Announcements

Home > Announcements > Speeches and Statements > Speeches 2007 > Excerpts from a Speech Given by Miyako Suda, Member of the Policy Board, at a Meeting with Business Leaders in Mie on September 27, 2007 (The Current Situation and the Outlook for Japan's Economy and the Conduct of Monetary Policy)

The Current Situation and the Outlook for Japan's Economy and the Conduct of Monetary Policy

Excerpts from a Speech Given by Miyako Suda, Member of the Policy Board, at a Meeting with Business Leaders in Mie on September 27, 2007

December 5, 2007
Bank of Japan

Contents

Click on ko0712b.pdf (102KB) to download figures.

I. Developments in Japan's Economy

A. The Standard Scenario for Japan's Economy

Japan's economy has remained on a moderate but sustained path of expansion since early 2002. This trend is generally in line with the projection of economic activity and prices presented in the Bank of Japan's Outlook for Economic Activity and Prices (Outlook Report) released in April.1 Exports are continuing to grow steadily supported by strong demand from Europe and Asia, and domestic private demand is firm, driven by the strength of the corporate sector. The U.S. subprime mortgage problem has caused large fluctuations in financial markets since the summer, but Japan's economy has so far been largely unaffected.

Looking at recent economic developments in more detail, real exports have been on an upward trend reflecting the expansion in overseas economies. A breakdown by destination shows that exports to the United States have weakened slightly due to an economic slowdown, exports to Europe continue to grow steadily, and those to East Asia also continue to rise, although with some fluctuations. In addition, exports to other regions, such as the Middle East, have risen sharply. In sum, the weakness in exports to the United States has been offset by those to other economies, and real exports as a whole have remained on an upward trend.

As for the outlook, exports are expected to continue rising. In the United States, mortgage lenders are tightening subprime loan qualification standards while the ongoing reassessment of risks seems to be starting to spread to some areas of prime loans. Adjustment in the U.S. housing market is expected to be prolonged somewhat, and as a result, the recovery of the U.S. growth rate to its potential level is likely to be delayed. If the weakness in Japanese exports to the United States turns out to be limited, the increased presence of East Asia and other emerging economies in world trade will likely offset it, and the current outlook for Japan's exports will be largely unaffected.2 I will go into more detail on this later on.

Regarding domestic demand, the pace of growth in business fixed investment has slowed but the upward trend continues, supported by the high levels of corporate profits. Real business fixed investment in the GDP statistics fell by a fairly large 1.2 percent in the April-June quarter from the previous quarter, reflecting a decline in fixed investment in the Financial Statements Statistics of Corporations by Industry, Quarterly (hereafter Financial Statements Statistics), which is one of the basic statistics for the estimation of GDP. Given that other indicators of business fixed investment, such as shipments of capital goods, have continued to rise, it is very likely that the decline was due to sample factors in the Financial Statements Statistics. Leading indicators such as machinery orders and construction starts (floor area, private, nondwelling use) are showing wide fluctuations at present.3 Over time, however, business fixed investment is expected to stay on an upward trend. As for housing investment, new housing starts have declined sharply due to the revision of the Building Standard Law.4 In the long term, however, they are expected to regain firmness.5

Turning to the employment and income environment, which affects consumption, the unemployment rate declined to 3.6 percent in August, indicating a further tightening of the labor market, and the number of employees is on an upward trend. Wages per worker, however, remain sluggish as firms are determined to restrain wages.6 The sluggishness is also due to the following factors: job openings due to retirement of the baby-boomer generation are being filled with relatively low-salaried workers; the proportion of part-time workers has increased again; and salaries of local government employees have been reduced. Special payments for June and July -- a gauge of summer bonus payments -- were down by a relatively large 3.1 percent on a year-on-year basis. Several surveys on summer bonus payments of large firms, however, showed an increase from a year earlier.7 It seems that the actual decline in June-July special payments is attributable to the retirement of the baby-boomer generation and a decline in bonus payments by small firms that are not properly covered in the surveys. The results of another survey show that the profits of small firms are being squeezed because they are experiencing difficulty in passing the surge in materials prices to sales prices.8 It is very likely that this deterioration in the earnings environment has been preventing a rise in bonus payments. To sum up, although wages per worker are sluggish, overall household income is rising moderately due to the steady increase in the total number of employees. This trend is expected to continue.

Against the background of this employment and income situation, private consumption has been firm. The adverse weather in July temporarily dented the level of consumption. However, sales of electrical appliances, such as flat-panel televisions and other digital appliances, and of game consoles remain favorable, and the number of new passenger-car registrations, which had been weak, rose in August, an encouraging sign. In addition, services spending, as seen in sales in the food service industry and in outlays for travel, also remains firm. Regarding the outlook, it is necessary to take into account the possible negative effects on consumer sentiment of, for example, high gasoline prices, the fall in stock prices, and the mismanagement of pension records. However, the moderate increase in household income is likely to keep consumption firm.

The strength in internal and external demand has kept industrial production on an upward trend. In the April-June quarter, industrial production was more or less unchanged as IT-related firms adjusted inventories and car production fell due to a strong earthquake in Niigata Prefecture, which damaged a major car parts plant. Industrial production is expected to resume its rise in the figure for the July-September quarter due to a continuing increase in shipments of electronic parts and devices for digital appliances and game consoles and a recovery in shipments of those for personal computers as a result of introduction of new operating systems. Automobile production is also expected to increase in the second half of this year as carmakers put new models on the market.

