April 6, 2018
< New phase of monetary easing has entered its sixth year >The BOJ’s Monetary Policy Dilemma— Fear that whether the BOJ heads for an exit or maintains monetary easing, it will
put a burden on the nation
JCER Financial Research Team1
Ikuko FUEDA-SAMIKAWA (Principal Economist)
Tetsuaki TAKANO (Economist)

The Bank of Japan’s (BOJ’s) new phase of monetary easing has entered its sixth year. Now
shrinking its balance sheet, the Federal Reserve Bank (the Fed) is expected to be able to avoid
incurring losses in the process of monetary normalization, but the BOJ will likely incur lossesof more than 10 trillion yen and will have difficulty steering a balanced course between
normalizing monetary policy and ensuring financial soundness. The prolongation of the newphase of monetary easing is merely the postponement of losses. In the meantime, the lending
margin of private banks will narrow and could impede the financial intermediary function.
Ultimately, the BOJ faces a dilemma because whether it heads for an exit or maintains
monetary easing, it will put a burden on the government, namely future taxpayers, and will
run into the problem of central bank independence. Can the BOJ claw back the losses though
future seigniorage, i.e. the revenue that a government receives by issuing money? The BOJ
should surely spell out the side effects of the new phase of monetary easing and outlook foran exit to come to an arrangement with the government on the distribution of profits andfuture losses.

1

Research Director: Ikuko SAMIKAWA (Principal Economist, samikawa@jcer.or.jp), Lead Researcher: Tetsuaki TAKANO(Economist), Trainee Economists: Shoto FUKUYAMA (Japan Finance Corporation), Yasuhiro TOMITA (Japan Housing
Finance Agency), Masato USHIDA (Japan Post Bank), Takayoshi YANAKA (Joyo Bank).

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

(Summary)○ The U.S .Federal Reserve Bank (the Fed) has been shrinking its balance sheet since October
2017. Its new policy is monetary tightening combining interest rate hikes and quantitative
tightening, and its impact is still unknown. Even after the fifth rate hike in January 2018, theyields on the assets held by the Fed is still only around 1% higher than the interest paid (interest
rate on excess reserves (IOER)) and the Fed is unlikely to make a loss in the process of monetarynormalization. Even if a loss is incurred, it would simply be called a deferred asset and booked asa negative liability on the Fed’s balance sheet and its net worth would not be hurt.
○ The BOJ will sustain losses on exiting the new phase of monetary easing. This is because there is
only a slight difference between yields on long-term JGBs and interest paid. When the core CPI
inflation rate reaches 2% in FY2022 and the BOJ starts raising interest rates from the following
year, the BOJ will incur losses of 19 trillion yen ($177bn) by the time it raises short-term interest
rates to 2%. The BOJ will be unable to cover these losses with its net worth, and measures suchas raising reserve requirement ratios or changing accounting methods will be examined. If the
BOJ falls into a negative equity, the question of independence, in other words, whether this willcause distortion of monetary policy will once again come to the fore. The BOJ will havedifficulty steering a balanced course between normalizing monetary policy and ensuring financial
soundness.
○ Some argue that it does not matter even if the BOJ incurs losses because it can recover thesethrough future seigniorage. Central bank seigniorage revenues depend on bank notes issued andthe more interest rates fall in the future or the more the growth rate or the inflation rate increase,the more seigniorage revenues will increase. The problem is that even if the BOJ can recoverlosses with future seigniorage, it will take the Bank a number of years to do so after making thelosses. The key is whether people believe that there is financial support from the government.
○ The “qualitative easing” policy which includes purchases of long-term JGBs and purchases ofrisk assets such as exchange traded funds (ETFs) and Japan real estate investment trusts(J-REITs) is verging on debt management policy or fiscal policy. Both in terms of quantity, thatis, the BOJ’s holdings of JGBs and the BOJ’s share of the JGB market and also in terms of speed,that is, the time taken for the BOJ to purchase new issues of JGBs, qualitative easing could be
identified as “monetization for all intents and purposes.” In the process of normalization, theconflict between monetary policy and debt management policy will come to the surface.
○ The BOJ has maintained QQE for five years but has not been successful in reaching the 2% pricestability target. Structural problems that have been identified include that imputed rents and otherservice prices have not been adjusted for changes in quality and that public utilities charges
remain stubbornly low. The purchasing behavior of the elderly may be causing prices at physicalstores to remain persistently high compared with online prices.

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

1. Kuroda’s Second Term at the BOJ: Is the path to monetary normalization in sight?
1-1 Questions are going to be asked about the boundary between monetary and fiscal policies,
and about central bank independency.
The reappointment of Haruhiko Kuroda as the Bank of Japan Governor was announced. In April
2018, Kuroda will start his second term as BOJ chief, with BOJ Executive Director Masayoshi
Amamiya and Waseda professor Masazumi Wakatabe serving as deputy governors. Initially when the
Quantitative and Qualitative Monetary Easing (QQE) policy was introduced five years ago, the BOJ
expected to be able to reach its 2% price stability target in around two years. However, five years on
from the introduction of QQE, consumer price inflation has not reached 2%, and achievement of thetarget has been carried over. Because the new phase of monetary easing had dragged on longer than
anticipated, the QQE framework changed to Additional Monetary Easing in October 2014 and QQEwith a Negative Interest Rate in January 2016 and then QQE with Yield Curve Control (YCC) in
September 2016. When the BOJ introduced QQE in April 2013, it shifted the target of its monetary
policy operations from interest rates (the overnight call rate) to quantity (the monetary base), but with
YCC it once again returned to interest rates and also targeted the long-term interest rate, namely, the10-year Japanese Government Bond (JGB) yield, in addition to the short term interest rate.
The decision to reappoint Governor Kuroda was taken by the markets as evidence of the current
Shinzo Abe administration’s strong determination to overcome deflation and reach the 2% pricestability target. The BOJ is expected to maintain the new phase of monetary easing but there is also
the possibility that the BOJ will adopt “permanent zero” as its long-term interest rate target. With JGB
yields for less than 10 years in negative territory under YCC, how long will the soundness of Japan’s
private financial institutions be maintained? Below is an assessment of Japan’s exit based on
observations of the normalization process of the U.S. Federal Reserve Bank (the Fed) which began tonormalize its monetary policy ahead of other countries.
Looking ahead to this report’s conclusion, the Fed has been shrinking its balance sheet since
October 2017 and it will not incur losses. On the other hand, the difference between the yields on
JGBs held by the BOJ and interest paid (interest on excess reserves) is only around 0.3% and theslight rise in the Bank rate is expected to result in negative spread. If the BOJ cannot maintain its
financial independence, not only may confidence in the national currency (the yen) fall, giving rise toinflation, but the BOJ may also face demands that are difficult to oppose from the government
concerning its monetary policy. The prolongation of the new phase of monetary easing is merely the
postponement of losses and the more easing drags on, the greater losses will be. Whether the BOJ tries
to cover these losses itself or whether it decides to seek support from the government, financial costs
will inevitably be incurred.

