COVER STORY • 7

Central Banks Face Mounting
Challenges Including Aging,
Bubbles & Climate Change

By Sayuri Shirai

Central banks in developed economies have been struggling toachieve the around 2% inflation target for some time despite theunprecedented scale of monetary easing and diversity of tools
adopted since the global financial crisis of 2008. This is true
especially in Japan where the likelihood of achieving its 2% inflation
target remains low and weak consumption demand appears to beclosely associated with the rapid pace of aging in the population.
Since the Covid-19 pandemic, moreover, central banks in developed
economies have conducted an unprecedented scale of monetaryeasing by rapidly expanding their balance sheets to prevent theireconomies from falling sharply. However, the resultant substantial
liquidity has amplified the risk of asset bubbles. The pandemic also
provided an opportunity to the world that coping with climate change
issues is essential to maintain our living standards. Central banks in
Europe have begun to examine the implications of climate factors forthe conduct of monetary policy. This article will cover the three
topics – aging, bubbles, and climate risks – and describe associatedchallenges faced by central banks.

Japan’s Low Inflation, Aging & Effectiveness ofMonetary Easing
Since April 2013, the Bank of Japan (BOJ) has initiated bold, largescale monetary easing under Governor Haruhiko Kuroda to achieve
the 2% inflation target. The quantitative and qualitative monetaryeasing – which mainly purchases substantial long-term Japanese
government bonds (JGBs) and also purchases some risky assets
including stock exchange traded funds (ETFs) – was adopted in 2013
and was expanded further in 2014. A negative interest rate and theyield curve control were added in 2016. In the midst of the Covid-19
crisis, substantial monetary easing was added again – but this time
mainly by providing short-term liquidity provision to banks andpurchasing short-term government bonds. As a result, the BOJ’sbalance sheet swelled from around 165 trillion yen (about 32% of
nominal GDP) to around 710 trillion yen (128% of nominal GDP) by
January 2021. Currently, the BOJ holds nearly one half ofoutstanding government bonds issued. Together with the yield curve
control that attempts to stabilize the 10-year yield at around zero
percent with a negative interest rate applied to part of excess
reserves, this has provided low and stable financing conditions to
the government and the economy. The BOJ is also the only central
bank that purchases ETFs as a monetary policy tool and has become
30 Japan SPOTLIGHT • May / June 2021

Author Sayuri Shirai

the largest shareholder in the domestic stock market.
This is in contrast with some central banks in the world thatpurchase foreign stocks as a part of foreign reserve management
strategies or purchase stocks to manage their employees’ pension
funds. In July 2018, two types of flexibility were added: doubling the
10-year yield target range from ±0.1% to ±0.2% (and further to±0.25% in March 2021) and allowing the annual pace of ETF
purchases to deviate from around 6 trillion yen depending on market
conditions. The expansion of the 10-year yield target was understoodby many market participants as the BOJ’s intention to steepen theyield curve due to concerns that persistent low long-term interest
rates would have an adverse impact on returns of institutional
investors. The flexibility on ETF purchases reflected the BOJ’s
willingness to reduce ETF purchases. Nonetheless, the unstable US
financial markets since the fall of 2018 and a subsequent shift inmonetary policy by the Federal Reserve have made it difficult to raise
the 10-year yield. When stock prices plummeted in March 2020,
moreover, the BOJ decided to introduce the maximum annual pace of
ETF purchases and set it at 12 trillion yen.
Despite this unprecedented scale of monetary easing and various
innovative tools adopted, Japan’s inflation excluding the direct
impact of the consumption tax hike and volatile energy and foodprices has remained well below 1% over the past eight years.
Inflation has entered into negative territory since September 2020reflecting a drop in energy prices, temporary downward pressures(such as subsidies provided to domestic accommodation fordomestic travelers), and various base effects. Inflation is likely topick up and enter into positive territory in 2021 as energy prices stop
declining and various temporary factors fade away. Nevertheless,inflation is projected to remain well below 2% for a long time.
The persistently low inflation might be related to unfavorable
demographics. Japan has the most rapidly aging population in theworld. The population has been declining over the past years andpeople over 65 years old currently account for nearly 30% of the
population. Many Japanese worry about their post-retirement life
and try to save due to sluggish wage growth (reflecting sluggish
productivity growth), limited public pension benefits, and longevity
risks. Aging caused by an increase in longevity could be deflationary
when the growing number of pensioners would pressure thegovernment to lower inflation and maintain the real value of theirsavings and pensions through voting behavior. As people live longer
and their life planning horizon becomes longer, their savings position
https://www.jef.or.jp/journal/

