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Based on a speech given by Teizo Taya, Member of the Policy Board, at a seminar held by the Tokyo International Financial Futures Exchange in Tokyo, on April 17, 2003.
May 12, 2003
Bank of Japan
I am delighted to speak to you today on recent economic developments and monetary policy. The fact that money market rates have dropped to virtually zero, together with our commitment that the easy policy stance will be maintained until the consumer price index (CPI) registers stable year-on-year growth of zero percent or higher, has no doubt made your business difficult. I hope this situation will not last long and that proper market functions will be restored in the near future. Today, I would like to touch briefly on recent economic and financial developments and then to talk about current issues related to monetary policy.
Military action against Iraq is now virtually over. The standard scenario of a short period (4-6 weeks) of military action has been realized. However, although oil prices have come down somewhat, the other widely-anticipated consequences of this, namely higher stock prices and a strong dollar, have not generally been observed until recently. Why? Are events taking place that were not anticipated in the standard scenario? Sources of instability in the Middle East, including the break-down of public order within Iraq and uncertainties surrounding Syria, may not have been reduced as expected, and the North Korean situation has emerged as a major geopolitical risk, not to mention the outbreak of severe acute respiratory syndrome (SARS). To a certain extent, these factors would be expected to have exerted a negative impact on the market.
The market, however, appears to place more emphasis on the outlook for the economy as the military action ended. In the U.S. economy, the employment situation appears to have deteriorated, while production remains flat. Consumer confidence indexes have declined, and consumption-related indexes have been showing weakness since the beginning of the year, although there are some signs of recovery in the most recent data for March and April. Housing investment has remained firm, while some indexes suggest the possibility of future vulnerability. However, a number of temporary or special factors are likely to have exerted influence over household expenditure and employment statistics. These include the reaction to incentive sales of automobiles at the end of last year, heavy snow in February, the increase in gasoline prices, and the call-up of the army reserves. Further, household expenditure may have been subdued in the face of the imminent and then the actual beginning of military action against Iraq. The market may need a little more time to judge to what extent the military action has blurred the outlook for U.S. domestic demand, including business fixed investment. Nevertheless, it is still safe to say that the market has so far assessed the U.S. economic outlook in a negative light.
An additional concern is the outlook for the dollar. The market seems to have started to pay attention to expansion of the U.S. twin deficits, the federal budget deficit and the current account deficit. Should it be the case that the inflow of direct investment and portfolio investment in U.S. equities has peaked out, it would be more difficult for the United States to finance its current account deficit and the autonomous outflow of U.S. capital. A weakening of the dollar is a headache for many economies, particularly for the Japanese economy, which has no option but to pursue export-led recovery.
I have nothing much to give you in the way of additional information about European economies and East Asian economies. Continental European economies, in particular the German economy, have been decelerating. The outlook for them looks severe. East Asian economies have recently experienced a slow-down of the pace of expansion of exports and production, although the expansion of intra-regional trade centering on China has been robust. Having increased its autonomy, the East Asian economy as a whole is likely to remain firm as a destination for Japanese exports.
With regard to the domestic economy, no significant changes have been observed in either exports or production recently. Both have remained flat or slightly upward-trending and are likely to remain so for a while. Meanwhile, the improvement in corporate profits has been confirmed, and although its impact is not strong enough to lead to an improvement in employment and wages or an expansion in investment, this profit recovery is expected to reduce the pace of deterioration of employment and wages, and to provide the basis for a modest investment recovery. Recent Tankan results have been generally consistent with these views.
Concern centers on recent stock price developments, especially in bank stocks. Financial markets managed to make it through the fiscal year-end, due in part to the ample supply of liquidity by the Bank of Japan. Neither were there any noticeable changes observed in corporate finance. However, recent developments for banks, in particular major banks, have been reflected in their stock prices, and require special attention.
Now, I would like to turn to monetary policy issues. First, the current account balance target for money market operations was maintained at 17-22 trillion yen at the April 7-8 monetary policy meeting, but, for the purpose of securing the stability of the financial market, liquidity has been provided beyond the target range. Both an increase in precautionary liquidity demand and the inflow of excess reserves that accompanied the launch of Japan Post as a public corporation with its account now separated from that of the government have provided occasion for the application of the contingency clause of the guideline for money market operations. In due course, the target balance will be reviewed on the understanding that Japan Post's current account balance should in principle be added on top of the previous target balance in order to maintain the same degree of monetary easing as before. This may require the occasional application of the contingency clause in case of need, as indeed has been the practice since the start of current account balance targeting.