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

The BOJ’s qualitative easing which includes large-scale purchases of long-term JGBs and buyingof risk assets such as exchange traded funds (ETFs) means that monetary policy has entered theterritory of fiscal policy. Not infrequently, it has been identified as monetization for all intents andpurposes, but whether this is the case or not will not be revealed until the BOJ starts raising its policy
rate. Twenty years ago, with the revision of the Bank of Japan Act, the BOJ’s independence from thegovernment was recognized2. However, should the Bank’s financial soundness be hurt and monetary
policy be distorted by political demands in the future, this could place a burden on the nation in theform of sharp rise of interest rate and vicious inflation. The BOJ does nothing but repeat that it’s too
early to debate an exit but it needs to spell out the exit outlook and side effects and to come to an
arrangement with the government on the distribution of profits and losses. Kuroda’s new team islikely to once again face questions about the boundaries between monetary policy and fiscal policy,
as well as the issue of central bank independence.
1-2 A new phase of monetary easing: Review of the past five years
Introduced in April 2013, the BOJ’s Quantitative and Qualitative Monetary Easing (QQE) policy
also known as a “new phase of monetary easing” will soon enter its sixth year. The BOJ doubled themonetary base (sum of banknotes in circulation, coins in circulation and the outstanding current
account deposits at the Bank) over two years, aiming to reach its price stability target of 2%, but it has
not achieved the 2% target and QQE has continued for five years. In the meantime, the monetary basehas more than tripled over five years and the BOJ’s holding of long-term JGBs has more thanquadrupled (Fig. 1-1). In January 2018, the seasonally adjusted monetary base shrank compared with
December, drawing attention as the first fall since the introduction of QQE, but February saw a return
to positive growth.
Fig. 1-1 The monetary base and the BOJ’s holding of long-term JGBs
600

(Trillion yen)

500
400
300

Monetary BaseAmount of JGB Holdings
138 Trillion(Dec. 2012)

200
100
0
07/01

89 Trillion
08/01

09/01

10/01

11/01

12/01

13/01

476 Trillion
437 Trillion (Jan. 2018)
QQE(Dec. 2016)
356 Trillion
275 Trillion (Dec. 2015)(Dec. 2014)
423 Trillion
201 Trillion(Dec. 2013)
360 Trillion
282 Trillion
201 Trillion
141 Trillion
14/01

15/01

(End of Month)
16/01

17/01

18/01
18/01

Source: Bank of Japan2

The existing Bank of Japan Act was enacted in 1997 and came into effect in April 1998.

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

The BOJ’s balance sheet now exceeds 500 trillion yen and is comparable in scale to the Japanese
economy, namely Japan’s nominal Gross Domestic Product. It can be seen from Fig. 1-2 how bloatedthe BOJ’s balance sheet is compared with that of major central banks such as the Fed and theEuropean Central Bank (ECB). In dollar terms also, the BOJ’s balance sheet is larger than that of theFed, which has begun shrinking its balance sheet.
Fig. 1-2 The BOJ’s balance sheet has expanded to a scale comparable to Japan’s GDP
100
90
80
70
60
50
40
30
20
10
0

(% of Nominal GDP)
BOJ

FRB

ECB

(Quarterly)
05:1

06:1

07:1

08:1

09:1

10:1

11:1

12:1

13:1

14:1

15:1

16:1

17:1

17:4

Source: Bank of Japan, Cabinet Office, BEA, FED, Bloomberg

The BOJ is currently implementing the YCC. Its aim is to conduct purchases of long-term JGBs
“more or less in line with the current pace -- an annual pace of increase in the amount outstanding of
its JGB holdings at about 80 trillion yen.” However, data on the BOJ’s holding of long-term JGBs
shows that the annual pace of increase dropped to around 55 trillion yen in January 2018. There has
been a noticeable tendency towards a slowdown in the pace of purchases since September 2016, when
YCC was introduced (Fig. 1-3). If the recent pace of purchases is maintained, the annual pace ofincrease is expected to drop below 40 trillion yen by the end of 2018. However, in 2018, out of thelong-term JGBs held by the BOJ, 51 trillion yen will reach maturity. To increase the JGBs on its
balance sheet by 40 trillion yen from 2017, the BOJ will have to purchase long-term JGBs worth
almost 90 trillion yen in total, including reinvestment.

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

Fig. 1-3 The annual pace of increase in the amount outstanding of the BOJ’s JGB holdings (left) andforecast of the pace of purchases (right)(Change from previous year, Trillion yen)

90

YCC

100

BOJ's JGB holdings(Change from previous year, Trillion yen)
YCC

80

80

60
70
40
60

The monthly purchase amount stays
at 7.3 trillion yen
The monthly purchase amount(Monthly)decreases

20(Monthly)

50
16/01

16/07

17/01

17/07

0

18/01

13/04

14/04

15/04

16/04

17/04

18/0418/12

Note: 1.Change in JGB outstanding in the BOJ’s balance sheet from previous year.
2.The dotted line is estimated. ‘The monthly purchase amount decreases’ is calculated by using the trend from October
2016 to January 2018.
Source: Bank of Japan

Since the introduction of YCC, 10-year JGB yields have remained stable at around zero (Fig. 1-4).
Directly after introduction in September 2016, it was thought that the BOJ would allow 10-year JGB
yields to fluctuate within a range between minus 0.1 percent and plus 0.1 percent. However, since thestart of 2017, yields have remained inside a narrower range between zero and plus 0.1%. When thelong-term JGB yield does edge close to 0.1%, the BOJ often conducts “fixed-rate purchase operations,”
where it purchases an unlimited amount of JGBs at a fixed yield, but there have also been instances
when the BOJ just announced fixed-rate purchase operations and no actual bids were tendered.
Fig. 1-4 JGB yields in the secondary market
2.0

(%)

0.9

fixed-rate purchase operation

1.5

0.6

1.0

0.3

0.5

0.0

0.0
-0.5
13/01

(%)

-0.3
(Daily)