Moving on to prices, against the background of continuing high levels of prices of commodities, such as crude oil and nonferrous metals, domestic corporate goods prices have continued to rise as an increasing number of firms passed on the higher materials prices to products including petroleum and coal products, chemical products, iron and steel, and construction goods. Semiconductor prices stopped falling as South Korean and Taiwanese manufacturers recorded progress in inventory adjustment. In addition, the corporate service price index, which measures the prices of services traded among firms, has recently been on an uptrend. In contrast, however, the year-on-year rate of change in the consumer price index (CPI; excluding fresh food) has been around 0 percent during the past few months. A breakdown shows that, while the prices of food services and educational services have been rising moderately, prices of consumer durables, rents, and cellular phone charges have been falling. The fact that the rise in corporate goods and service prices has not been passed on to consumer prices reflects firms trying to avoid raising sales prices by improving productivity and restraining personnel costs against the background of economic globalization and the resulting inflow of low-priced overseas products.

However, with the output gap indicating that supply and demand conditions continue to tighten, an increasing number of producers of final goods are likely to pass on the rise in materials prices to sales prices. Therefore, the year-on-year rate of change in the CPI (excluding fresh food) is likely to be on a positive trend.

  1. Semiannually in April and October, the Bank makes public its projection for economic activity and prices in the Outlook Report after discussion at the Monetary Policy Meeting. In the Outlook Report, the Bank presents the most likely projection, and as a reference releases the forecasts of Policy Board members concerning the growth rate of real GDP, the domestic corporate goods price index, and the consumer price index (CPI; excluding fresh food, on a nationwide basis). This is part of the Bank's efforts to enhance transparency in the conduct of monetary policy through communicating clearly to the public its thinking on the conduct of monetary policy and its views regarding economic activity and prices.
  2. The expression used to describe the Bank's view on overseas economies in the Monthly Report of Recent Economic and Financial Developments has been changed from "the expansion of overseas economies" for August to "the expansion of overseas economies as a whole" for September.
  3. Machinery orders (private demand, excluding orders of shipbuilding and orders from electric power companies) have fluctuated largely: they increased by 17.0 percent in July from the previous month after having declined by 2.4 percent in the April-June quarter from the previous quarter. The surge in July seems to be largely attributable to the increase in orders for cellular phones, which are not included in business fixed investment in GDP statistics, but even excluding orders for communications equipment from the telecommunications industry, which includes orders for cellular phones, machinery orders marked a double-digit increase. Construction starts (floor area, private, nondwelling use) also showed large fluctuations, declining by 43.7 percent in July from the previous month after increasing by 24.5 percent in the April-June quarter from the previous quarter. This is attributable to the rush in demand just before the revised Building Standard Law took effect and the subsequent drop in demand.
  4. According to the revised Building Standard Law -- which took effect on June 20 -- a more stringent review of applications for building permits has been introduced, and the procedure was also changed significantly. As a result, construction starts were delayed, since those related to the construction business were not fully prepared for these changes to the system.
  5. GDP statistics may fluctuate due to the effects of the revised Building Standard Law as they are expected to persist for some time until the new procedures under the revised law run smoothly.
  6. For details on the relationship between economic globalization and wages, see "Nihonkeizai no Genjo, Sakiyuki to Kin'yuseisaku (The Current Situation and Outlook for Japan's Economy and the Conduct of Monetary Policy)," a speech by Miyako Suda at a meeting with business leaders in Saga on January 25, 2007 (available only in Japanese).
  7. The results of the surveys are shown below:

    7

  8. According to the survey on the effect of the rise in crude oil and materials prices on small firms conducted in July by the Small and Medium Enterprise Agency, 90 percent of firms responded that the rise in crude oil and material prices had been exerting downward pressure on their profits, indicating their difficulty in passing on the rise to sales prices.

B. Risk Factors in the Standard Scenario

So far, I have talked about the standard scenario for economic activity and prices presented in the Outlook Report. Next, I will touch on the risk factors that might affect this scenario. Previous issues of the Bank's Outlook Report and speeches by Policy Board members show that the Bank has on various occasions pointed out three risk factors: (1) developments in overseas economies, with particular focus on the scale of adjustment in the U.S. housing market; (2) progress in IT-related inventory adjustment; and (3) possible larger swings in financial and economic activity based on optimistic assumptions regarding, for example, financial conditions.9 The current turbulence in financial markets stemming from the U.S. subprime mortgage problem has been caused by the excessive loan-to-value ratios in a low interest rate environment and the subsequent adjustment of house prices. This is an example of the materialization of a risk the Bank has pointed out for some time, that is, large swings in financial and economic activity occurring based on optimistic assumptions under accommodative financial conditions.

  1. 9For details, see the April 2007 Outlook Report and "Nihonkeizai no Genjo, Sakiyuki to Bukka no Antei (The Current Situation and Outlook for Japan's Economy and Price Stability)," a speech by Miyako Suda at a meeting with business leaders in Kobe on July 26, 2006 (available only in Japanese).

1. Risk factors in overseas economies.

I mentioned earlier that even if U.S. economic growth decelerates as a result of the subprime mortgage problem, the effect on Japanese exports will be limited. I will go into this topic in more detail. But first, I will examine the emergence of the subprime mortgage problem and measures taken by various central banks.

a. Emergence of the subprime mortgage problem and liquidity measures taken by central banks

The subprime mortgage problem, originating in the U.S. housing market, shook financial markets not only in the United States but also in Europe and Japan. In the United States and Europe, doubts loomed large over the credibility of securitized products, such as collateralized debt obligations and collateralized loan obligations, following the increase in the rate of delinquencies and foreclosures among borrowers with subprime mortgages (mortgages for individuals with poor credit histories) in the United States, a series of failures among U.S. subprime mortgage lenders, and announcements of losses incurred by investment funds with exposure to the U.S. subprime market. As a result, it became difficult to raise U.S. dollars to fund such securitized products, resulting in a surge in money market rates. Central banks around the world immediately responded by providing ample supplies of funds to the markets and took various measures to secure sufficient liquidity (Chart 1).

