate. For such central banks, achieving this specific percentage rate becomes an objective of monetary policy. Furthermore, these central banks have tried to increase the transparency of their policy operations by making public their projection of the future rate of inflation, and conducting monetary policy so as to respond to the relationship between this projection and their "target inflation rate."
Next, I would like to discuss whether inflation targeting should be introduced as a measure for economic recovery when the economy is in a deflationary situation under zero interest rates.
First, let me give a brief comparison of the thinking behind inflation targeting and the Bank's conduct of monetary policy.
Like other central banks around the world, the Bank is fully aware of the importance of a forward-looking view in the conduct of monetary policy. Looking at the past 20 years in Japan, we see a clear relationship between inflation and lagged growth: any time the real economic growth rate has increased, one or two years later the inflation rate has risen above its year-earlier level. This makes it possible for us to predict that if the real economy begins to recover, there is a strong likelihood that the inflation rate will rise. In addition, it takes time for the effects of monetary policy to be seen in real economic activity. As a result, it may be a long time before monetary policy has an effect on the economy, and longer still before that in turn finally has an effect on prices. The central banks of major countries share the views that when conducting monetary policy, it is important to keep a close eye on expected financial and economic conditions in the future.
Therefore, in general, under inflation targeting, monetary policy is conducted, not in response to the actual rate of inflation, but in response to the difference between the central bank's projection of the inflation rate and its "target inflation rate." If, for example, the central bank projects that there is a strong likelihood that the inflation rate will rise in the near future, it could conceivably begin monetary tightening even if the current inflation rate is below the target rate.
Given this awareness, and to make clear its strong determination not to tolerate deflation, the Bank is providing extremely ample funds, committing itself to maintain the current monetary easing measures, until the actual inflation rate climbs up to and stabilizes at zero percent or higher.
Please allow me to expound for a moment on the meaning of this commitment in the context of inflation targeting. A moment ago, I alluded to the notion that "after the real economy recovers, the inflation rate begins to rise." If we consider this time lag, we see an economic situation where the expected rate of inflation may be positive, although the actual inflation rate remains below zero. In other words, the Bank has effectively made a declaration that it will continue its current extremely easy monetary policy measures not just until the projected inflation rate reaches zero percent, but until such time as it reaches positive territory.
For these reasons, I believe the Bank's current monetary policy gives rise to monetary easing effects in the financial and capital markets similar to those induced through inflation targeting, since it translates into numerical figures the Bank's strong determination not to tolerate deflation.
Countries that use inflation targeting make public their targets, both for the annual increase in the CPI, or a similar economic indicator, and for when they expect to attain the target level. The Bank, by contrast, declares publicly that it will continue its current policy stance until the inflation rate (in terms of the CPI) rises to and stabilizes at zero percent or above, but believes it is very difficult at present to say when it expects to achieve this goal. As a result, the Bank's stance might be seen as insufficient, in comparison with inflation targeting.
This is not, however, because the Bank is neglecting what it should do, nor indeed because it is failing to achieve what, in its own judgment, it is capable of doing. Instead it reflects the current difficult economic situation in which it is hard to fight the fall in prices by applying monetary policy alone.
I would like to move on now to discuss a few points of debate concerning policy instruments.
For inflation targeting to function effectively through people's expectations of inflation, it is vital that the central bank has sufficient policy instruments to achieve its goals. The number of foreign countries using inflation targeting, with the aim of curbing inflation, increased in the 1990s. This was not a matter of coincidence; it was because central banks could finally be said to have sufficient tools at their disposal to curb inflation effectively. 5
If Japan were to adopt inflation targeting at the present time, its aim would be to provoke inflationary expectations and increase the inflation rate. Looking at the actual changes in the inflation rate in countries that adopt inflation targeting, we see that they do not always succeed in keeping to their targets or target ranges. Many are above, many are below. If Japan were to introduce inflation targeting at present, when we can already see how difficult it is to control falling prices by applying monetary policy alone, it is easy to imagine the most likely outsome: merely the prolongation of a situation in which we cannot achieve our goals. At some point, external pressure to abide by our promises and commitments would become irresistible, increasing the likelihood that we would be forced to use policy instruments which carry greater risks or have more undesirable side effects in order to achieve our goals.
As a hypothetical example, let us say that the Bank could give money away either through directly disbursing currency to the public for nothing or by disbursing it through the banking system without buying an asset of any kind; literally implementing a so-called "money rain."
It is true that under the revised Bank of Japan Law, the obligation that banknotes be backed by prime-quality assets, the "reserve for banknote issuance" system, has been abolished. Behind this revision, however, as in other major countries, is the concept that the value of Japan's currency should be secured by the Bank's appropriate conduct of monetary policy. 6 In order for people to have faith in the value of the currency, it is vital that the Bank maintains its own financial soundness.