14/01

15/01
1-Year

16/01
5-Year

17/01

-0.6
18/03
18/01
17/01
10-Year（Daily)17/07
20-Year

18/03
18/01

Note: Daily data up to and including March 30, 2018.
Source: Bloomberg

After introducing YCC, the BOJ was able to guide 10-year JGB yields in the secondary market tozero with fewer purchases than before. As also pointed out by Samikawa, Takano, Ushida, Fukuyama
and Yanaka (2017), the introduction of YCC made the BOJ’s policy more sustainable. What made thispossible is the “stock view” approach. This is the approach that it is stock, for example, the central
bank’s holdings of JGBs and share of the JGB market (and not purchasing flow) that strongly affects

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

long term interest rates. Already holding more than 40% of the outstanding balance of JGBs, the BOJ
has become a “whale in a pond” in the secondary market and is also starting to command an
overwhelming presence in the primary market.
The BOJ’s JGB purchases also stand out because of their speed. Although the total amount of JGB
increase has been slowing, the BOJ’s purchasing pace of newly issued JGBs is increasing rapidly.
Since the introduction of YCC, the degree to which new issues of JGBs “suddenly evaporate” fromthe secondary market has increased (Fig. 1-5). These transactions are called “BOJ trade.” Morelong-term JGBs are purchased by the BOJ in a mere one to two months after they are issued anddisappear from the secondary market. Before the adoption of QQE, the BOJ had excluded the twomost recent issues of JGBs from the scope of its purchase operations, but with the introduction of
QQE, the Bank scrapped this “JGB purchase rule.” The BOJ’s JGB purchases are now such that they
can be described as “monetization for all intents and purposes” both in terms of quantity and in termsof speed.
Fig. 1-5 Time to purchase of new issues of JGBs by the BOJ (market survival rate)
10-yearIssue Date
Issue Number(reference:320) Jan-12
328
Mar-13329
Jun-13330
Sep-13331
Nov-13332
Dec-13333
Mar-14334
Jun-14335
Sep-14336
Dec-14
337
Jan-15338
Mar-15339
Jun-15340
Sep-15341
Dec-15342
Mar-16343
Jun-16344
Sep-16345
Dec-16346
Mar-17347
Jun-17348
Sep-17349
Dec-17

Market survival rate of newly issued government bonds
M
M＋1 M＋2 M＋3 M＋4 M＋5 M＋6 M＋7 M＋8 M＋9 M＋10 M＋11 M＋12
100% 100% 100% 100% 100% 97% 97% 96% 96% 96% 96%
96%
96%
100%
83%
83% 81% 81% 81% 81% 81% 79% 75% 65%
65%
65%
70%
57%
58% 55% 55% 55% 55% 55% 55% 55% 55%
55%
54%
71%
64%
57% 56% 50% 47% 45% 45% 45% 45% 45%
45%
45%
56%
45%
45% 45% 45% 45% 45% 44% 44% 44% 44%
44%
39%
89%
80%
60% 58% 58% 57% 53% 53% 53% 53% 53%
53%
53%
68%
58%
47% 38% 38% 38% 34% 32% 32% 32% 31%
31%
31%
55%
49%
46% 40% 33% 33% 33% 33% 33% 30% 30%
30%
29%
78%
66%
57% 41% 41% 41% 41% 39% 39% 39% 35%
35%
33%
76%
64%
60% 46% 46% 42% 40% 40% 38% 38% 38%
38%
38%
54%
36%
34% 33% 30% 30% 30% 30% 30% 30% 30%
28%
26%
57%
43%
51% 38% 36% 36% 35% 32% 30% 27% 25%
25%
23%
79%
73%
65% 47% 47% 47% 43% 43% 43% 38% 38%
38%
36%
64%
54%
38% 31% 31% 28% 19% 19% 19% 19% 19%
19%
19%
86%
60%
53% 46% 39% 39% 37% 37% 37% 28% 28%
28%
28%
73%
53%
44% 25% 24% 23% 21% 21% 21% 21% 18%
15%
14%
75%
46%
34% 28% 28% 22% 20% 19% 19% 15% 15%
15%
15%
80%
48%
47% 37% 36% 31% 29% 27% 27% 27% 27%
27%
24%
76%
54%
41% 40% 40% 39% 33% 33% 33% 33% 33%
33%
30%
67%
28%
25% 22% 17% 17% 14% 13% 13% 13% 13%
63%48%
31% 20% 20% 20% 19% 19%
69%36%
31% 17% 17%
69%
41%
0-33%

34-66%

67-100%Note: 1. M means the end of month in which the JGB was issued, M + 12 represents 12 months after its issuance.
2. The more red turns, the shorter the period of staying in the secondary market.
Source: Ministry of Finance, Bank of Japan

On introducing YCC, the BOJ announced an “inflation-overshooting commitment” in which the
Bank commits itself to expanding the monetary base until the year-on-year rate of increase in theobserved consumer price index (CPI) exceeds the price stability target of 2% and stays above thetarget in a stable manner. According to this, the price stability target of 2% is based on the headline
CPI, but the inflation-overshooting commitment is based on Core CPI excluding fresh food. Fig. 1-6

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Japan Center for Economic Research
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April 6, 2018shows the most recent trend of the CPI. In January 2018, the core CPI rose by 0.9% from a year earlier,which is still a long way from reaching the price stability target of 2%. The timing for reaching 2%
indicated by the BOJ in its Outlook Report published in January 2018 is also “around FY2019”.
According to the ESP Forecast, a consensus survey conducted by the Japan Center for Economic
Research, the core CPI is expected to remain below 1% in FY2019 (February 2018 survey). Provided
that the BOJ maintains its “inflation-overshooting commitment,” then it is safe to assume that the BOJ
will continue expanding the monetary base for the time being.
Fig. 1-6 Rate of increase in the consumer price index (CPI)
2.0(YoY, %)
Core CPI
Core core CPI
BOJ core CPI

1.0

0.0
(Monthly)

-1.0
12/01

12/07

13/01

13/07

14/01

14/07

15/01

15/07

16/01

16/07

17/01

17/07

18/01
18/02

Source: Ministry of Internal Affairs and Communications

ETFs are the instruments that the BOJ purchases the most after JGBs. Data on recent ETF
purchases shows that the BOJ tends to purchase ETFs during the phase of stock price decline (Fig.
1-7). In other words, the BOJ puts off purchases when stock prices rise. Also when the Nikkei Stock
Average enjoyed its longest winning streak in history, with 16 consecutive days of advances, the BOJ
put off purchases. Empirical analysis shows that when the BOJ purchases ETFs, the TOPIX rises byaround 1.0% in later trading. Tests have also confirmed that stock price volatility differs significantly
between days with BOJ purchases and days without.
Fig. 1-7 Trend of the Nikkei Stock Average and status of the BOJ’s ETF purchases
25,000(Yen)

The amount of BOJ's purchase of ETF(RHS)
Nikkei225(Billion yen)