In the Tokyo interbank market, transactions take place daily in which yen funds are raised and converted into dollars to cover financial institutions' need for dollar funds. Therefore, if the subprime mortgage problem prompts financial institutions that require dollars to bid up the yen in the Tokyo interbank market, money market rates are bound to be affected. In view of this possibility, the Bank gathered information on the situation from other central banks and financial institutions, and fine-tuned money market operations paying due attention to liquidity risk. Generally speaking, the Japanese money market has been calm due to the low exposure of Japanese financial institutions to securitized products backed by subprime mortgage loans.

Regarding the Bank's actions, some market participants have voiced the view that its liquidity provision was insufficient compared with the Federal Reserve and the European Central Bank. The Bank, however, having experienced periods of increased concern about stability in the financial system and the quantitative easing policy, has on hand an adequate series of measures for supplying liquidity. Based on the information gathered from other central banks and financial institutions, the Bank decided that it could deal with the situation by using conventional market operations. There were factors indicating that the Bank's response was adequate: the uncollateralized overnight call rate was sharply lower than the targeted level of 0.5 percent in the last few days of the reserve maintenance period ending September 15; and it remained mostly stable excluding those days (Chart 2).

b. Is the U.S. economy on course for a soft landing?

The credit markets in the United States and Europe are still in the process of reassessing credit risk. The credit spread will not, of course, narrow to the extremely low levels of the past. However, once the repricing of securitized products backed by, for example, subprime mortgage loans, progresses, credit markets will begin to return to normal given that investors' risk appetite had been robust before the emergence of the subprime mortgage problem. Indeed, the landscape seems to be brightening with news that some mortgage lenders facing financing problems have acquired new funding and some borrowers who had been experiencing difficulty in financing leveraged buyouts have acquired funds. Also, some consider that the pace of decline in the outstanding amount of CP issuance is slowing down. However, concern remains among financial institutions that those currently experiencing increased difficulty in securitization and resale will accumulate risk assets on their balance sheets. Measures by central banks have to some extent restrained upward pressure on overnight money rates, but interest rates on term instruments remain high due to strong demand for liquidity among issuers of securitized products. So far, quarterly financial statements of U.S. financial institutions have largely been within expectations, but many results are yet to be released. Also, there is a need to watch whether asset-backed commercial paper due to mature will roll over. The markets are likely to remain generally sensitive, and continued vigilance is in order.

Even after credit markets regain stability, reassessment of credit risk will lead to generally stricter lending standards, especially for borrowers with low credit ratings. It is unlikely that borrowers with low credit ratings, who have been forced out of the markets because of the reemergence of risk premiums, will return to the housing market soon, even after a lowering of the policy interest rate by the Fed. It follows that the correction in the housing market will be prolonged further.

The Federal Open Market Committee (FOMC) decided at its meeting in September to lower its target for the federal funds rate by 50 basis points as "tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally." In fact, an increasing number of market participants have been making downward revisions to their forecasts for U.S. real GDP growth for 2008. Many of them have factored in additional rate cuts by the Fed and have forecasted that the economy will return to a rate of growth exceeding its potential growth rate during the second half of 2008. However, on the basis of the high level of housing inventories and a market forecast that the rate of delinquencies and foreclosures will be higher in 2008, I expect that the correction in the U.S. housing market will continue into the second half of 2008.10 If this happens, the growth rate in 2008 is likely to fall below the average market forecast of around 2.5 percent. It should be remembered, however, that even if the growth rate in 2008 falls to around 2.0 percent, that is still the level of the market forecast for 2007, and that the soft-landing scenario is still valid.

  1. 10While inventories of houses have remained at a high level, the Office of Federal Housing Enterprise Oversight (OFHEO) house price index is still high although the pace of increase is decelerating.
c. The effects on the standard scenario

(1) The channel of transmission to the Japanese economy

As we have seen, the Japanese economy has been relatively immune from the effects of the intensification of credit and liquidity risks that has been triggered by the U.S. subprime mortgage problem. Nevertheless, it is necessary to examine secondary effects that may be transmitted through developments in economic activity, that is, weaker exports to the United States due to deceleration of U.S. economic growth, and negative effects on firms' investment attitude and consumer sentiment from swings in stock prices and the foreign exchange market.

(2) The effects of weaker exports to the United States

Japanese exports are unlikely to be seriously affected by the deceleration in U.S. economic growth, as long as it is within the limits forecasted so far by market participants, who have factored in an economic slowdown caused by adjustment in the housing market and an ensuing soft landing. I think that the deceleration will be greater than generally expected, but not great enough to have a large impact on the global economy as a whole. According to a study by the International Monetary Fund (IMF), spillovers tend to be larger during full-blown U.S. recessions or when a slowdown is caused by factors that affect many countries at the same time, such as the bursting of the IT bubble.11 The study says that neither applies to the current slowdown driven mainly by a correction in the housing sector, which has a relatively low import content. The IMF also states in a separate report that "despite the significant ongoing correction in financial markets, global growth remains solid, though some slowdown could be expected." The Asian Development Bank also recently revised upward its 2007 and 2008 growth forecasts for developing Asia, which does not include Japan and Australia.12

Japan's trade structure has changed significantly from the days when it was said that "if the United States sneezes, Japan catches a cold." During the current economic expansion, the contribution of exports to the United States has been limited, while the contribution of exports to China, the European Union, and other regions has been large.13 Furthermore, compared to the period of the IT bubble, exported goods are more diverse and better balanced, ranging widely from cars and car parts to capital goods. Therefore, even if the U.S. growth rate falls below market expectations, the effect on Japanese exports will be limited due to the diversification in terms of destinations and types of goods.

