April 19, 2006
Bank of Japan

Contents

1. Introduction
2. I. Termination of the Quantitative Easing Policy
   1. A. A New Framework for the Conduct of Monetary Policy
   2. B. Background to the Change in Policy
   3. C. Assessment of the Quantitative Easing Policy
3. II. Current Situation and Outlook for Japan's Economy
   1. A. Steady Recovery of the Economy
   2. B. Outlook for Japan's Economy and Related Risk Factors
   3. C. Start of a Moderate Upturn in Prices
4. III. Conduct of Monetary Policy
   1. A. "Price Stability" and the Introduction of a New Framework for the Conduct of Monetary Policy
   2. B. Future Conduct of Monetary Policy and Points of Consideration
5. Conclusion

Introduction

The Bank of Japan decided at the Monetary Policy Meeting held on March 9, 2006, to terminate the quantitative easing policy that had been in force for the past five years. In other words, the Bank decided to change the operating target of money market operations from the outstanding balance of current accounts at the Bank, i.e., "quantity," to the "uncollateralized overnight call rate." Today, I will first briefly explain the outline of the new policy framework and then proceed to discuss the current situation and the outlook for Japan's economy and the future conduct of monetary policy, also giving my personal view as a member of the Policy Board.

I. Termination of the Quantitative Easing Policy

A. A New Framework for the Conduct of Monetary Policy

The Bank decided at the Monetary Policy Meeting on March 9 to terminate the quantitative easing policy that had been in force for the past five years and adopt a "zero interest rate policy." The Bank also introduced a new framework for the conduct of monetary policy whereby it ensures monetary policy transparency by announcing a specific level of inflation rate that its Policy Board members currently understand as "constituting price stability from a medium- to long-term perspective," and in the light of which it will examine economic activity and price developments.

First, I would like to talk about the termination of the quantitative easing policy. From March 2001, the operating target of money market operations was the outstanding balance of current accounts held by private financial institutions at the Bank. The target has now been changed to the uncollateralized overnight call rate, which will be guided to stay at effectively zero percent. Under the quantitative easing policy, the Bank supplied funds to the money market through purchases and sales of bills and Japanese government securities, targeting an outstanding balance of current accounts at the Bank of around 30 to 35 trillion yen. In accordance with the change in policy, the outstanding balance of current accounts will be reduced over the following few months to a level basically in line with the amount legally required of deposit-taking financial institutions under the reserve requirement system.

Since a sudden reduction in the Bank's ample supply of funds aiming at immediately reducing the huge outstanding balance of current accounts may lead to confusion in financial market transactions, the reduction of funds will proceed gradually over a period of a few months, taking full account of market conditions, and during this period, the Bank will conduct money market operations so that the uncollateralized overnight call rate remains at effectively zero percent. Throughout the process of reducing the outstanding balance of current accounts, the amount of funds financial institutions will have in their current accounts will exceed the amount necessary as required reserves, and as a result, short-term interest rates, in addition to the overnight call rate, will likely remain close to zero percent. Furthermore, the Bank has decided to continue for the time being its outright purchases of Japanese government bonds which currently amount to 1.2 trillion yen per month. Also, current conditions governing the complementary lending facility, which is a tool supporting funds management of financial institutions in any emergency, were not changed at the meeting.

B. Background to the Change in Policy

The Bank adopted the quantitative easing policy in March 2001. At the time, Japan's economy, already in recession, was facing the risk of falling into serious deflation, coupled with mounting concerns about financial system stability triggered by the nonperforming-loan (NPL) problem. The policy was adopted to prevent further economic deterioration, stop a continued fall in prices, and improve the fundamentals of the economy to return to a sustainable growth path. It was a totally unprecedented emergency prescription to stave off a deflationary spiral. The Bank, while providing ample funds to the money market, made a clear commitment to continue the quantitative easing policy until the year-on-year rate of change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) registered zero percent or higher on a sustainable basis. The commitment was a device to strengthen the effect of monetary easing by inducing expectations of the zero interest rate environment under the quantitative easing policy continuing until the rate of change in the CPI reached zero percent or above.