80
70

23,00060

21,00050

19,00040
30

17,00015,000
16/07
16/09
16/11
17/01
17/03
17/05
17/07
17/09
17/11
Note: 1.Date excludes ETFs that support firms proactively investing in physical and human capital.
2.Daily data up to and including Mar 30,2018.
Source: Bank of Japan, NEEDS-FinancialQUEST(Daily)
18/01

20

10
18/03
18/03

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Japan Center for Economic Research
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April 6, 2018

What was the BOJ’s objective in purchasing ETFs in the first place? A phrase that has been
repeated since the days of former governor Masaaki Shirakawa is “to encourage a reduction of themarket's risk premium.” In this report, therefore, to what extent the risk premium haschanged as a result of the BOJ’s purchases is measured (Fig. 1-8). Analysis of the risk
premium determined by the Cyclically Adjusted PE Ratio (CAPE Ratio) advocated by Nobel
Prize Winner Robert Shiller, a professor at Yale University, and the most common risk
premium (spread between dividend yield and JGB yield) in addition to the risk premium
determined by the Dividend Discount Model shows that they are all of a level that makes it
difficult to claim that “the risk premium has been reduced” as a result of the BOJ’s purchases.

Fig. 1-8 Trend of risk premium since start of ETF purchases
12

(%)

6.0

(%)

3.0

(%)

⇒QQE

10

5.0

2.5

8

4.0

2.0

6

3.0

1.5

4

2.0

1.0

1.0

2

0.5

(Monthly)
0
10/01

13/01

0.0
16/01 18/02 10/01

Yield gap(Stock yield+Nominal GDP
growth rate-Long term interest rate)(Monthly)(Monthly)
13/01

16/01 18/02

Risk Premium based on cape ratio(Stock yield-Long term interest rate)

0.0
10/01

13/01

16/01 18/02

Yield spread (Dividend yield-Long
term interest rate)

Note: 1.Stock yield (left figure) = Expected EPS/TOPIX.GDP growth is long term 6-10 year forecasts.
2.Stock yield (central figure) = EPS(10 years moving average)/TOPIX.
3.Dividend yield (right figure) =TSE REIT index.
4.Long term interest rate is 10-Year JGB Yields.
Source: Bloomberg, NEEDS-FinancialQUEST, Consensus Forecast.

The BOJ’s indirect holdings of individual shares have risen as a result of its ETF purchases.
Calculation of the BOJ’s indirect holdings from its holdings as of the end of January 2018 shows thatthe BOJ indirectly holds almost 20% in Advantest, a Japanese manufacturer that supplies
semiconductor manufacturing equipment, and in Fast Retailing, which owns clothing companies suchas UNIQLO (Fig. 1-9). Based on shares floating freely on the secondary market, the BOJ alreadyholds almost 70% of the free-floating shares of Fast Retailing. If the BOJ continues purchases ETFs at
its current pace, the BOJ will buy up all the free-floating shares of Fast Retailing by the end of 2020.
The BOJ does not have voting power because it holds shares in individual companies indirectly.
However, considering that a company in which an investee holds 20% or more of the voting power isreferred to as an “associate” of the investee, the impact of the BOJ’s ETF purchases on management
decisions including corporate governance and investment behavior, and price formation should not beignored.
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April 6, 2018

Fig. 1-9 The BOJ’s indirect holdings have risen as a result of its ETF purchases (as of the end ofJanuary 2018)
Company
Advantest
Fast Retailing
Taiyo Yuden
TDK
Family Mart UNY Holdings
Toho Zinc
Trend Micro
Comsys Holdings
Nissan Chemical Industries
Konami Holdings
Tokyo Electron
Nitto Denko
Okuma

Indirectholdingratio(%)
18.8
17.1
16.2
15.4
14.9
14.7
14.1
13.7
13.5
13.5
12.5
12.1
12.0

Floatingstockbase(%)

Company

41.8 Mitsubishi Logistics
68.6 Nisshinbo Holdings
27.1 Nippon Kayaku
23.7 Kyocera
37.3 Credit Saison
22.7 TERUMO
25.6 Tokyo Dome
30.5 Alps Electric20.8 Fanuc30.0 Seiko Epson
19.2 Yamaha
17.4 Takara Holdings
21.7 Pacific Metals

Indirectholdingratio(%)

Floatingstockbase(%)

11.7
11.4
11.4
11.3
11.3
11.1
11.0
10.9
10.8
10.5
10.5
10.4
10.4

19.5
20.7
18.9
16.2
17.4
17.1
17.0
15.6
14.4
17.6
19.1
17.4
20.8

Note: 1. The indirect holding ratio is calculated by following steps. Multiply the BOJ's ETF balance by the composition ratioof the Nikkei average and dividing the value by market capitalization of each issues.
2. For the days prior to September 2016, we assume that the daily prices purchased by the BOJ are proportional to themarket capitalization of ETFs. After October 2016, we also assume that 47% (= 2.7 / 5.7) is TOPIX, the remaining
53% is proportional to market capitalization of ETFs.
3. Assume that the purchase unit price is the closing price of the purchase date and calculate the number of acquired
units based on purchase / closing price. Calculated values are closing prices at the end of January 18.
Source: NEEDS-FinancialQUEST, Bloomberg.

The Japanese economy has improved steadily under Abenomics and the new phase of monetaryeasing. Japan’s real GDP growth in the October-December 2017 quarter was 0.4% quarter on quarter.
In annualized terms, the growth rate was 1.6%. Japan’s economy has recorded eight consecutive
quarters of economic growth, a run that began in the January-March 2016 quarter. This is the longest
growth streak for 28 years since the 12 consecutive quarters of growth (which began in the April-Junequarter 1986) during the economic bubble in the late 1980s. The economic expansion that began in
December 2012 also entered its sixth year in December 2017 and is the second-longest expansion
since the end of World War II.
Why has Japan failed to reach the 2% price stability target? The price stability target was
introduced in the form of the Joint Statement of the government and the Bank of Japan on January 22,2013 before the introduction of QQE3. In April 2014, the CPI inflation rate temporarily rose to 1.7%
on a core basis excluding fresh food. However, as shown in Fig. 1-6, oil prices then started to fall andthe CPI inflation rate began to show a downward trend. Since the beginning of 2017, the CPI inflation
rate has risen gradually. The supply-demand gap (according to Cabinet Office estimates), which shows
the balance between supply capacity and demand, exceeded zero, which is the long-term average, in3January 22, 2013, Cabinet Office, Ministry of Finance, and Bank of Japan “Joint Statement of the Government and the
Bank of Japan on Overcoming Deflation and Achieving Sustainable Economic Growth”(https://www.boj.or.jp/en/announcements/release_2013/k130122c.pdf)