  1. 11See "Decoupling the Train? Spillovers and Cycles in the Global Economy," World Economic Outlook: Spillovers and Cycles in the Global Economy , International Monetary Fund, April 2007, pp. 121-160.
  2. 12See "Financial Market Turbulence: Causes, Consequences, and Policies," Global Financial Stability Report, International Monetary Fund, September 2007, and Asian Development Outlook 2007 Update , Asian Development Bank, September 2007.
  3. 13See "Recent Developments of Japan's External Trade and Corporate Behavior," BOJ Reports & Research Papers , Research and Statistics Department, Bank of Japan, October 2007.

(3) The psychological effect of instability in financial asset prices

In order to gauge the extent to which fluctuations in prices of financial assets, such as stocks, may affect corporate investment attitudes and consumer confidence -- another of the channels through which the Japanese economy might be affected -- it is necessary to keep close watch on developments in economic indicators. Since the summer, stock prices have fallen and the yen has appreciated, and so it is reasonable to assume some impact. It is necessary to monitor carefully these developments, together with the continuing strength in crude oil prices, to see if they will affect the basis of the standard scenario.

2. Risk factors in the domestic economy.

a. Will the strength in the corporate sector continue?

I will next touch upon domestic risk factors. The Bank has already pointed out in the Outlook Report and on other occasions the downside risk to the economic outlook caused by inventory adjustment in IT-related goods. However, completion of inventory adjustment of electronic parts and devices is in prospect, reflecting the favorable state of global shipments of them for digital appliances and game consoles and the recovery in shipments for personal computers as a result of the introduction of new operating systems. If the favorable supply and demand conditions for IT-related goods continue through to the Christmas shopping season, the risk of a downswing from this front is likely to be significantly reduced in the second half of fiscal 2007.

Recently, however, the business conditions of small firms are the source of some concern. According to the Financial Statements Statistics for the April-June quarter, business fixed investment by firms capitalized at 1 billion yen or more rose by 2.5 percent from the same period a year earlier, maintaining an upward trend. However, business fixed investment by firms capitalized at 100 million yen to less than 1 billion yen fell by 3.7 percent year on year, while that by firms capitalized at 10 million yen to less than 100 million yen fell by 19.9 percent year on year. The contrast between large firms and small and medium-sized firms is becoming marked. The Survey on Plant and Equipment Investment by Small and Medium Enterprises in the Manufacturing Sector conducted by the Japan Finance Corporation for Small and Medium Enterprise (JASME) shows that the initial business fixed investment plans of small and medium-sized manufacturers for fiscal 2007 were 7 percent below the initial plans for the previous fiscal year. I mentioned earlier that the decline in business fixed investment as a whole in the Financial Statements Statistics may be attributable to sample factors, but that is not sufficient to explain the weakness in small firms. The business fixed investment plans of industries with a high proportion of small firms, such as food, wholesaling and retailing, and real estate, are also lower than the previous year, indicating the increasing severity of the earnings environment of small firms. A survey conducted by the Small and Medium Enterprise Agency reveals that the rise in crude oil and materials prices is squeezing profits,14 and the Quarterly Survey on Small and Medium Enterprise Trends by JASME shows that the diffusion index for business conditions has not been improving.

The pace of increase in business fixed investment has decelerated across industries, but there is no need to change the standard scenario that it will continue to increase. If, however, materials prices remain high and increases are not passed on to sales prices, the impact on business fixed investment may not be negligible. Therefore, attention should be paid to the possible deterioration in the earnings environment and business sentiment of small firms and also to the impact on wages.

  1. 14See the survey on the effect of the rise in crude oil and materials prices on small firms conducted in July by the Small and Medium Enterprise Agency.
b. Will the inflation rate remain at around 0 percent?

When considering the outlook for Japan's economy, which has continued a sustained expansion, the weight of attention tends to be drawn toward downside risks. Here, however, I will touch upon the upside risks, or to be more specific, future price developments.

Recently, increases in prices of, for example, mayonnaise, wine, instant noodles, copy paper, and taxi fares have been much in the news. I am concerned with these price increases as a housewife. The CPI classified by annual purchase frequency shows that the pace of increase is rapid for items like daily necessities that are purchased more frequently (Chart 3). This trend, however, has not yet been strong enough to push the CPI upward. It has been sort of a puzzle that, although the output gap has been indicating the tightening of supply and demand conditions for quite a while, the CPI has remained at around 0 percent. I pointed earlier to the possibility that increased awareness of corporate governance, together with globalization, has resulted in firms increasing productivity and reducing personnel costs in order to restrain sales prices. However, firms' capacity to absorb the rise in labor costs and materials prices by increasing productivity has been approaching its limit. The recent increase in news reports of price increases is evidence of this trend. Furthermore, it seems that, against a background of sustained economic expansion, consumers are gradually becoming more receptive to price increases in general, since they are facing higher prices for daily necessities and are exposed to frequent reports about price increases in the media. In various industries, there have been cases where price leaders have decided to raise prices recently. They are likely to be followed by competitors who have been waiting to take their cue from these firms in the same industry. Whatever the case, it is necessary to bear in mind the possible risk of an unexpected rise in the inflation rate in the near future if the labor market remains tight and materials prices stay high.

II. Appropriate Monetary Policy

Now I would like to share my thoughts on the conduct of monetary policy.