Next, I would like to briefly touch on the effects of quantitative easing. This is widely considered to have brought interest rates down further. The abundant supply of liquidity has also helped to ensure stability in the financial market, and thereby contributed to the prevention of a deflationary spiral. However, it has not been effective enough to stimulate the economy and to pull it out of deflation. In particular, the expected portfolio re-balancing effects (which describe the effect of banks responding to an increase in reserves, as opposed to a decline in interest rates, by shifting a part of their assets into riskier vehicles) appear to have been limited. In circumstances where banks are continuing to reduce loans and stock holdings, they are presumed to look for opportunities in not only government securities, but also in corporate bonds and commercial paper (CP) as well as foreign currency-denominated securities.
I think the quantitative easing has had the effect of reducing risk premiums on corporate bonds and on CP with relatively high credit ratings. However this has had little impact on the economy and prices. This is because the debt market is relatively small compared to the size of bank loans, and interest rates were already fairly low. Banks have increased their purchases of foreign currency-denominated securities, mainly US dollar bonds, but they usually hedge their currency exposure in the foreign exchange market, so that the impact, if any, of these purchases on the foreign exchange rate will have been minimal. Although some market participants relate the ratio between the monetary base in Japan and that in the United States to the yen/ dollar exchange rate, this relationship seems weak when we consider that, at least in the case of Japan, the channel of influence from the monetary base to the money supply and then from the money supply to prices is weak and uncertain.
In order for quantitative easing to be more effective, it is necessary to mitigate capital constraints on banks, thereby enabling them to respond more positively to credit demand. It is also important to develop the corporate bond and CP markets, to complement the weak banking system. This is particularly important for Japan, which has a less developed corporate debt market. As regards corporate fund raising, the outstanding amount of corporate bonds and CP was only 16 % of bank loans as of the end of last year in Japan, while in the United States the equivalent figure for corporate bonds and CP is one and a half times larger than that for bank loans.
Under the present circumstances, a simple increase in the outstanding balance of current accounts at the Bank is not likely to be able to produce the intended effect. The transmission mechanism of monetary easing has to be strengthened. An attempt to strengthen this mechanism lies behind our most recent decision to consider the purchase of asset-backed securities (ABSs) including ABCP, which facilitate securitization of loans to small and medium-sized corporations and of their accounts receivable. Against the background of a weak performance by banks of their financial intermediary function, while small and medium-sized corporations rely mainly on bank loans, it was considered necessary and relevant for the Bank to nurture the development of such an ABS market, thereby promoting smooth corporate financing. This may potentially help to free up part of bank capital. Although private debt including ABSs has been accepted as eligible collateral for money market operations and purchased under repurchase agreements by the Bank, outright purchase of private debt is an unprecedented measure for a central bank. The Bank is now in the process of seeking market participants' views to determine the specific design of the purchasing scheme. I think that nurture and expansion of the market should be regarded as important in designing a final plan.
Following the purchase of stocks held by banks, the Bank has decided to involve itself directly in the credit market. In this regard, concern has been expressed about how to maintain the financial soundness of the Bank in order to preserve its ability to pursue appropriate monetary policy in future. We are fully aware of the fact that our limited capital base will constrain our risk-taking capacity. There is also other concern based on the fact that these actions contain some fiscal policy elements. For example, private asset purchase operations by the Bank can be conceptually decomposed into the following two elements: the government sets up an institution to buy assets and issues bonds to finance the purchase, while the Bank buys a corresponding amount of government securities. The former represents fiscal policy; the latter represents monetary policy. Since money market rates, traditional tools of central bank market operations, have dropped to almost zero, many conceivable policy measures inevitably contain fiscal policy elements in the sense that has just been described. With this in mind, I think it is important to continue our communication with the government along the full range of possible channels.