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Japan Center for Economic Research
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April 6, 2018

the April-June quarter 2017 and then widened further within positive territory, reaching 0.4% in themost recent October-December quarter 2017 (Fig. 1-10).
Fig. 1-10 Trend of GDP gap, exchange rates and crude oil prices
2.0(YoY, %)

(Yen/Dollar, Dollar/Barrel）
GDP gap

1.5

yen/dollar (RHS)

Oil prices (RHS)

145
130

1.0

115

0.5

100

0.0

85

-0.5

70

-1.0

55

-1.5

(Quarterly)

-2.0
12：1

12：3

13：1

13：3

14：1

14：3

15：1

15：3

16：1

16：3

17：1

40
25

17：3 17：4

Source: Cabinet Office, NEEDS-FinancialQUEST

In its Comprehensive Assessment released in September 2016, the BOJ identified three factors that
hampered achievement of the 2% price stability target: (1) declines in crude oil prices; (2) weakness indemand following the consumption tax hike; and (3) the slowdown in emerging economies andvolatile developments in global financial markets reflecting that situation. Moreover, since the actual
rate of inflation fell due to substantial declines in crude oil prices, “adaptive inflation expectation
formation,” whereby people’s inflation expectations increase on confirming that prices are actuallyrising, had the reverse effect of pushing down inflation expectations.
While inflation lacks momentum, the labor market is tight and there is a shortage of labor. It haslong been said that Japan is under full employment. The unemployment rate was 2.5% in February
2018 and the effective job openings ratio to job offering reached 1.59 in January, its highest level for
44 years (Fig. 1-11). The employment condition D.I. (“Excessive” minus “Insufficient”) also recorded
its lowest level for 26 years at minus 34 percentage points for enterprises of all sizes. The employment
environment is also much improved and there is a shortage of labor.
Fig. 1-11 The unemployment rate has dipped below 3%, and the effective job openings ratio is also at
its highest level for 44 years.
6.0(%)
Unemployment rate

5.0

-40

(Excessive - Insufficient, % point)
Employment conditions

-30

3.0

00/01

03/01

06/01

09/01

12/01

15/01

1.4
1.2
1.0

0

0.8

10

0.6

(Monthly)

0.0

1.6

-10

2.0
1.0

Labor shortage

Effective ratio of job offers
(RHS)

-20

4.0

(Times)20(Quartely)

30

18/02
18/01

00:1

03:1

06:1

09:1

12:1

15:1

0.4
0.2

18:1

Source: Ministry of Internal Affairs and Communications, Ministry of Health, Labour and Welfare, Bank of Japan

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Japan Center for Economic Research
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April 6, 2018

However, the improvement in the employment environment is not reflected in wages, which holdthe key to the inflation challenge. The scheduled earnings of part-time workers for which wage
adjustment is easily comparable grew by more than 1.0% year on year, but wage growth for regular
workers was less than 1%.

1-3 The exit strategy of the Fed, the first central bank to start shrinking its balance sheet
In October 2017, the Fed became the first central bank to begin shrinking its balance sheet. The Fed
has adopted a monetary tightening strategy that combines interest rate hikes with quantitative
tightening. Under the plan, the Fed will allow the principal proceeds from maturing treasury securities
and mortgage-backed securities (MBS) that are below caps (horizontal lines in Fig. 1-12) to run off
the balance sheet each month and will reinvest principal proceeds that exceed the caps as the securities
mature. In the three months since October 2017, the Fed has allowed up to 6 billion dollars in
Treasury securities a month plus 4 billion dollars in MBS to run off the balance sheet, and in the next
three months, it plans to shed up to 12 billion dollars of Treasury securities a month plus 8 billion
dollars in MBS.
Fig. 1-12 Trend of principal proceeds from securities held by the Fed and caps
800
700
600
500
400
300
200
100
0

【U.S. Treasury Note】(100 million dollars)
Redemptions
Runoff Cap

250
200
Reinvestment【MBS】
Reinvestment(100 million dollars)
UP
Redemptions（Estimate） Runoff Cap
Red line
DO
WN

150

UP

Redemption

Red line 100
DO
WN

50

Redemption

17/10

18/04

18/10

19/04

19/12 (monthly)
19/10

0
17/10

18/04

18/10

19/04

19/12 (monthly)
19/10

Note: 1. Bonds above Runoff cap (red line) are reinvested at maturity. If it falls below, it does not reinvest.
2. Redemption forecast for U.S. Treasury Note is as of the end of September 2017.
3. The redemption forecast for MBS is estimated based on the balance as of the end of September 2017 assuming that
1% of the monthly holdings will be redeemed.
Source: Federal Reserve Bank of New York, Bloomberg

With respect to the optimal size of the Fed’s balance sheet, Goodhart (2017) argues that central
banks should run down their excess reserves to zero on the grounds that central banks losses could
develop into a fiscal problem that will affect taxpayers. In contrast, former Fed Chairman Ben
Bernanke said that keeping a large balance sheet would (1) enhance the stability of financial markets;(2) improve the transmission of monetary policy (to the real economy); and (3) enable the Fed to play

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Japan Center for Economic Research
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April 6, 2018its role as a lender of last resort during financial crises4. According to the projections of the Federal
Reserve Bank of New York, the amount of domestic securities held in the SOMA (System Open
Market Account) that manages the Fed’s balance sheet will be around 3 trillion dollars by 2025 (Fig.
1-13 left)5. While net income will temporarily decrease to 50 billion dollars, it will then increase (Fig.
1-13 right). The Fed is not expected to incur losses in the process of monetary normalization, though
this depends in some respects on the extent of future rate hikes.
Fig. 1-13 The size of the SOMA portfolio could shrink to around 3 trillion dollars(Trillion dollars)
5【SOMA Holding】
120

Forecast(Billion dollars) 【SOMA Net Income】
Forecast

100

4

80
3
60
2

Larger liabilities
Smaller liabilities
Median

1

2010
2015
2020
Source: Federal Reserve Bank of New York

Larger liabilities
Smaller liabilities
Median

40
(CY)

20

2025

2010

2015

(CY)
2020

2025

By the end of February 2018, the Fed had raised interest rates five times since December 2015, butthere is still a gap between yields (averaging 2.6% as of the end of September 2017) and interest paid
(interest on excess reserves of 1.25-1.5%) (Fig. 1-14 right). The average remaining maturity ofTreasury security and MBS holdings was 7.2 years as of the end of September 2017 and there is amismatch between the maturity structure of assets and liabilities, but the Fed is thought to have opted
not to sell MBS in the process of monetary normalization in order to avoid a negative spread (Fig.
1-14 left).