In the Bank's accounting, unlike that of ordinary companies, current funds surpluses (after legal reserves and dividends have been deducted) are transferred to the Government's treasury account. If the Bank's balance sheet is impaired, not only is the value of the currency undermined, but the Government also loses valuable revenue. 7 In other words, under current fiscal conditions, it is no exaggeration to say that any deterioration in the Bank's financial soundness could lead directly to an increase in the Government's fiscal deficits.
Bearing this in mind, when a central bank literally implements a money rain, it should be understood that in essence it is a form of fiscal policy mechanism: its effect is channeled through income distribution, instead of through the provision of macro liquidity as would be the case with a more orthodox monetary policy.
I strongly doubt whether a central bank could increase private-sector wealth and thereby stimulate aggregate demand though implementation of a money rain. On the contrary, the wanton distribution of money would undermine the trust that ensures that banknotes are generally accepted by anyone. In that event, people might begin to use foreign currencies to make payments, and in an extreme cases they might even resort to barter transactions.
Moreover, although at present the Bank has enhanced autonomy, the Bank of Japan Law does not provide authorization for a direct transfer of funds at the expense of taxpayers. I hope that everyone here understands that what a money rain involves is the discretionary allocation by the Bank of funds that it ought to pay to the national treasury (which ultimately belong to the public).
That being the case, instead of simply spreading banknotes around for nothing in the form of a money rain, how would it be if the Bank engaged in aggressive purchases of long-term Japanese government bonds (JGBs), listed stocks, real estate, etc., as a way of drastically increasing the supply of money in the economy?
Taking the case of stocks or bonds purchases, it would first be necessary to decide which specific stocks and corporate bonds should be purchased. Having bought these assets in large amounts, the Bank would then be saddled with a high level of credit risk and also exposed to the risk of potentially large price fluctuations. The Bank does not have any advantage over commercial banks in making judgment on the quality of individual companies. If these downside risks were to materialize, the value of the assets the Bank had purchased would fall dramatically, and the resulting damage to the Bank's balance sheet would be the same as with the nonsensical money rain policy. The end result would be taxpayers subsidizing the firms which had issued the stocks and/or bonds. To avoid such a situation, all major countries share the view that central banks should be neutral with regard to the nature of the assets they trade and the counterparties they deal with in their monetary adjustment operations. Moreover, if central banks engage in large-scale purchases of stocks or bonds, there is an increased risk of distorting resource allocations.
Despite these problems, if the Bank were to act through fiscal policy mechanisms, increasing banknote issuance and raising the level of current account balances at the Bank, at some point deflation might cease and inflation expectations be kindled. At the same time, however, it is incumbent upon us never to forget the potential danger of damaging public faith in banknotes.
The next time you hear a proposal asking for "additional monetary easing since fiscal policy has reached its limit," I would be grateful if everyone here would bear in mind the full extent of the potential problems, and ask him or herself whether such a policy would really be any different from a money rain policy.
On the other hand, strong advocates of inflation targeting often say that, in the future, when prices have begun to rise, the Bank will be able to absorb excess funds from the market to prevent any excessive rise in inflation. From a theoretical standpoint, this is a fully understandable view. It may prove difficult, however, to win the understanding and support of the general public when the Bank is abruptly required to tighten its policy stance after such a long and uninterrupted period of ultra-low interest rates. Whatever the theoretical background, this is my pragmatic judgment. 8
As part of the current debate about the introduction of inflation targeting, one often hears the view that the Bank could actively buy long-term JGBs, as a way of expanding the money stock and of kindling inflationary expectations without somehow raising long-term interest rates.
In terms of standard economic theory, however, long-term interest rates are inevitably influenced by a rise in the expected rate of inflation. In the dominant view, nominal long-term interest rates are determined by (1) the current average of the forecast of future nominal short-term interest rates, and (2) the risk premium attached to long-term investment of funds. If the expected rate of inflation rises, the forecast of future nominal short-term interest rates will naturally also rise.
If we consider the international flow of funds in an environment in which there is domestic inflation-targeting, we note that to the extent that the adopted target influences market participants' expectations of inflation, it is also likely to encourage expectations of a depreciation of the yen in the foreign exchange market. Recent understanding of the process by which foreign exchange rates are determined in the short term centers on the notion that foreign exchange rates and interest rates adjust themselves simultaneously and endogenously until the relative profitabilities of investing domestically and overseas (including the risk premium for investing in foreign currencies) are equal. Assuming the risk premium and interest rates for some foreign country are given, we note that, should the yen then weaken, this will favor foreign assets, and yen-denominated assets will be avoided. In the standard scenario the result is that the yen will continue to depreciate, and long-term interest rates for the yen will rise.