Taking a look at the present situation, the economy is on a steady recovery trend, assisted by a favorable increase in both domestic and external demand. As for the outlook, although several risks and uncertainties persist, it is likely that the recovery will stay on course with the economy advancing at a slightly faster pace than the potential growth rate. The output gap continues to narrow, though gradually, and the year-on-year rate of change in the CPI has turned positive. Compared with the two previous recovery phases of the 1990s, the present recovery has a number of distinguishing features. First, the soundness of firms' financial conditions has improved markedly. Second, many corporate managers are maintaining a cautious view concerning future economic conditions although the economy continues to be on a sustainable recovery path. Third, the financial system has regained its stability and is functioning almost smoothly since banks have overcome the NPL problem. Fourth, the long-standing growth of the global economy continues, particularly in the United States and China. And fifth, progress is being made toward medium- to long-term structural reform of Japan's economy. In other words, it can be said that many signs are appearing which suggest that the mechanism of the sustained economy will be firmly established. It is in view of these developments that the Bank decided that the timing was ripe to terminate the unprecedented quantitative easing policy.

C. Assessment of the Quantitative Easing Policy

Let us now consider how effective the quantitative easing policy has been. Various views have been expressed on its effects from both theoretical and practical standpoints. Personally, I am of the view that the quantitative easing policy was a more effective policy than merely a "zero interest rate policy" and deserves credit accordingly. The supply of abundant funds, or the "impact of quantity," has helped restore the proper functioning of financial intermediaries by preventing the spread of uncertainty about financial system stability. It also contributed to the resolution of the corporate balance-sheet problem, which involved burdens of excess in debt, employment, and production capacity -- the "three excesses" -- through the maintenance of an extremely accommodative financial environment. Furthermore, the effect of the Bank's commitment regarding the duration of the policy, the so-called "duration effect," i.e., to continue the quantitative easing policy until the year-on-year rate of change in the CPI registered zero percent or higher on a sustainable basis, generated a sense of security that ample funds provision and low interest rates would continue into the future. This sense of security, by dispelling deflation expectations not just among market participants but also among firms and households, has been instrumental in underpinning economic activity and preventing further deepening of deflation.

The "portfolio rebalancing effect" until now never quite clear, is at last firmly in evidence. This term signifies the effect on the ability of economic entities, such as banks, firms, and individuals, to direct their funds toward higher-risk assets as a result of the ample funds provision by the Bank. This is apparent in the gradual expansion of bank lending and also in the ongoing review and enhancement of firms' business portfolios with the dissolution of the "three excesses."

II. Current Situation and Outlook for Japan's Economy

A. Steady Recovery of the Economy

I have so far summed up the background to the decision at the previous Monetary Policy Meeting to end the quantitative easing policy and shift to a policy framework targeting the uncollateralized overnight call rate. Now, I would like to discuss in some detail the current situation in Japan's economy and the outlook for the near future.

To begin with, I would like to underline the Bank's view expressed in the March 2006 issue of the Monthly Report of Recent Economic and Financial Developments that "the economy continues to recover steadily" against the background of moderate increases in both domestic and external demand. The economy is growing at a somewhat faster pace than that suggested in the standard scenario in the Bank's Outlook for Economic Activity and Prices (Outlook Report)¹ released in October 2005.

Figures released on March 13 for real GDP growth for the October-December quarter of 2005 (compared with the previous quarter) put growth in excess of 5 percent on an annualized basis even after slight downward revision. Various economic indicators for this year point to continued overall improvement in the real economy, even though production and inventory adjustments are being made in some sectors of materials-related industries such as steel and petrochemical products. Production and exports, after a period of slowdown during the summer of 2005, have started to increase, and business fixed investment is also expanding steadily thanks to buoyant corporate profits and ample cash flow. With regard to households, private consumption is likely to stay steady against the background of the improvement in the employment and income situation. Furthermore, the economic recovery, which had previously been driven by manufacturers and large firms, is gradually spreading to nonmanufacturers and small firms, and also from metropolitan areas to regional areas. Given these developments, the sustainability of the economic expansion is looking increasingly secure.