4

September 2, 2016, Brookings (Ben S. Bernanke）“Should the Fed keep its balance sheet large?”(https://www.brookings.edu/blog/ben-bernanke/2016/09/02/should-the-Fed-keep-its-balance-sheet-large/)
5July, 2017, Federal Reserve Bank of New York “Projections for the SOMA Portfolio and Net Income”(https://www.newyorkFed.org/medialibrary/media/markets/omo/SOMAPortfolioandIncomeProjections_July2017Update.pdf)

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Japan Center for Economic Research
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April 6, 2018

Fig. 1-14 Average yield of securities held in SOMA is around 2.6%
12
11
10
9
8
7
6
5
4
3
2

(Year)【Average maturity (SOMA)】
U.S. Treasury Note
MBS
Average maturity(Quarter)
08:4
12:1
08:4 11:412:1

13:1

14:1

15:1

16:1

17:117:3

5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0

【Average interest rate (SOMA)】(%)

FF rate target (Range)
U.S. Treasury Note
MBS
Average interest rate

(Quarter)
11:1

12:1

13:1

14:1

15:1

16:1

17:1 17:4

Note: 1.Average maturity from 2008 to 2011 is only plotted for the each fourth quarter that is the data published. MBS is avalue considering premature redemption.
2.Average maturity is calculated by weighted average. We conveniently define average maturity following methods 7.5
days within 15 days, 53 days from 16 days to 90 days, 91 days from 1 year to 228 days, 3 years from 1 to 5 years,
7.5 years from 5 to 10 years, and 20 years over 10 years.
3.Average maturity and average interest rate are weighted average of U.S. Treasury Notes and MBS.
Source: the Fed

The shadow rate is the interest rate that would prevail in the absence of a zero lower bound and,after the global financial crisis of 2008, the shadow rate was confirmed as being in negative territory.
The shadow rate data published by the Federal Reserve Bank of Atlanta (the Wu-Xia Shadow Rate6)
shows that, after hitting bottom in May 2014 (minus 3.0%), the shadow rate rose to 1.3% in December
2017, suggesting that, during this period, interest rates were raised 4.3 percentage points on aggregate(Fig. 1-15). However, the shadow rate data published by Leo Krippner, economist at the Reserve Bankof New Zealand, shows that the aggregate increase from the rock-bottom level (April 2013) to the endof December 2017 is 6.7 percentage points7. Many market participants take the view that there will bethree or four rate hikes in total during 2018. The Federal funds rate target is low at 2.75%, but in
addition to further rate hikes, the Fed will also start to shrink its balance sheet in earnest and the
combined overall monetary tightening effect may be greater than that of the streak of rate hikes from
2004.

6

Federal Reserve Bank of Atlanta (https://www.FEDatlanta.org/cqer/research/shadow_rate.aspx?panel=1)
Reserve Bank of New Zealand(https://www.rbnz.govt.nz/research-and-publications/research-programme/additional-research/measures-of-the-stance-of-unit
ed-states-monetary-policy/comparison-of-international-monetary-policy-measures)7

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

Fig. 1-15 According to the Wu-Xia Shadow Rate, the recent rate increase is comparable to the streakof rate hikes from 2004(%)

6

Effective FF rate

4

Wu-Xia shadow rate

Krippner shadow rate

+4.3%

2
0

+4.4%

-2
-4

+6.8%

-6
04/01

05/01

06/01

07/01

08/01

09/01

10/01

11/01

12/01

13/01

14/01

15/01

(Monthly)

16/01

17/01 18/02
18/01

Note: Shadow rates are shown from January 2009 to November 2015.
Source: Federal Reserve Bank of Atlanta, Reserve Bank of New Zealand

1-4 The losses that will be incurred by the BOJ on exiting QQE
Iwata and the Japan Center of Economic Research (2014) estimated the losses that would beincurred by the BOJ on exiting QQE in the future and proposed that the BOJ should discuss the
distribution of profits and losses with the government in advance. The estimates of Iwata et al. (2014)
were based on the assumption that the BOJ would reach the 2% target in two years as initiallydeclared and the estimated losses are, therefore, conservative, totaling between 570 billion yen and2.26 trillion yen.
The BOJ has maintained QQE for five years, but has still not reached the price stability target of
2%. Below, the losses that the BOJ will incur on exiting the new phase of monetary easing arecalculated once again. The estimate is based on the assumptions shown in Fig. 1-16. After the BOJ has
reached its 2% price target, the level of the benchmark interest rate that will be required to keep prices
stable is the natural rate of interest plus inflation. Here, the benchmark rate after normalization isassumed to be 2%, which is the natural rate of interest of zero plus inflation of 2% in accordance withthe estimate results of the BOJ. The amount of long-term JGBs held by the BOJ after normalization isassumed to be around the same level as before the introduction of QQE (20% of nominal GDP).
Fig. 1-16 Estimate is based on the assumption that the BOJ will reach the 2% target in FY2022 andwill raise interest rates from FY2023
Policy schedule
FY

PricesShort-term
interest rates

Long-term interest rates

2018
2019

CPI(Less Fresh Foodand Energy) ⇒ 1%

2020
2021
2022 Core CPI ⇒ 2%
2023
2024
2025
2026
2027
2028

JGB Holdings(Residual maturity)+40 trill. yen (8 years)

Target for the long-term interest rate
⇒ 5-Year JGBs Yield+20 trill. yen (8 years)

Trget rate(5-Year) ⇒ 0.25%+20 trill. yen (8 years)+20 trill. yen (7 years)+20 trill. yen (7 years)

YCC abandonment,Interest hike(Once) ⇒ 0.25%
Trget rate(5-Year) ⇒ 0.75% (spread: 0.5%)
Trget rate(5-Year) ⇒ 1.25%
Interest hike(Twice) ⇒ 0.75%
Trget rate(5-Year) ⇒ 1.75%
Interest hike(Twice) ⇒ 1.25%
Trget rate(5-Year) ⇒ 2.50% (spread: 0.75%) Interest hike(Twice) ⇒ 1.75%
Trget rate(5-Year) ⇒ 2.75%
Interest hike(Once) ⇒ 2.00%

Only reinvestments (6 years)
Only reinvestments (6 years)
Only reinvestments (6 years)-20 trill. yen (5 years)
Continueing until 2041
Maintaining 20% of GDP after 2042