is likely to change: young workers are more willing to borrow, while
the retired or those close to retirement ages tend to accumulate
more savings to maintain the same consumption pattern over alonger time horizon. In this circumstance, a change in the interest
rate may have different implications for the young and the elderly:
lower interest rates imply a reduced cost for the young who areindebted and thus stimulate residential investment and consumptionof durable goods (such as cars and furniture), while the elderly may
hardly react to lower interest rates due to reduced or limited demandfor credit. Monetary easing may be more effective in an economy
with an ample younger population, such as emerging and developing
economies, than in an economy with a growing aging population. As
Japan and Europe face aging, the feasibility of the 2% inflation target
is increasingly being questioned.

expectation that monetary easing will continue for a long time. The
US stock price hike is also attributed to excellent earnings
performance of big tech companies benefitting from new online
business demand, large-scale fiscal stimulus, and the rapid pace ofvaccination. US higher stock prices together with the BOJ’s ETF
purchases contributed to Japan’s rapid stock price hike with the
Nikkei 225 index exceeding 30,000 yen sometime in February andMarch 2021. The US has stronger economic fundamentals thanJapan and Europe. High economic growth of around 5-6% is
expected in 2021, thus enabling the economy to recover the level
just before the Covid-19 pandemic this year. Meanwhile, US stock
prices are viewed as overvalued even before the pandemic based on
the historical price-earnings ratio. A quick rebound in US stock
prices from the March 2020 sharp fall was possible with ample
liquidity provided by the Federal Reserve, leading to a further
Risk of Stock Price Bubbles, Inequality &overvaluation of stock prices. Ample liquidity has also contributed to
Corporate Restructuring
higher commodity prices, precious metals, and crypto assets bygenerating speculation.
Global stock prices collapsed and stress in financial markets
High stock prices (and real estate prices) in the US have enhanced
intensified in March 2020 due to growing concerns over thewealth effects among high income people, but has deteriorated
lockdown and resultant recession. Together with large-scale fiscal
inequality further. The labor market has not yet recovered fully. Many
support (which deteriorated the fiscal balance by more than 10% of
non-regular workers cannot get back their jobs while skilled whitenominal GDP), central banks especially in Japan, Europe, and theworkers could return to their jobs more easily than non-white
United States reacted promptly and aggressively to deteriorating
workers. The Federal Reserve stresses the need to continue
economic performance. Since the pandemic, the central banks’monetary easing due to the large number of unemployed people. Asbalance sheets expanded by over $3 trillion in the US and the euro
stock prices count on monetary easing, however, the central bank’sarea, and by about $1.2 trillion in Japan in 2020 (Chart). In response,
dilemma may be emerging. Higher economic growth and inflation
stock prices quickly rebounded and hit a record high in the US and
expectations in the US have begun to generate upward pressures onreached the highest level in Japan over the past 30 years, with thelong-term yields from late 2020, amplifying downside risks on asset
prices. Although the 10-year yields ofaround 1.5-1.7% remain well below the level
CHART
in early 2018 (around 3%), the recent rapid
Size of financial assets of major central banks
pick-up has resulted in the correction of US(US$ Trillion)
stock prices at the end of February 2021.
9
The rising yields may tighten the financial
conditions, thereby possibly making it
8inevitable for the Federal Reserve to
US
Japan
7
purchase more financial assets. This could
Euro Area
add more liquidity and stimulate more
6
speculative activities at the expense of5
deteriorating asset inequality further. Fiscal
stimulus with targeted income support is4
more effective in reducing income inequality.
3
Ironically, this effort might be somewhat
offset by rising asset inequality driven by2
massive liquidity and associated bubbles
1
and speculative activities.
The remarkable stock performance is also0
contrasted with the fragile economic
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
conditions in Japan. After two consecutive
Source: Prepared by the author based on Federal Reserve Bank of St. Louispositive growth periods since the third
Japan SPOTLIGHT • May / June 202131

