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Miyako Suda, Member of the Policy Board, Bank of Japan
April 2, 2003
Bank of Japan
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Any textbook of macroeconomics will tell you that the starting point of the transmission mechanism of monetary policy is a change in reserves and an associated change in short-term interest rates. Reserves can only be provided by a central bank. Therefore, when a central bank increases its provision of reserves, it is certain that short-term interest rates will decline. Changes in short-term interest rates subsequently affect medium- and long-term interest rates, foreign exchange rates, and stock prices, leading to changes in the behavior of economic agents such as financial institutions, firms and households.
However, no textbook clearly explains whether an increase in reserves can still stimulate economic activity when short-term interest rates stay at close to zero percent. There is an argument that, even in such a situation money supply would "automatically" grow substantially and deflationary concern would be dispelled in the near future if the Bank of Japan (BOJ) expanded monetary base significantly.
Let me explain briefly the background to this proposal calling for increasing monetary base: the quantity theory of money. Monetary base consists of bank reserves and currency in circulation. In other words, monetary base is generally defined as the liabilities of the central bank. Money supply, which is the amount of money available in an economy, is proportional to monetary base. By dividing money supply by monetary base we get money multiplier. As textbooks of macroeconomics explain, the quantity theory of money is based on the quantity equation, which can be written as M(money supply) x V(velocity of money)=P(GDP deflator) x Y(real GDP). Although this formula is merely a definition and not a description of causality, it might be seen as an equation that determines nominal GDP, PY, by assuming that both the velocity of money and the money multiplier are constant. It also assumes that both monetary base and money supply are policy instruments. This leads to the basis of the argument that deflation is a monetary phenomenon and that the BOJ is in a position to prevent a continuous decline in prices. Based on this, some have advocated an increase in monetary base in order to expand money supply, which would increase the growth of nominal GDP.
Taking this into account, the BOJ decided to adopt a new framework of monetary easing never previously employed by any central bank. Let me focus on the quantitative aspect of the current easing. The BOJ has changed the main operating target from the overnight call rate to the outstanding balance of current accounts held by financial institutions at the BOJ, which accounted for about 20 percent of monetary base as of February 2003. In general, the BOJ can guide the overnight rate down to virtually zero percent just by providing funds that exceed required reserves, which are about 4 trillion yen now. Nonetheless, it has raised the target for the current accounts from around 5 trillion yen in March 2001 to 15-20 trillion yen by March 2003 (from April 1, 2003, considering necessary adjustment due to the establishment of the Japan Post, the BOJ conducts money market operations, aiming at the outstanding balance of current accounts held at the BOJ at around 17 to 22 trillion yen). As the average balance was 23 trillion yen in March 2003, it has risen fourfold since March 2001. As a result, the overnight rate has been pushed down to 0.001-0.002 percent. Thus the current monetary policy is often called "quantitative monetary easing."
Meanwhile, the BOJ has committed to flexibly provide liquidity irrespective of the guideline above when financial institutions' precautionary demand for liquidity increases in line with rising concern about the stability of financial markets. It is very likely that, were it not for the BOJ's flexible provision of liquidity based on this contingency clause, short-term rates would have temporarily surged, destabilizing financial markets. There are various reasons for such concern. For example, demand for liquidity increased in the immediate aftermath of September 11 in 2001. Also, a plunge in stock prices, especially in stock prices of financial institutions, might act as a trigger intensifying the risk of a financial crisis.
In addition, the BOJ established a so-called "Lombard-type" lending facility. The BOJ provides ample funds exceeding required reserves by 16 trillion yen, but some financial institutions might still be short of funds if a large proportion of the funds is held by other influential funds suppliers and this might lead to financial market instability. In order to achieve stability in financial markets and prevent large fluctuations in short-term interest rates, the BOJ introduced the Lombard-type lending facility. This facility allows financial institutions with eligible collateral to borrow funds from the BOJ at the official discount rate (Figure 1 for the outstanding balance of eligible collateral accepted by the BOJ).
Furthermore, the BOJ has increased its outright purchases of long-term government bonds when necessary to provide liquidity smoothly. The volume of outright purchases per month has been increased from 400 billion yen as of March 2001 to the current 1,200 billion yen. Long-term government bonds holdings amounted to 44 percent of the BOJ's total assets at the end of February 2003. Also, the BOJ held 12 percent of the total outstanding of long-term government securities as of January 2003.
The important point to note is that the current policy framework has another component besides ample provision of reserves. The BOJ has made a commitment to maintain the new framework for its market operations explained above until the year-on-year growth of the Consumer Price Index (excluding fresh food) becomes stable at or above zero percent. The expectation hypothesis of the term structure of interest rates tells us that long-term interest rates today will be the sum of market expectations regarding the future course of short-term interest rates and a term premium based on risk caused by uncertainty or the preference of market participants. Thus, the commitment based on the CPI can be understood as strengthening easing effects by clearly indicating the path of monetary policy in the future. If this commitment wins the market's confidence, the market participants can understand the path of monetary policy in the future and expect the overnight call rate to stay around zero percent as long as deflation continues. This will result in term rates and medium- to long-term rates stabilizing at extremely low levels. The effect of this monetary easing based on the BOJ's undertaking or commitment to the market is called the "commitment effect", or the "duration effect."