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Japan Center for Economic Research
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It is assumed that inflation rate stands for the BOJ’s version of the core CPI, which the BOJ focuseson as an underlying inflation gauge, will reach 1.0% in FY2019 and that the BOJ will change thetarget of its long-term interest rate operations to the 5-year rate (guiding the yield on 5-year JGBs tozero). Let us consider the case where the BOJ upholds its inflation-overshooting commitment, the core
CPI reaches 2% in FY2022, and the BOJ starts raising interest rates in FY2023. The BOJ raises thebenchmark rate at the gentle pace of two hikes a year, and starts to shrink its balance sheet in FY2026.
It is conceivable that, when exiting QQE, the BOJ is paying interest on excess reserves balances(IOER). When the BOJ raises IOER and market interest rates start to rise in conjunction with this, it ispossible that some of the banknotes in circulation will flow back into current account deposits at theBOJ. If interest on deposits at the BOJ is almost zero, as is the case now, in terms of portfolio
selection, it makes no difference whether money is held in cash or held in deposits (given cash
custody fees). However, once interest on deposits moves into positive territory, households and firms
may move cash into deposits to save on the cost of holding cash (opportunity cost) and excess
reserves that earn interest may increase.
Currently, under YCC, which entails keeping the 10-year JGB yield at zero, the BOJ purchases
JGBs with an average auction clearing yield (interest income less adjustments) of almost zero.
Therefore, as long as it maintains YCC, even if the BOJ purchases further long-term JGBs in its
operations, there will be no interest from these JGBs.
Fig. 1-17 shows the BOJ’s interest earnings (adjusted) and IOER payments, and its net income,which is equal to the difference between the two, estimated in this way. From FY2024 onwards, theBOJ will incur losses, with losses of as much as around 5 trillion yen in FY2026. Later, in FY2031,
negative spread will be eliminated, and net income will turn positive from FY2031 onwards.
Especially from FY2043 onwards, when the BOJ will have finished reducing its JGB holdings, net
income will expand. The BOJ’s losses will amount to around 19 trillion yen in total. This amount isequal in size to the cost of the reconstruction projects over the five-year period after the Great East
Japan Earthquake, which was designated as the “Intensive Reconstruction Period8.” The net income
subsequently earned until FY2050 will only amount to around 12.5 trillion yen and the BOJ will be
unable to recover the losses during the forecast period.

8
Around 19 trillion yen in July 2011. Later, the Abe Administration increased this amount to around 25 trillion yen in
January 2013. March, 2013, Government of Japan “Road to recovery”(https://japan.kantei.go.jp/policy/documents/2012/__icsFiles/afieldfile/2012/03/07/road_to_recovery.pdf)

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April 6, 2018

Fig. 1-17 Forecast of BOJ’s losses(Trillion yen)

12
10
8
6
4
2
0
-2
-4
-6

Income - Expenses
Income: Interest on Japanese government bonds
Expenses: Interest on excess reserve12.5 trill. yen
19 trill. yen
2017

20

25

30

(FY)
35

40

45

50

Fig. 1-18 compares the three scenarios. The 1% inflation exit scenario, which entails heading for anexit with 1% inflation, would reduce the balance sheet the quickest and would also leave the BOJ witha small balance sheet. On the other hand, under the large balance sheet scenario, which only involves
reducing the amount of long-term JGBs held by the BOJ to 50% of GDP, the amount of long-term
JGBs held by the BOJ would only be reduced to 400 trillion yen and would then expand according to
GDP growth and, as of FY2050, the BOJ’s long-term JGB holdings would exceed the current level.
Fig. 1-18 Interest earnings, IOER payments and net income (comparison of the three scenarios)
800(Trillion yen)
Baseline【BOJ's JGB Holdings】
Large BS

Exit at 1% inflation

6.0(Trillion yen)
Baseline【Net profits of BOJ】
Large BS

Exit at 1% inflation

4.0
600
2.0
400

0.0
-2.0

200
(FY)

-4.0
(FY)

-6.0

0
2017 20

25

30

35

40

45

50

2017 20

25

30

35

40

45

50

The amount of losses incurred would almost be lowest in the case where the BOJ heads for an exit
early. This is because IOER would be kept low and because the BOJ would start shrinking its balance
sheet early and, as a result, the excess reserves on which the BOJ pays interest would also start todecrease sooner. On the other hand, the larger the balance sheet, the higher the earnings from assets
held commensurate to excess reserves, resulting in high income.
1-4-1 It would be unrealistic to raise reserve requirement ratios or change accounting methods.
If the BOJ looks likely to make losses, it may reverse provisions or reserves to try to cover them.
The BOJ’s net worth is made up of (1) paid-up capital, (2) required reserve balances, (3) special
reserves, (4) provision for possible loans losses, (5) provision for losses on bond transactions, and (6)provision for possible losses on foreign exchange transactions. Of this, paid-up capital accounts for
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Japan Center for Economic Research
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April 6, 2018just 100 million yen, while provisions and reserves combined also amounted to just 8 trillion yen in
the first half of FY2017 (end of September) (Fig.1-19). In contrast, losses incurred in the exit phase
may well swell to around 19 trillion yen. Even if the BOJ tries to cover its losses with its provisions
and reserves, its net worth will fall to zero in around three years and the BOJ will end up falling into
negative equity.
Fig. 1-19 Trend of the BOJ’s net worth
10(%)
Provision for possible losses on foreign exchange transactions
Provision for possible losses on bonds transactions
Capital accounts
Total net worth

8
6
4
2

(FY)

0
98

99

00

01

02

03

04

05

06

07

08

09

10

11

12

13

14

15

16

17

Note: 1.2017 is the first half (September 2017) value.
2. Capital accounts are the sum of Capital and Legal and special reserves.
Source: Bank of Japan