A. The Taylor Rule

It may be considered useful to show with a simple rule the path of optimal monetary policy for achieving the policy objectives of a central bank, as it may contribute to assessment of the actual path of the policy interest rate and to enhancement of communication about the interest rate level with the market.15 One such monetary policy rule is the Taylor rule. I will first explain the rule, as I will use it as the benchmark for assessing monetary policy in my later discussion.

Under the Taylor rule, the policy interest rate is calculated based on the equilibrium real interest rate (that is, the real interest rate that is considered theoretically as an average in the medium to long term and is determined by the potential growth rate), and using the target inflation rate, the deviation of the actual inflation rate from the target inflation rate, and the output gap. The basic equation of the Taylor rule takes the following form:

Policy interest rate = equilibrium real interest rate + target inflation rate + alpha X (actual inflation rate - target inflation rate) + beta X output gap.

Implementation of the Taylor rule to derive the desirable level of the policy interest rate requires setting the numerical value of the target inflation rate, and determining the equilibrium real interest rate and policy response parameters alpha and beta. Taylor shows that when the parameters are determined as alpha= 1.5 and beta= 0.5, the rule describes surprisingly well the Fed's policy during 1987-92.16 This is the original form of the Taylor rule. Taylor did not formulate it so as to obtain the most desirable monetary policy rule. The optimal policy rule can be defined as the rule that minimizes social welfare loss. An example of the social welfare loss function is given as follows:

Social welfare loss = (actual inflation rate - target inflation rate)2 + lambda(output gap)2.

This equation suggests that policymakers recognize deviations of inflation and output from their respective targets as losses, and the weight lambda reflects how policymakers weight the two losses relative to each other.

In fact, when obtaining the path of the policy interest rate that minimizes social welfare loss under a particular model, the Taylor rule describes the path of optimal monetary policy.17 However, the numerical value of policy response parameters alpha and beta may not necessarily match the values in the original Taylor rule, since their optimal values depend on the economic structure and the weight lambda of the social welfare loss. For example, a higher value of lambda often leads to a higher ratio beta/alpha.18 Thus, when the parameters are set to obtain the most appropriate monetary policy path, the Taylor rule has normative qualities. I have shown a simple loss function here, but welfare losses need to be minimized over time given the dynamic changes in an economy. Thus the optimal Taylor rule, that is to say, the one that minimizes welfare loss over time, is a forward-looking and preemptive monetary policy rule.

Needless to say, the structure of an economy is complex in reality, and central banks should not mechanistically apply a particular policy rule. In addition, since there are many versions of the Taylor rule, the central bank and the market may not necessarily share an identical one when they communicate with each other.19 Nevertheless, the Taylor rule is helpful, at least as one of the benchmarks for the conduct of monetary policy when we consider how a central bank should respond to various shocks, and therefore its communication with the market will improve and its accountability will be enhanced.

  1. 15For details on monetary policy rules, see Nobuyuki Oda and Takashi Nagahata, "Kin'yu Seisaku Ruru to Chuo Ginko no Seisaku Un'ei (Monetary Policy Rules and Central Banks' Conduct of Monetary Policy)," Bank of Japan Review Series , 2005-J-13, Bank of Japan, 2005 (available only in Japanese).
  2. 16The equilibrium real interest rate and the target inflation rate were both 2 percent. For details, see the following publications by John B. Taylor: Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation, W. W. Norton, New York, 1993, and "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy , 39, December, 1993, pp. 195-214.
  3. 17For details, see Lars E. O. Svensson, "Inflation Targeting as a Monetary Policy Rule," Journal of Monetary Economics, 43 (3), 1999, pp. 607-654, and Laurence Ball, "Efficient Rules for Monetary Policy," International Finance , 2 (1), 1999, pp. 63-83.
  4. 18See Alan S. Blinder, "Monetary Policy Today: Sixteen Questions and about Twelve Answers," a paper presented at the Banco de España Conference in Madrid on June 8-9, 2006. The full text is available at http://www.princeton.edu/blinder/papers/06BkSpainMP16questions.pdf.
  5. 19There are many versions of the Taylor rule, depending on the assumption of the equilibrium real interest rate and the output gap, or whether the rule incorporates trends, interest rate smoothing, or ambiguity. For recent analysis on the versions of the Taylor rule, see Adriana Z. Fernandez and Alex Nikolsko-Rzhevskyy, "Measuring the Taylor Rule's Performance," Economic Letter , 2 (6), Federal Reserve Bank of Dallas, 2007.

B. Timing of Monetary Policy Action in the Context of the Taylor Rule

Various views have been expressed regarding the Bank's conduct of monetary policy during the time when Japan's economy was experiencing a long adjustment after the bursting of the bubble. Some have argued, by applying the Taylor rule as a benchmark, that the Bank should have raised the policy interest rate much earlier in the second half of the 1980s, or that the Bank should have reduced it more rapidly and aggressively in the first half of the 1990s.20 With regard to the former argument, analytical results show that the Bank's conduct of monetary policy in the second half of the 1980s is in line with the Taylor rule and that the criticism does not apply. However, regarding the latter argument, the Fed concluded that the most serious shortcoming of Japanese monetary policy during the post-bubble period was the fact that the Bank did not reduce the policy interest rate aggressively in the first half of the 1990s. Governor Frederic Mishkin has said, "The lesson that should be drawn from Japan's experience is that the task for a central bank confronting a bubble is not to stop it but rather to respond quickly after it has burst."21