If, as currently advocated by those who support the adoption of inflation targeting, the Bank were to buy large volumes of JGBs to achieve its target inflation rate, financial markets might speculate that the Bank's aim was not to provide ampler funds in the money markets, but to relieve upward pressure on long-term interest rates to make it easier for the Government to finance its deficits. This in turn might bolster the viewpoint that the Bank had begun to try to influence the economy using fiscal policy tools, as described above. In that case, market participants might begin to feel less secure about the Government's commitment to fiscal discipline, leading them to sell JGBs in the belief that the price of JGBs was certain to fall in the future. This could result in a rise in long-term interest rates, even without a change in inflationary expectations.
To prevent this kind of scenario, it is vital that market participants maintain their faith in the Government's commitment to fiscal discipline. As far as fiscal policy is concerned, I believe it is not a matter of choosing either economic stimulus or fiscal reconstruction. There is a need for a deeper debate with the aim of determining how we can construct a system that maintains fiscal discipline in the medium- to long-term while responding flexibly to the economic situation and making best use of fiscal policy. 9
Looking at the debate on inflation targeting, we are reminded how complicated the current price developments in Japan are.
In Japan today, declines in general price levels and changes in relative prices reflecting productivity are occurring at the same time, complicating the debate about prices. It is probably better to view the fall in prices in recent years as a reflection of a fall in the prices of "services" (more precisely, non-tradable goods) that had previously been protected by regulation, rather than as reflecting a further fall in the prices of "goods" (more precisely, tradable goods), against the background of globalization.
Certainly it is fair to expect that structural adjustment will have the merit of raising productivity in the economy as a whole, mainly through improved productivity in the services sector. In Japan, the cost of living is expensive due to relatively high service prices and distribution costs while industrial products that are exposed to world competition are inexpensive. Should it be the case that the adjustment process of the price level through revisions of high domestic prices and a narrowing of the price gap between Japan and abroad does not progress much further, some parts of the manufacturing process will have to be moved abroad. I believe that the "globalization of prices" eventually enhances economic efficiency. Also, for Japan's economy to recover, foreign direct investment in Japan will have to increase, expanding employment opportunities. As long as Japan keeps its reputation for having the world's highest prices, however, foreign direct investment in Japan is unlikely to increase. On the other hand, however, in the short-term this adjustment process also produces deflationary effects, and therefore needs careful monitoring.
In principle, if the yen depreciates during the adjustment process, deflationary pressure would be eased. I believe that as long as a depreciation of the yen is one of the natural consequences of the progress of structural adjustment, we should accept this. On the other hand, I oppose the proposal that the Bank should buy foreign currency bonds and attempt to devalue the yen. I believe that in view of current contractionary trend in global trade, a deliberate devaluation of the yen by the Bank could be viewed by nearby countries in an unfavorable light, since it may have a negative impact on their current accounts and thereby economic growth.
Today I have offered you some commentary on the thinking behind the Bank's conduct of monetary policy, especially focusing on discussions of inflation targeting. I do not deny the benefit of inflation targeting. The Bank has great respect for the current debate on inflation targeting as a means of increasing the central bank's sense of responsibility and its transparency, and we will continue to study the issue in its many aspects. Moreover, as I have already discussed, even after exhausting orthodox policy measures, the current framework for monetary policy has some important elements in common with inflation targeting. The Bank has taken advantage of the merits of inflation targeting, and made as clear as possible our firm determination not to tolerate deflation. We have declared our intention to continue the framework of the current monetary easing policy until such time as the rate of increase in the CPI stabilizes at zero or higher.
At the same time, we wonder about the negative aspects of adopting inflation targeting at the present time. As we have discussed here today, we see a variety of potential problems that require our careful attention. At the risk of repetition, allow me to say that, given the current financial and economic conditions, it is extremely difficult to see how we can hope to stop the trend of falling prices using monetary policy alone, while simultaneously maintaining public faith in Japan's banknotes.
Early in my talk, I touched on the subject of payments and settlements. It is no exaggeration to say that one of the unique tasks for all central banks, not just the Bank, is to ensure that people are able to use money with confidence. To achieve this, it is necessary that prices be stable. Through the financial system, money spreads to all corners of the Japanese economy, so the financial system itself must also be kept stable. To meet these conditions, it is important always to take a long-term view, and ask how any policy instrument ties in with the sound development of the national economy. Central banks are given policy autonomy so that they can always take that long-term view. In addition, it is for this reason that the Japanese people have the strong expectation that the Bank will always act in the best interests of the national economy. As a member of the Bank's Policy Board, I feel a great responsibility, and will do everything I can to deserve that trust.
Thank you for your kind attention.