1. 1The Bank releases forecasts for economic activity and prices semiannually, in April and October, in the Outlook Report, following deliberations at the Monetary Policy Meetings. In the October 2005 Outlook Report, forecasts of the majority of Policy Board members for real GDP growth in fiscal 2005 ranged from 2.2 to 2.5 percent, with the median at 2.2 percent. The forecasts for the year-on-year rate of change in the CPI ranged from 0.0 to 0.1 percent, with the median at 0.1 percent. For fiscal 2006, forecasts for real GDP growth ranged from 1.6 to 2.2 percent, with the median at 1.8 percent. Those for the rate of change in the CPI ranged from 0.4 to 0.6 percent, with the median at 0.5 percent. The upcoming April Outlook Report will include forecasts for fiscal 2006 and 2007.

B. Outlook for Japan's Economy and Related Risk Factors

As I have described, the economy has been on a steady recovery trend. However, there are still a number of risks and uncertainties attending the economic outlook over the course of fiscal 2006 and 2007. Let me briefly elaborate on these.

First, uncertainty about the outlook for overseas economies seems to be increasing recently, particularly for the U.S. and Chinese economies. Although the mainstream view is that the U.S. economy will continue to enjoy stable growth at a pace around its potential, I am concerned that it might experience a slight slowdown from the second half of 2006 through 2007 due mainly to the following risk factors: the slowdown in housing investment dampening increases in private consumption; rises in wage costs and energy prices exerting downward pressure on growth in corporate profits; and possible intensification of concern about inflation necessitating further raising of the policy interest rate. As for the Chinese economy, despite its recent steady expansion, there is still a risk that current growth may not prove sustainable since, as was discussed at the recent session of the National People's Congress, rapid growth has generated distortions in the social structure which have yet to be resolved. In addition, concerns remain about geopolitical risks, particularly the situation in the Middle East, and avian flu as potential risk factors. At any rate, it is certain that developments in external demand remain an important factor in projecting the outlook for Japan's economy, and therefore careful attention should be paid to the risk of a slowdown in overseas economies.

The second risk factor pertains to developments in crude oil prices. At first, there was concern that the surge in crude oil prices would have a major impact on the global economy, but its effect has so far been minimal. Nevertheless, crude oil prices are likely to remain high for the time being given that the current surge in crude oil prices derives from structural factors, which take time to solve, and that geopolitical risks, particularly the Middle East situation, have been intensifying. Therefore, attention should be paid to the risk of the rise in crude oil prices combining with rises in the prices of other natural resources to affect corporate profits as well as other areas of the real economy.

The third risk factor is developments in profits at Japanese firms. So far, based on the projection of a major securities company, the total net profit of listed companies will continue to post a large increase in fiscal 2006, as in fiscal 2005. Recent indications of firms, however, suggest that they are likely to face a number of increases in costs. In particular, with both the break-even point for firms and the share of labor in income distribution in Japan seeming to have stopped falling, there is slightly stronger upward pressure on labor costs stemming from further rises in base pay and labor shortages, as well as a persistent risk that prices of crude oil and other natural resources might rise again. Considering that the strength in corporate profits has been one of the driving forces of the ongoing economic expansion, the sustainability of the economy could be seriously affected if profits deteriorate because firms facing global competition are unable to pass through increases in costs to sales prices of final goods.

The fourth risk factor is developments in household spending. Recently, household spending has been steady on the whole as the employment and income situation is showing improvement reflecting the long-lasting economic recovery and the retirement of the babyboomers, particularly from 2007. However, there are some signs giving cause for concern, including sluggishness in automobile sales in Japan, which is lingering somewhat longer than expected, and a slight slowdown in buoyant housing sales. Looking ahead through fiscal 2007, the effects of an increase in the household burden due to rises in taxes and pension premiums also warrant attention. Furthermore, strength in stock prices since 2005 seems to have been supporting the recent steady developments in consumption in terms of households' confidence and real purchasing power. Thus, attention should be paid to the risk of a reversal in high Japanese stock prices, currently slightly overvalued compared with U.S. and European stock prices, negatively affecting private consumption.

The fifth risk factor is developments in capital and foreign exchange markets. The stock market seems to have been gradually losing momentum in response to a lull in foreign investors' purchases of Japanese stocks since the beginning of 2006. The effects of future stock market developments on corporate and household sentiments should be monitored carefully. As for the foreign exchange market, there is no doubt that a significant depreciation of the yen in terms of the real effective exchange rate has been contributing to the steady economic recovery by driving up corporate profits. Recently, however, the movement of the yen against the U.S. dollar has lacked clear direction so that future foreign exchange developments require attention, especially since the fundamental imbalances in the United States have yet to be solved.