quarter of 2020, the economic recovery process has stalled as aresult of the second state of emergency declaration in Tokyo andsome prefectures during January-March 2021 of the Covid-19
pandemic. Japan’s high stock prices are influenced by the BOJ’s
substantial intervention through mitigating downside risks on stock
prices at the expense of causing market distortions. In a normal
stock market, diverse investors perform transactions and discoverfair stock prices while obtaining opportunities to promote soundasset formation. A company that loses the ability to sustainably earn
profits should be delisted from the stock market while start-up
companies will emerge, grow and eventually be listed. This kind of
dynamism among firms is essential for the stock market to function
well. The corporate governance code introduced in 2015 and its
revision in 2018 aimed at reforming corporate management
practices to enhance earning capacity sustainably and raise the longterm corporate value. The 2021 revision is expected to increase thenumber of independent nonexecutive directors and encourage
management to make greater efforts to increase diversity andpromote monitoring.
Long-term institutional investors (such as pension funds andinsurance firms) and asset managers are increasingly engaging inconstructive dialogue with listed companies and exercising theirvoting rights as shareholders to transform corporate behavior andincrease long-term corporate value. Such value must be achieved ina sustainable manner from environmental, social and corporate
governance (ESG) perspectives. In particular, companies urgently
need to align their business models with the Paris Agreement oflimiting global warming to below 2 or close to 1.5 degrees Celsius,
compared to pre-industrial levels. Such ESG-oriented corporate
management will be supported further in 2022, when the Tokyo
Stock Exchange will reorganize the existing four market segments
into three and replace the first tier market with a Prime Market
comprising companies that meet the tougher criteria, including
corporate governance standards for the first time. An expansion of
ESG investment and a sustainable finance market is essential for
Japan and the world to achieve the net-zero greenhouse gas
emission target and the United Nations sustainable development
goals (SDGs).
The BOJ is likely to hold stocks for an extended period without
drastically exercising responsible ESG investment since the BOJ
does not regard itself as a responsible investor. As long as the BOJ
purchases ETFs and increases stock holdings temporarily as a part ofmonetary policy packages, this could be justified. However, thecontinuation of ETF purchases without the prospect of achieving the
2% inflation target may undermine corporate efforts and pressuresarising from ESG investment. Overvalued prices regardless of ESG
performance risk delaying corporate restructuring. As a way tomitigate this problem, the BOJ could stop purchasing ETFs whenstock prices are overvalued and intervene in the market only when
disturbances arise. In line with this view, the BOJ removed theexpression of “around 6 trillion yen” on the annual pace of ETF
32 Japan SPOTLIGHT • May / June 2021

purchases while maintaining the same upper limit in March 2021. Bysuggesting that large-scale purchases will be conducted only during
times of heightened market instability, the ETF purchases could benearly zero when the stock market is performing well. In any case,stopping ETF purchases completely and beginning to sell thoseholdings are challenging for the BOJ since they would trigger a sharp
fall in stock prices.

Growing Awareness of Climate Risks & Impact on
Monetary Policy Conduct
Many economies, including the European Union (EU), Canada,
China, Japan, and the US, have committed to achieving net-zeroemissions by 2050 (2060 in the case of China). Climate change
could have a significant impact on GDP, prices and asset prices.
Central banks may have to measure price stability by taking into
account the direct and indirect impact of climate change. A growing
number of extreme weather events is likely to make it difficult forfirms to continue activities in stressed areas. Corporate funding
costs might rise as the collateral value (such as real estate andequipment) falls in such areas. Coal-fired power plants will no longer
become profitable in the face of tighter environmental regulations
and higher carbon taxes. Therefore, firms must assess the expected
impact of climate risks on their long-term financial performance.
Through forward-looking investment and innovation, firms are able
to make their business models more sustainable and enhanceinternational competitiveness.  Firms also need to make more
research activities and invest in costly, but essential new technology
development – including renewable energy, batteries, and grids;hydrogen and ammonia fuel technology; and carbon, capture, andstorage (CCS) or carbon capture, utilization, and storage (CCUS)
technology.
The Financial Stability Board established the private sector-led
Task Force on Climate-related Financial Disclosures (TCFD) in 2015
and published recommendations on climate-related information
disclosure for companies in 2017. The TCFD recommendations are
increasingly adopted by large listed firms globally. In 2017, central
banks and financial regulators established the Central Banks andSupervisors Network for Greening Financial System (NGFS) to
explore ways to integrate climate factors into their operations.
Following the BOJ, the ECB and many other central banks, theFederal Reserve finally became a member of NGFS in December
2020. Central banks find it necessary to develop an econometricmodel that incorporates climate factors into existing statisticalmacroeconomic models that cover the transmission process ofmonetary policy. In June 2020, the NGFS published practicalguidelines for central banks and financial supervisors to quantify the
impact of climate risks on financial institutions and aim forinternational standards. The guidelines help determine the resilienceof banks’ assets and insurance companies’ liabilities up to 2050
under various climate scenarios including the scenario in line with