Recently, the same kind of criticism that was directed to Japan during the bubble and post-bubble period is now leveled against the United States. At the end of August 2007, the Federal Reserve Bank of Kansas City sponsored a symposium entitled "Housing, Housing Finance, and Monetary Policy," which was a topical subject and attracted a lot of interest. At the symposium, against the background of the ongoing adjustment in the housing market, criticisms were directed at the Fed that it had maintained the federal funds rate too low relative to the level that the Taylor rule indicates and also that it was slow in reducing the federal funds rate target.22 In response to these criticisms, the Fed explained that it had the tools to limit the negative effects on the economy from a house price decline and that it would respond appropriately to the decline when it emerged, based on the lessons drawn from Japan's experience. This policy stance was reflected in a paper by Governor Mishkin that suggested the Fed was ready to lower the federal funds rate more aggressively and substantially faster than with the Taylor-rule reaction function to respond to the house price decline.23

The reason the Fed waited a while to raise the federal funds rate target was that there were strong concerns about deflation at that time. Then Chairman Alan Greenspan's Congressional testimony in May 2003 indicated that, while there was considerable uncertainty about how to respond to deflationary pressures, the Fed had responded aggressively and preemptively to prevent deflation, and that further policy action might become warranted as the Fed continued its careful monitoring.24

On the other hand, according to the minutes of the meeting of the FOMC held in December 2004,25 the following views were expressed regarding the surge in the Office of Federal Housing Enterprise Oversight (OFHEO) house price index. Some participants said that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads. They also said there were anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums. Moreover, in his Congressional testimony in June 2005, then Chairman Greenspan said, "There can be little doubt that exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding and home turnover, and especially in the steep climb in home prices. Although a 'bubble' in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels." He also said, "It appears that a substantial part of the acceleration in turnover reflects the purchase of second homes" and "This suggests that speculative activity may have had a greater role in generating the recent price increases than it has customarily had in the past." However, the Fed did not pursue a more aggressive monetary policy, continuing to raise the federal funds rate target only at a measured pace by 0.25 percentage point, although it was aware that the economy was in a quasi-bubble situation.26

  1. 20For discussion on Japan's monetary policy in the 1980s, see Ben Bernanke and Mark Gertler, "Monetary Policy and Asset Price Volatility," a paper presented at the Federal Reserve Bank of Kansas City's symposium in Jackson Hole, Wyoming on August 26-28, 1999; Kunio Okina, Masaaki Shirakawa, and Shigenori Shiratsuka, "The Asset Price Bubble and Monetary Policy: Japan's Experience in the Late 1980s and the Lessons," Monetary and Economic Studies, 19 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2001; and Kunio Okina and Shigenori Shiratsuka, "Asset Price Bubbles, Price Stability, and Monetary Policy: Japan's Experience," Monetary and Economic Studies, 20 (3), Institute for Monetary and Economic Studies, Bank of Japan, 2002. For discussion on Japan's monetary policy in the 1990s, see Alan Ahearne et al ., "Preventing Deflation: Lessons from Japan's Experience in the 1990s," International Finance Discussion Papers , 729, Board of Governors of the Federal Reserve System, 2002; and Yutaka Yamaguchi, "Monetary Policy in a Changing Economic Environment," a speech given at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on August 30, 2002. The references listed in these papers are also useful.
  2. 21See Frederic S. Mishkin, "Housing and the Monetary Transmission Mechanism," Finance and Economics Discussion Series , 40, Board of Governors of the Federal Reserve System, 2007.
  3. 22For details, see John B. Taylor, "Housing and Monetary Policy," and Edward E. Leamer, "Housing and the Business Cycle," both presented at the symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on August 30-September 1, 2007. Taylor argues that, in the context of the Taylor rule, the Fed was too slow in raising the federal funds rate target and that if the Fed had raised it earlier the correction in the housing market would not have become as severe as the current situation. Leamer argues that the Fed should have raised the federal funds rate target more aggressively during 2003 through 2005, and that it has been slow in reducing the federal funds rate target to deal with the current situation. See also William Poole, "Understanding the Fed," a speech presented at the Dyer County Chamber of Commerce Annual Membership Luncheon in Dyersburg, Tennessee on August 31, 2006. Poole discusses the Fed's conduct of monetary policy based on the Taylor rule, and Figure 1 in his speech suggests that the federal funds rate at the time was low.
  4. 23For details, see Frederic S. Mishkin, "Housing and the Monetary Transmission Mechanism," Finance and Economics Discussion Series , 40, Board of Governors of the Federal Reserve System, 2007.
  5. 24Refer to his Congressional testimony on May 21, 2003, available on the Fed's web site. See also "Deflation: Making Sure 'It' Doesn't Happen Here," remarks by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C. on November 21, 2002, which suggests that there were concerns about deflation at the time.
  6. 25See the Minutes of the FOMC on December 14, 2004.
  7. 26In the same Congressional testimony made on June 9, 2005, then Chairman Greenspan expressed an optimistic view. He said, "Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages make it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections..

C. The Need for Forward-Looking Policy Actions Taken at a Gradual Pace

So should a central bank further take account of changes in asset prices such as house prices in the conduct of monetary policy? In other words, in the Taylor rule, should changes in asset prices be added to the right-hand side of the equation?27 The Fed has been experiencing difficulty in conducting monetary policy due to growing uncertainty about the outlook caused by turbulence in financial markets stemming from the U.S. subprime mortgage problem, and the fundamental cause of the uncertainty is indeed the boom and the subsequent adjustment in the U.S. housing market. However, the Fed is very critical about directly applying monetary policy to deflate an asset price bubble, mainly because of the difficulty of detecting a bubble. Although it is a view widely held at the Fed that a central bank should deal with changes in house prices according to the extent of impact these changes have on overall demand and resource utilization, it has made clear that changes in asset prices should not be incorporated in the Taylor rule. This stance is evident from the speech made by former Vice Chairman Ferguson in January 2005: "Although asset-price booms and busts are often linked to recessions, a clear-cut policy response to suspected waves of exuberance cannot be suggested."28