Now, I would like to comment on suggestions regarding the assets that the Bank ought to buy. The first such suggestion is for further aggressive purchases of Japanese government bonds (JGBs). The Bank has increased its outright purchases of JGBs, whenever this was deemed necessary to effect a smooth increase in the outstanding balance of current accounts at the Bank, taking into consideration the likely market response anticipated from such an increase. Although it is not the primary purpose of such operations, the impact of the Bank's purchases on bond prices can hardly be denied, since these purchases represent a fairly sizable proportion of the market. At the same time, it is not at all certain that an increase in the purchase of JGBs always brings about a fall in interest rates. Advocates of aggressive purchase of JGBs emphasize the merits of yet lower interest rates. However, it is not certain that such purchase will in fact lower interest rates, since it may, for example, suggest to the market a possible relaxation of fiscal discipline and hence trigger a rise in interest rates. Conversely, it may initially lower interest rates only to bring forward the timing of a subsequent reversal. The outcome depends on the prevalent market conditions as well as the fiscal situation of the time. Besides, long-term interest rates have already come down substantially and are, as you all know well, at unprecedented levels. At the same time, private financial institutions need a certain level of interest rates in order to make profits.
Among advocates of aggressive purchases of JGBs by the Bank, some maintain that the aim of such purchases is not to lower nominal interest rates but to lower real rates. According to their view, aggressive purchase of JGBs by the Bank will likely lead to an increase in the expected rate of inflation, through speculation about possible loss of fiscal discipline, and will therefore lead also to higher interest rates. However, they maintain that interest rates are not likely to rise as much as the expected rate of inflation, with the result that real interest rates will decline, thus easing the process of balance-sheet adjustment for various economic entities and promoting economic growth. This smaller increase in nominal interest rates is based on the premise that nominal interest rates have not been able to drop as much as they should have due to the zero constraint on nominal interest rates, or alternatively on the idea that the rise in nominal rates would be limited under current deflationary conditions in which the GDP gap, the gap between potential and actual GDP, remains large. However, real long-term interest rates, calculated based on long-term government bond yields and consumer price indexes or GDP deflators, appear to retain a general tendency towards convergence across developed countries, including Japan and the United States, and they seem to have been on a declining trend since the 1980's. In other words, real interest rates in Japan are not particularly high either by international or by historical standards. A closer look at the data indicates that real interest rates in Japan were on average lower than those in the United States during the 1980's and the 1990's. It appears that this underlying relationship has been broadly maintained since then. The gap between them may have become somewhat smaller, however the difference does not seem to be significant.
I would now like to touch on a view that the Bank should buy exchange traded funds (ETFs). Most proponents of this view expect the Bank to support stock prices. While never rejecting a possible policy measure for dogmatic reasons, I should emphasize that I find myself, at present, quite at odds with this view. Once the Bank enters the market to support stock prices, it is not easy to get out. Even if stock prices rise in response to the purchase of ETFs by the Bank, it is not certain, except for a brief period, how long high prices can be maintained. Whenever stock prices decline, the Bank will be called for, thereby leading to a situation where the Bank ends up accumulating a fairly sizable amount of ETFs on its balance sheet. Moreover, the presence of a strange big player without a profit-making motive may make the relevant level of stock prices less clear; i.e. it tends to weaken the price discovery function of the market, critical to the proper functioning of a market economy.
It would be nice to have higher stock prices, but the cost of achieving it may be very high. It is sometimes argued that the purchase of ETFs does not distort the formation of stock prices. However, it may make the prices of less liquid stocks fluctuate widely, since the formation of ETFs often involves the additional purchase of such stocks from the market. In addition, excessive formation of ETFs will promote an unnecessary degree of passive fund management in the market, tending to discourage efforts to assess individual stock values and thus to cause inconsistency between stock prices and corporate earnings. On top of all these, intervention by the monetary authority will be remembered for a long period of time, damaging the reputation of the Japanese stock market.
The debate on whether to introduce inflation targeting continues. I am still against the adoption of inflation targeting. I agree that, as a policy framework, the idea of inflation targeting contains positive elements. There are reasons why some countries have adopted it. Under certain circumstances, it is considered to promote the accountability and effectiveness of monetary policy. However, it is not necessarily appropriate, in the light of current circumstances, for the Bank of Japan to adopt it now. Most countries which have recently adopted inflation targets, almost without exception, introduced them to contain inflation or to respond to currency crises. Although often cited as a reference relevant to the present situation in Japan, the situation in Sweden during the 1930s was quite different. In particular, there was considerable room left for monetary easing, especially for a reduction in interest rates.