review, which is expected to be completed
before the middle of 2021, covers the issuesof how the ECB can respond to climate
First Phase• Promoting financial institutions to disclose climate-related information in line
change effectively. The ECB has beenwith TCFD recommendations• Implementing a climate-related stress test on financial institutions
purchasing green bonds as part of its asset
purchase programs since around 2015.
Second Phase• Integrating climate risks into central banks’ longer-term economic and inflation
forecasts
Since January 2021, furthermore, the ECB• Disclosing climate-related information about central banks’ operations in line
began to accept sustainability-linked bonds
with TCFD recommendations
as collateral and making them eligible for its• Assessing the carbon footprint of central banks’ assets
ongoing asset purchase programs. The• Adopting the environmental standards on non-monetary policy related assets
sustainability-linked bonds refer to bonds
Third Phase• Adopting the environmental standards on monetary policy related assets
whose issuing conditions (such as coupon• Accepting various climate-related financial assets as collateral• Incorporating the environmental standards to the terms and conditions of its
rates) are adjusted based on the pre-set
targeted long-term lending facilities
performance. If issuers improve• Adding the climate factor to central banks’ mandate
performance, more favorable issuing
Source: Prepared by the author
conditions (i.e. lower coupon rates) areprovided. The coupons must be linked to a
the Paris Agreement.
performance target referring to one or more of the environmental
In June 2020, the Bank of England (BoE) released its first own
objectives set out in the EU Taxonomy Regulation and/or to one orreport based on the TCFD recommendations. Furthermore, the UK
more of the SDGs relating to climate change or environmental
government has begun to require listed firms and major financial
degradation. The ECB is also purchasing more green bonds as theinstitutions to disclose information based on TCFD recommendations
German government began to issue green bonds for the first timefrom 2021 in collaboration with the BoE. The BoE already conductedsince 2020 and the EU began to issue green bonds to finance oneclimate-related stress tests on major insurance companies in 2014
third of the €750 billion NextGenerationEU recovery fund in 2021.
These central banks maintain the “market neutral” principle ofand is preparing a comprehensive stress test on banks andbuying financial assets according to the size of the market for each
insurance firms in 2021. The European Central Bank (ECB) has also
asset. The urgent need to promote green actions may eventually leadcalled on banks to account for climate risks in their businessto the abandonment of the principle, allowing more active purchases
strategies and risk management.
of bonds that finance green projects and low-emission companies.
As financial institutions are encouraged to make their business
Given that emission-intensive firms tend to be capital-intensive andmodels and portfolios greener, it is natural that such actions will bedominant issuers of corporate bonds, the market neutral principle
demanded on central banks as well by verifying their assets’ carbon
may end up favoring high emission companies over small or newly
footprint (Table). Central bank assets include foreign currency
emerging low emission companies and hamper the economy fromreserves, employees’ pension assets, as well as those purchased andachieving the net-zero emission society. Moreover, central banks
loans to financial institutions for monetary policy purposes. The BoE
may find it necessary to provide long-term liquidity to banks actively
already disclosed its first assets’ carbon footprint in the 2020 TCFD
supporting green projects and low-emission firms.
report and concluded that emissions linked to its government bonds
In the future, frequent extreme natural disasters and rising global
have decreased compared to other G7 economies, but the UK
population may complicate monetary policy as they may amplify thegovernment must make greater reduction efforts in the future. As forprice volatility and generate upward pressures on general prices
corporate bonds, the central bank admitted that many issuers arethrough higher commodity and food prices. In such a circumstance,
carbon intensive. In March 2021, the BoE became the first central
central banks in advanced economies may witness upward pressuresbank in the world that added climate factors in its monetary policy
on inflation driven by non-monetary policy factors. This may lead to
mandate in addition to the existing 2% inflation target by reflecting
a reexamination of the 2% inflation target; and central banks may
the government’s economic strategy of achieving a net-zero
begin to prioritize supporting a smooth transition to a net-zero
economy. The central bank plans to announce details in the next few
emission society by 2050. It should be aware that climate changemonths on how climate factors will be reflected in its reinvestment
has the potential to fundamentally change the central banking
policy over its holdings of corporate bonds when the next timing
operations.
arises in October-December 2021. Green sovereign bonds will also
be purchased when the government begins to issue them for the firsttime in 2021.
Sayuri Shirai is currently a professor of Keio University. She holds a Ph.D. ineconomics from Columbia University. She was a Member of the Policy Board of
Furthermore, ECB President Christine Lagarde intends to make thethe Bank of Japan (BOJ) in 2011-2016.
central bank’s portfolio greener as well. The monetary policy strategy
TABLE

Central banks’ possible actions on climate risks

Japan SPOTLIGHT • May / June 2021

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