Lastly, there has been growing concern over inflation at many central banks, not only in the United States and Europe, but also in emerging economies, with the result that most of these banks have begun to change their monetary policy stance from easing to tightening one after another. Abundance of liquidity has continued to flood global markets due to reflationary policies that have long been in place, but recently these central banks are starting to absorb these funds. There is thus a risk that, by impacting on global financial markets, such policy changes could significantly influence real economies.

Although I have spelled out several risk factors, I should note that, at this juncture, I do not consider the possibility of these factors materializing to be especially high. Nevertheless, given that, as structural and fiscal reforms progress further, the strains on monetary policy will inevitably increase, the risk of a deceleration in the ongoing economic expansion should be borne in mind. The Bank should therefore conduct monetary policy from a risk management perspective, i.e., monetary policy should be implemented preemptively, by identifying the direction of potential risks and reducing their impact as much as possible. In this regard, the Bank will need to continue to monitor various risks such as those I have mentioned.

C. Start of a Moderate Upturn in Prices

Now let me move on to price developments. With the output gap continuing to improve, the domestic corporate goods price index has been on a steady uptrend, led by increases in the prices of raw and intermediate materials reflecting the rises in crude oil and materials prices. The year-on-year rate of change in final goods prices, which had been negative, has turned positive since fall 2005. As for the corporate service price index, the year-on-year rate of decline seems finally to have come to a halt. Meanwhile, the year-on-year rate of change in the CPI, slightly positive since the beginning of fall 2005, posted a somewhat larger increase in January 2006. This development is mainly attributable to the rise in prices of petroleum products and the diminishing effects of the decline in rice prices and the reduction in electricity and telephone charges. However, even excluding the effects of such factors, the rate of change in consumer prices has turned slightly positive, so that it is increasingly likely that this positive trend will become established.

There are several factors behind this uptrend in prices. Reflecting the steady recovery trend of the economy, the output gap continues to improve moderately, and the pace of decline in unit labor costs (labor costs per unit of output), which had been placing downward pressure on prices, has been slowing as wages have gradually started to increase.

Even though price developments are likely to trend upward in the future, I believe there are still various sources of uncertainty which make the outlook for prices less optimistic. Considering that the potential growth rate of the economy may be increasing as a result of already implemented expansions in business fixed investment, it seems that the pace at which the output gap is narrowing remains moderate and there still persist global supply-side pressures, especially for final goods. Meanwhile, the pricing power of firms, the suppliers of goods and services, remains relatively weak. Taking these factors into consideration, it is difficult to say that any fundamental changes have occurred in the current price situation, in which economic expansion is unlikely to exert upward pressure on prices. Although the year-on-year rate of change in consumer prices has turned positive, the rate of increase in the few months up to and including December 2005 was only marginally positive. I therefore wonder whether, with only the January figures for 2006, the Bank should have taken a little more time to conduct its analysis before concluding that the positive trend in the year-on-year rate of change in the CPI will be firmly established. Various factors should be taken into consideration in projecting the outlook for prices: the recent increase in consumer prices has been due to the rise in petroleum product prices and other special factors; in fiscal 2006, medical costs, electricity and telephone charges are likely to dampen prices, and the revision of the base year for the CPI is expected to exert downward pressure on a year-on-year basis. Such factors could cause the rate of change in the CPI to turn negative again, and therefore due attention needs to be paid to this risk.

III. Conduct of Monetary Policy

A. "Price Stability" and the Introduction of a New Framework for the Conduct of Monetary Policy

Let me touch on the new framework for the conduct of monetary policy, another key element of the change in the Bank's monetary policy. The Bank decided to introduce the new framework to coincide with the crucial shift of the operating target of money market operations from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call rate, thereby further enhancing the transparency of its policy conduct, with the aim of increasing the predictability of the policy and in turn stabilizing market expectations.