Reflecting on Japan's experience of the asset price bubble, I have doubts about whether the Bank could have adopted an aggressive monetary easing policy after the bursting of the bubble, although some at the Fed say it should have done so. According to one analysis, the Bank's monetary policy after the bursting of the bubble was essentially optimal under uncertainty in terms of policy effects, or to be more specific, the value of the policy multiplier. On the other hand, another analysis concludes that policymakers at the Bank should have been acutely aware of the uncertainty about inflation dynamics and that they should have implemented a more aggressive monetary easing: in other words, policymakers should have implemented monetary policy with a higher parameter alpha in the Taylor rule in mind. However, simulation results also suggest that a more accommodative monetary policy would have produced only limited effects on the inflation rate and the real GDP growth rate, and that the lack of such policy was not the only reason for the long stagnation of the Japanese economy in the 1990s.29

The lesson learned from Japan's experience is that it is difficult for an economy to achieve a soft landing by monetary policy measures alone once concerns about the possible bursting of the bubble start to strengthen.30 In addition, when economic agents' expectations about the economic outlook become excessively bullish, it is difficult to implement policy measures to deal with the situation. Therefore, it is important for a central bank to preempt the emergence of an asset price bubble. To this end, a central bank must be forward-looking in identifying various types of risks before they materialize and take swift countermeasures.

Interestingly, the Financial System Research Council stated as follows in the "Report Concerning the Revision of the Bank of Japan Law,"31 which provided the basis for formulating the Bank of Japan Law that came into effect in 1998: the main objective of the Bank's conduct of monetary policy (that is, "currency and monetary control") is to secure price stability; the conduct of monetary policy should be aimed at contributing to the sound development of the national economy through the pursuit of price stability; the pursuit of price stability, however, is not the only aim of the Bank, and it should conduct flexible and appropriate monetary policy to contribute to the sound development of the national economy while maintaining price stability; in addition, the Bank should take account of developments in asset prices, because past experience indicates that even when the general price level is stable, prices of assets including land and stocks may surge or plunge and in turn seriously affect the national economy.

How should this statement be understood? I do not interpret it as meaning that the Bank should use monetary policy to directly respond to changes in asset prices, in other words, that in terms of the Taylor rule, changes in asset prices should be added to the right-hand side of the equation. I believe the objective of the conduct of monetary policy is to secure sustainable price stability and thus maintain an environment where the public can make decisions regarding economic activities without being concerned about fluctuations in the general price level.32 In this regard, the Bank needs to conduct a forward-looking and preemptive monetary policy.

This thinking is indeed embodied in the new framework for the conduct of monetary policy introduced in March 2006. The framework sets out the "understanding of medium- to long-term price stability" (the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term) and the following two perspectives for assessing economic activity and prices. The first perspective involves assessing whether the most likely outlook for economic activity and prices is that the economy will follow a path of sustainable growth under price stability. The second perspective extends the time horizon and assesses the risks considered most relevant to the conduct of monetary policy, taking account of the cost incurred should risks materialize, even though the probability may be low. Under this framework, the Bank will need to swiftly raise the policy interest rate, even when the general price level is stable at the time, to secure sustainable price stability if it is judged that there is an increasing risk that sustainable price stability will be jeopardized. This forward-looking and preemptive conduct of monetary policy is easier said than done, but the Bank will continue to do its utmost.

  1. 27Theoretically, economic activity and prices could become more stable by reflecting asset prices in a monetary policy rule. According to one analysis, it is desirable to conduct monetary policy taking into account changes in asset prices when imperfect capital markets cause short-term distortions in resource allocation. For details of this analysis, see the following reports available only in Japanese: Ichiro Fukunaga, "Shihonshijo no Fukanzenseika no Kin'yuseisaku (Monetary Policy Conduct in Imperfect Capital Markets)," Bank of Japan Review Series, 2006-J-13, Bank of Japan, 2006; and Masashi Saito and Ichiro Fukunaga, "Shisankakaku to Kin'yuseisaku: Dogakuteki Ippankinko Moderu ni yoru Bunseki to Tenbo (Asset Prices and Monetary Policy: Analysis Based on a Dynamic General Equilibrium Model and Issues for Future Studies)," IMES Discussion Paper Series , 2007-J-21, Institute for Monetary and Economic Studies, Bank of Japan, 2007.
  2. 28For details, refer to the speech by Roger W. Ferguson, Jr., "Recessions and Recoveries Associated with Asset-Price Movements: What Do We Know?" at the Stanford Institute for Economic Policy Research on January 12, 2005. Governor Bernanke said in a speech titled "Asset-Price 'Bubbles' and Monetary Policy," made on October 15, 2002, that "as a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goals -- price stability and maximum sustainable employment -- while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability." Governor Donald Kohn said in a speech titled "Monetary Policy and Asset Prices," made on March 16, 2006, that "the extra-action proposal is by no means a bold call for central banks to prick market bubbles." The texts of these speeches are available on the Fed's web site.
  3. 29For details, see Ippei Fujiwara et al., "Japanese Monetary Policy during the Collapse of the Bubble Economy: A View of Policy-making under Uncertainty," IMES Discussion Paper Series , 2007-E-9, Institute for Monetary and Economic Studies, Bank of Japan, 2007; and Yutaka Yamaguchi, "Monetary Policy in a Changing Economic Environment," a speech given at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on August 30, 2002.
  4. 30Okina, Shirakawa, and Shiratsuka say in their 2001 paper that "The most significant lesson that central banks have learnt from the emergence of bubble economies is the importance of conducting monetary policy in such a forward-looking manner that it is possible to grasp the potential risk to the economy as early as possible." Also in a paper presented at the third Workshop on Price Stability held by the Bank in Tokyo in September 2001, Masaaki Shirakawa and Kazuo Momma said that, to prevent a bursting of a bubble, it was crucial that central banks make efforts to prevent the formation of a bubble.
  5. 31For details, refer to the "Report Concerning the Revision of the Bank of Japan Law" released by the Financial System Research Council on February 6, 1997. Prior to its release, similar contents had been presented in the report titled "Chuoginkoseido no Kaikaku -- Hirakareta Dokuritsusei wo Motomete (Reform of the Central Bank System -- In Pursuit of 'Open Independence')" formulated by the Central Bank Study Group on November 12, 1996 (available only in Japanese). This report set out the framework of the revised Bank of Japan Law, which came into effect in 1998.
  6. 32A similar idea about the objective of the conduct of monetary policy is described in Shigenori Shiratsuka, "Shisankakaku to Bukka: Baburu Seisei kara Hokai ni kakete no Keiken wo Fumaete (Asset Prices and General Prices: Experience of the Bubble Economy from Its Formation to Its Bursting)," Kin'yu Kenkyu (Monetary and Economic Studies), 20 (1), Institute for Monetary and Economic Studies, Bank of Japan, 2001 (available only in Japanese).