Advocates of inflation targeting stress that price developments are a monetary phenomenon. The general price level is after all an exchange ratio between goods and services on the one hand and money on the other. If money were to be supplied constantly, the price level would eventually increase. For example, suppose the government implemented a large-scale tax reduction financed by issuing government securities that the Bank then purchased. If this process were continuously repeated for some time, the money supply would increase constantly and inflation would occur. Under the fiduciary currency system, creation of inflation is always possible. In this example, however, the Bank alone does not create inflation; it merely has a part in the creation of inflation through monetization of the fiscal deficit. The Bank can print money but does not have authority to distribute it.
A recent proposal by Prof. Stiglitz concerning the large-scale issuance of government notes can be considered a variant of the above discussion on tax reductions (or expansion of government expenditure) financed by the Bank of Japan. If government notes are converted into BOJ notes and flow into the Bank, the Bank may end up accumulating government notes equivalent to non-interest bearing consols (perpetual JGBs). There is no doubt that this would have negative implications for the financial soundness of the Bank.
Under normal circumstances, the Bank can increase the amount of the money supply by stimulating demand for money via the following process. The Bank provides liquidity in exchange for financial assets, thereby lowering interest rates and, in turn, affecting various asset prices. Economic activity is thus stimulated, and demand for money is increased. However, where there is very little room for money market rates to decline, the central bank might not be able to achieve its intended results with regard to the direction and magnitude of changes in asset prices, such as long-term interest rates, stock prices, and real estate prices, even if it were to try to influence these directly. Under such conditions, where there are very few policy options available to the central bank, it cannot commit itself to achieving a certain rate of inflation within a specified period, and even if it were to make such a commitment, the Bank's actions would not be considered credible. Promoters of inflation targeting stress the effect on expectations as a merit of adoption, but the idea has already been adopted within the Bank's existing policy, along with the commitment to which the Bank can be accountable in the current circumstances. Specifically, the Bank has made a commitment in terms of policy duration to continue its current easy stance until the consumer price index records year-on-year increases of zero percent or more on a sustainable basis. This has contributed greatly to stabilizing medium- to long-term interest rates.
However, it is possible that this commitment may be mistakenly interpreted as suggesting that the Bank is satisfied with a minimal rate of inflation above zero, such as somewhere between zero and, say, 1 percent. It may be desirable for the Bank to make clear that its commitment should be interpreted in a more flexible manner. It should also be mentioned that, since there is a considerable time lag between the taking of a monetary policy action and its effect revealed in prices, the commitment to an actual rate of change in prices implies that the easy policy stance is likely to be maintained until the rate of change in prices rise significantly above zero percent. In other words, even with the eventual policy reversal dictated by the framework of the current commitment, the actual rate of inflation that results is likely to be significantly higher than zero percent.
Is it useful to define how we think of price stability in numerical terms? It is worth examining this idea, but, at this point, it may not be useful, since the Bank would be seen as moving toward inflation targeting without improving the effectiveness of the policy measures with which to achieve its target. Such a move may also invite further pressure to achieve this numerical target within a specified period, whatever the cost and using whatever bizarre measures it might take. On the other hand, I feel it is more necessary than ever to explain why the adoption of inflation targeting would not necessarily lead to sustainable price stability and sound economic development. For example, it may be desirable to use reports such as the half-yearly "Semiannual Report on Currency and Monetary Control" to explain in plain terms not only our assessment of economic and financial conditions but also how these relate to our monetary policy choices.
In the meantime, I think the Bank should continue striving to make its easy monetary policy more effective, strengthening the transmission mechanism of monetary easing through normalization of the banking system and development of capital markets, while maintaining stability in the money market. Clearly, it is necessary either to remove or to bypass the impediments that have hitherto blocked the effective working of the extremely easy monetary policy. In particular, it is necessary to continue to examine the actions available to the Bank in the field of corporate finance. In addition, if it is deemed necessary, early injection of public money into banks to strengthen their capital base should not be ruled out.