In the new framework, the Bank reviewed its basic thinking on "price stability" and announced that, when expressed in terms of the year-on-year rate of change in the CPI,² the Policy Board members' understanding of what constitutes "medium- to long-term price stability" lay in an approximate range between zero and 2 percent, and that most members' median figures fell on both sides of 1 percent. In the light of this thinking on price stability, the Bank will examine Japan's economic activity and prices from the following two perspectives in deciding how to conduct monetary policy. The first is to examine, as regards economic activity and prices one to two years in the future, whether the outlook deemed most likely by the Bank follows a path of sustainable growth under price stability. The second is to examine, in the longer term, the various risks that are most relevant in conducting monetary policy aimed at realizing sustainable growth under price stability. Based on deliberations from these two perspectives, the Bank will outline its current view on monetary policy and disclose it periodically in the Outlook Report.

The Bank conducts monetary policy based on the principle stipulated in the Bank of Japan Law: "contributing to the sound development of the national economy" "through the pursuit of price stability." The Bank defines price stability as "a state where various economic agents including households and firms may make decisions regarding such economic activities as consumption and investments without being concerned about the fluctuations in the general price level." This thinking on price stability is also shared by the U.S. Federal Reserve as well as many other central banks. Price stability is a prerequisite for realizing sustainable growth of the economy and preventing distortion in the allocation of resources and in the economic structure. Moreover, in the Bank's conduct of monetary policy to achieve price stability, it should be noted that the effects of monetary policy take time to work through the real economy and that there is a risk that fluctuations in business conditions may actually be amplified if attempts are made to absorb every short-term change in prices with corresponding policy measures. Thus, the Bank should conduct monetary policy aiming to achieve price stability over the medium to long term.

Since assuming office as a member of the Policy Board, I have insisted that the Bank should clarify what it considers a "desirable rate of inflation" in achieving its policy goal of price stability. This is because I believe that indicating a desirable rate of inflation in terms of a numerical figure not only contributes to increasing the transparency of monetary policy, but also, after the termination of the quantitative easing policy, acts as a policy anchor producing a type of "duration effect" (i.e., an effect broadly equivalent to a commitment by the Bank regarding policy duration). Taking into account the measurement bias of the CPI and the "safety margin" that acts as a buffer against the economy falling into deflation again, I consider the desirable rate of inflation to be around 1 to 2 percent expressed in terms of the year-on-year rate of change in the CPI. The Bank's quantification of price stability referred to earlier is merely a range of numerical figures of each Policy Board members' understanding of what constitutes price stability, and thus its role as a policy anchor is expected to be limited. However, this decision by the Bank to define its understanding of price stability numerically, and in particular to indicate the median figure of most Policy Board members' understanding, should be regarded as significant progress from the viewpoint of enhancing monetary policy transparency.

1. 2The Bank as well as other central banks monitor and analyze various price indexes in conducting monetary policy. The CPI is widely used in explaining monetary policy since it covers goods and services consumed by households and so the public at large is accustomed to it; and also in view of its timely availability and the fact that preliminary figures for the CPI are subject to the least revision (see "Kin'yu Seisaku no Setsumei ni Tsukawareteiru Bukka Shisu [Price Indexes Used in Explaining Monetary Policy]," available only in Japanese, Bank of Japan Review, 2006-J-2, February 2006). The CPI referred to in the new framework is the headline CPI, and not the core CPI that excludes fresh food. Over the medium to long term, the difference between the headline CPI and the core CPI becomes negligible since fluctuations in fresh food prices are temporary.

B. Future Conduct of Monetary Policy and Points of Consideration

As I mentioned earlier, the Bank will gradually reduce the outstanding balance of current accounts at the Bank over a period of a few months, taking full account of financial market conditions. Specifically, the Bank will reduce the outstanding balance to a level in line with required reserves³ at a measured pace, while at the same time maintaining the overnight call rate at effectively zero percent so that other short-term interest rates will also remain at extremely low levels.