D. Assessment of the Pace of Interest Rate Adjustment

Lastly, I would like to comment on the current pace of adjustment of the policy interest rate. If real interest rates remain at the current level, they are likely to be extremely low relative to real GDP growth (Chart 4). If the expectation takes hold that interest rates will remain low for a long time regardless of developments in economic activity and prices, there is a medium- to long-term risk of larger swings and of inefficient allocation of resources as firms and financial institutions overextend themselves. Since upward pressure on prices has remained weak, the Bank has adjusted the policy interest rate gradually, about every six months. If this interest rate adjustment were examined in terms of the original Taylor rule, the results would probably show that its pace has been too slow. However, it should be noted that the optimal policy rule depends on how the economic structure and welfare losses are considered, as I mentioned earlier.

I have always thought that the combination of forward-looking policy and gradualism is an important element in conducting monetary policy in a highly uncertain economy.33 This is because, given that there is uncertainty about the assessment of the outlook for economic activity and prices, gradually implementing policy measures, that is, interest rate smoothing, according to the economic situation is a robust policy for stabilizing economic activity, prices, and interest rates.34 This thinking can be expressed in the context of the Taylor rule as follows: the current level of the policy interest rate is determined as a weighted average of the policy interest rate for the previous period and the rate indicated by the Taylor rule. Although the current pace of interest rate adjustment may be slower than that indicated by the original Taylor rule,35 I do not consider that it has been too slow.

As for the future conduct of monetary policy, the Bank will adjust the level of the policy interest rate in light of economic and price developments as well as the degree of uncertainty surrounding them. Since the desirable path of interest rate adjustment differs according to these factors, the pace at which the Bank should adjust the policy interest rate is uncertain. However, if the pace of adjustment were too slow, the risk of the economy overheating would rise. The Bank would need to respond aggressively if the risk of overheating increased as a result of belated adjustment in the policy interest rate, and therefore the Bank should continue to monitor this risk. To prevent so far as possible the conduct of monetary policy from being behind the curve, the Bank should take measures at a relatively early stage and gradually implement them based on the projection of the economic situation for the distant future.

Regarding the Bank's decision to maintain the level of the policy interest rate at the Monetary Policy Meeting in September, there was a view outside the Bank that the decision was not a surprise because the Fed had reduced the federal funds rate target immediately before. It hardly needs to be said that the Bank's monetary policy is not restricted by the policies of other central banks. The Bank conducts monetary policy based on its own projection of economic activity and prices, and the standard scenario is the projection that the Bank considers most likely based on its assessment of all available information. Therefore, regardless of the change in the Fed's monetary policy, how the turbulence in financial markets and the resultant downward pressure on the U.S. economy will affect the likelihood of the standard scenario materializing is the key element in the Bank's decisionmaking.

In any case, while confirming that the Japanese economy remains likely to follow a path of sustainable growth under price stability in light of the "understanding of medium- to long-term price stability" and assessing relevant risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation.

  1. 33See "Nihonkeizai no Genjo, Sakiyuki to Kozokaikaku (The Current Situation of and Outlook for Japan's Economy and Structural Reform)," a speech by Miyako Suda at a meeting with business leaders in Yamaguchi on October 6, 2006 (available only in Japanese). Blinder's 2006 paper raises five reasons for stating that the preference for gradualism is rational: option value, serially correlated shocks, Brainard conservatism, the desire to smooth (market) interest rates, and expectational effects on long-term rates.
  2. 34See Takeshi Kimura and Tomoki Tanemura, "Kin'yuseisakururu to Makurokeizai no Anteisei" (Monetary Policy Rules and the Stability of the Macroeconomy)," Kin'yu Kenkyu (Monetary and Economic Studies), 19 (2), Institute for Monetary and Economic Studies, Bank of Japan, 2000 (available only in Japanese). In this paper, they take up the forward-looking rule -- whereby the conduct of monetary policy is based on projections of the economy -- and the backward-looking rule -- whereby monetary policy is conducted based on data up to the present, and on this basis they carry out simulations to obtain the most appropriate degree of interest rate smoothing. With regard to the forward-looking rule, simulation results show that gradualism is the desirable policy conduct from the viewpoint of maintaining the stability of the economy.
  3. 35Such interest rate smoothing can be formulated by a version of the Taylor rule. It can be obtained by incorporating interest rate volatility in the loss function, based on the thinking that the stability in financial markets is desirable.