The Bank's conduct of monetary policy after the outstanding balance has been reduced to the level of required reserves will in principle be based on developments in economic activity and prices and in financial markets at the time. If I were to make a projection today, I would say that if it is judged that inflationary pressures remain subdued while the output gap narrows moderately and the economy follows a sustainable growth path, then the accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time. This implies that the Bank's conduct of monetary policy will be "behind the curve." In other words, the Bank will respond with a slight lag to developments in the real economy and financial markets in conducting monetary policy. Some outside the Bank argue that, if interest rates are kept extremely low while the rate of change in the CPI is rising, the result may be real interest rates remaining negative and triggering an asset price bubble. I will not go into detail, but I consider that there is very little risk of an asset price bubble materializing across the board, from stock and real estate markets to golf course memberships and valuable works of art. Since the economy currently faces various challenges, including administrative reform, fiscal reform, deregulation, the strengthening of international competitiveness, an aging population with a declining birthrate, and a decreasing labor force, I believe we need to pay attention to the structural problems that continue to dampen sustainable economic growth. Some say that it is inappropriate to implement monetary policy measures aimed at stabilizing cyclical economic fluctuations to solve structural policy issues in the medium to long term, but I think it necessary for the current economy to maintain a relatively accommodative financial environment for as long as possible, at least while the risk of resource allocation becoming distorted or of economic inefficiency emerging remains muted.

Recently, market attention is more drawn to the estimation of the level of the neutral interest rate as well as the likely pace of policy rate rises by the Bank. It should be noted that the concept of a neutral interest rate differs considerably according to various factors such as its definition, the assumptions set at the time of its estimation, the economic model by which the natural interest rate is calculated, the methods employed to calculate the output gap and the potential growth rate, and the level of the expected inflation rate. The issue of the neutral interest rate should be discussed in the light of the process of resolving the medium-term problems facing the economy, and the Bank will need to study it further and share a common understanding of the concept as well as the general level of the neutral interest rate with market participants. However, I believe that the conditions are not yet ripe to discuss the specific level of the neutral interest rate nor the interest rate path for achieving that level.

The points I have mentioned above have been explained in detail in "Change in the Guideline for Money Market Operations," which was released in line with the termination of the quantitative easing policy. Market developments since then, however, seem to indicate that market participants' uncertainty about the Bank's conduct of monetary policy and the interest rate path after the outstanding balance of current accounts is reduced to the level of required reserves has not been fully dispelled. In the current unstable situation where a major change in monetary policy has been made, it is important to achieve smooth communication with the markets in a careful and market-friendly way, with a view to increasing the transparency and predictability of monetary policy and in turn stabilizing market expectations. Stable market expectations are not achieved via oral interventions by the Bank aimed at manipulating expectations. Instead, it is necessary for the Bank to make efforts to share a common understanding with market participants regarding current and future developments in financial markets and economic activity, policy issues related to the economic structure, and hence the future path of monetary policy.

It was a great pity that, in the run-up to the termination of the quantitative easing policy, there was so much market speculation with regard to the timing. Distracting comments from outside the Bank may negatively affect Policy Board members' discussions on monetary policy, as well as misleading market expectations or distorting proper price formation in financial markets, and the result of this may be, once again, to adversely affect the Bank's policy decision-making. The Bank should pay due consideration to such a vicious cycle and the resulting potential of reputational risk impairing the credibility of its monetary policy, and at the same time it should make efforts to promote wider understanding of this point outside the Bank.

1. 3Required reserves consist of reserves that deposit-taking financial institutions are legally required to hold in their current accounts at the Bank, and funds in the current account of Japan Post held at the Bank as required based on the contract between the Bank and Japan Post. Currently, the total of required reserves is about 6 trillion yen.

Conclusion

The recovery trend of the economy has become clearer, and it is becoming increasingly sustainable. However, there are still various challenges confronting the economy, including the issue of huge fiscal deficits under an aging population with a declining birthrate, the issue of the maintenance of firms' international competitiveness in facing globalization, and the issue of a growing disparity between conditions at large and small firms as well as between metropolitan and regional areas. On many occasions, I have pointed out that incisive initiatives taken in the private sector are the driving force in resolving these issues, and I believe that firms' potential strength has recently increased enough to address them both appropriately and flexibly.

We should not forget the importance of the "human factor" in enabling us to achieve steady economic growth while dealing with these issues. I took the opportunity afforded by my current visit to remind myself of the wealth of gifted individuals associated with Toyama Prefecture. For example, among the twelve Japanese Nobel Prize winners, I am aware that both Messrs. Susumu Tonegawa and Koichi Tanaka have close ties to the area. Surely there can be no clearer evidence of the merits of your local characteristics of diligence, consistency, and abundant enthusiasm for education.