If the BOJ falls into negative equity, one possible way of ensuring financial soundness would be toraise the reserve requirement ratio to reduce payment of interest on excess reserves. Since the BOJ
does not need to pay interest to required reserve balances, raising the reserve requirement ratio would
help the BOJ to limit losses. However, this is, to all intents and purposes, nothing more than a banklevy and private banks will be forced to pass the cost onto depositors and borrowers in the future. If
the cost is not fully passed onto depositors, banks will end up bearing the cost themselves and, forbanks, whose margins have already grown much smaller, this may lead to worsening businessconditions which could in turn reduce the financial intermediary function and destabilize the Japanesefinancial system. Any significant increase in the reserve requirement ratio is unlikely to offer arealistic solution because when changing reserve ratios, the burden placed on private financial
institutions needs to be considered (Article 4 of the Act on Reserve Deposit Requirement System).
When the US Reserve Bank’s incomings are less than its outgoings, the Fed’s net worth will not be
hurt because under accounting regulations, payments to the Treasury are suspended and a negative
amount is booked on the liabilities side of the balance sheet of the Fed as Accrued Remittances toTreasury (a deferred asset). If the BOJ were to create a deferred asset like the Fed, this raises theprocedural issue of changing the BOJ’s accounting methods and also the question of when the Bank
could recover the negative deferred assets recorded on its balance sheet. It may take the BOJ as longas 20 years to recover the losses incurred in the process of normalization. Even if the BOJ changes its
accounting methods, the fact remains that the BOJ will to all intents and purposes fall into negative
net worth.
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1-4-2 After falling into negative equity, will the BOJ’s policy be distorted by government
demands?
A central bank which is recognized as having the exclusive right to issue currency is likely to beable to continue its operations even if it falls into negative equity. Suda (2003) gives two reasons why
it is not a problem for a central bank to have negative equity, namely (1) a central bank will neverdefault on obligations denominated in its own national currency because it has the exclusive right toissue banknotes and current deposits at the central banks; and (2) the government, which has the rightto collect taxes, to all intents and purposes entirely guarantees the liabilities of the central bank. But
more essentially, we must question whether, if and when the BOJ falls into negative equity, central
bank policy will not be distorted as a result. In general, the time horizons of the central bank and thegovernment are considered to be different. Whereas the central bank tries to conduct monetary policy
over a medium-to-long-term time span because it takes one or two years for policy effects to appear,
the government tries to stimulate the economy over a shorter time span, conscious of the next election.
If the central bank is less independent, making it more difficult to refuse government demands, evenwhen monetary tightening becomes necessary, the central bank may have no choice but to leave
inflation unchecked.
Referring to Stella (1997, 2002), who argues that the ability of the central bank to achieve its policy
target is seriously undermined if it falls into negative equity, Ueda (2003) gives two reasons for thehigh inflation in many countries whose central bank has fallen into negative equity, including Latin
American countries. One reason is that when a central bank tries to overcome negative equity by itself,
it needs to earn a large amount of seigniorage and thus high inflation becomes necessary. Anotherreason is that when fiscal provisions to eliminate the negative equity are prepared, this gives the fiscal
authorities room to interfere with monetary policy and “policy targets that are not always consistent
with price stability may restrict central bank activity.” Whether the central bank tries to restore its
financial health by itself or whether it seeks support from the fiscal authorities, there is the risk thatprice stability will no longer be achievable. As a rule, the money collected from taxpayers can be used
for government expenditure only after approval of the budget in the Diet.
The central bank must not prioritize ensuring its financial independence and abandon its
responsibility for price stability. A situation in which the policy target has been reached but monetary
tightening is still not possible from the viewpoint of JGB management policy could lead toundesirable rate hikes and currency devaluation (loss of confidence in the Japanese yen) and turn out
to be counterproductive.

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1-5 If the government does not cover the BOJ’s losses - the problem of the distribution ofseigniorage
It has been pointed out in connection with the BOJ’s losses that the BOJ should increase theissuance of currency to increase seigniorage. Broadly speaking, seigniorage can be divided into thefollowing three types. The “monetary base seigniorage” treats newly issued currency as the central
bank’s revenue. The central bank can earn income such as interest from assets purchased with issued
currency. This interest income is the second type seigniorage called “opportunity cost seigniorage.”
The third type “inflation tax seigniorage” arises from the erosion of the real value of assets held byprivate entities when inflation occurs as a result of the issuance of currency. Under inflationary
conditions, the real value of government bonds falls and the government that issued the government
bonds earns the final profit. This is called inflation tax because it allows the government to reduce thevalue of its obligations without relying on unpopular taxation.
Next, let us consider the income and expenditure of the central bank and the government (Fig. 1-20).
Neither the central bank nor the government is allowed to spend more than it earns. The amount offinancial resources the central bank and the government raise is, therefore, their spending limit. The
central bank generates financial resources through the issuance of currency, interest income on assets
held (seigniorage), and net worth carried forward from the previous period9. Meanwhile, it uses thesefinancial resources to purchase assets, pay ordinary expenses and IOER. Since the central banksupplies money in exchange for assets held by the private sector, the amount of asset purchases isequal to currency issuance. If the sum of asset purchases, expenses and interest payments is less than
the sum of currency issuance and interest income from assets, a portion of the difference is carriedforward to the following period as net worth and the remainder is paid to the government as payments
to the national treasury. Conversely, if the central bank spends more than currency issuance andinterest income from assets held, it draws down its net worth accordingly (at such time the reserved
amount of net worth is negative and net worth carried forward to the following period decreases).

9

For simplification, the means used by the central bank to raise funds have been limited to currency issuance, interest
income and net worth, but the central bank can also raise funds by selling (redeeming) the JGBs it owns as stock. However,in this case, the central bank’s reserves (or the government deposit) will decrease by the amount of the sale (redemption) of
the JGBs. If the funds raised will ultimately be used by the central bank, net worth carried forward to the following period
decreases.

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April 6, 2018

Fig. 1-20 Budget constraints of the central bank and government

Budget Constraint

CentralBank

Expenditure

Financial Resources

Purchase of treasury
bonds

Issuing of money

Operation cost
Interest on excess reserve

൑Payment to treasury

Interest income(Treasury bonds etc.)

Net worth to next period

Net worthTax revenue

Government

Operation cost൑

Payment to treasury
Issuing of treasury bonds

Treasury bonds interest

When the BOJ heads for monetary normalization in the future, it may incur losses in excess of its
net worth. If expenditure exceeding its financial resources is required, the BOJ will temporarily fall
into negative equity. To satisfy the budget constraint shown in Fig. 1-20, the central bank must either
issue currency or bolster its net worth through a capital injection, etc. from the government (anyincrease in interest income from assets would not materialize until the following period or later). In
this event, the issuance of currency would be backed by assets such as perpetual bonds that are, to all
intents and purposes, worthless, something akin to helicopter money.
Even if the central bank temporarily falls into negative equity, provided it can generate sufficient
seigniorage revenue in the future and can reduce its expenses, it may not be a problem. This is where
it is necessary to consider intertemporal budget constraint, taking future expenditure and revenue into
consideration. Buiter (2007) imposes constraints as shown in Fig. 1-21 that apply to assets andliabilities for the indefinite future. These include that the central bank must keep the assets that backthe currency on its balance sheet indefinitely. This means that the central bank must at some stage
return the capital injection received from the government or the helicopter money. The government on
the other hand must not keep the liabilities (government bonds) on its balance sheet indefinitely.
Fig. 1-21 Constraints on the balance sheets of the central bank and the government
Central bank

Solvency constraints
The present discounted value of the assets≧0

Government

The present discounted value of the liabilities≦0

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How should the central bank and government approach the generation and use of financial
resources in each period to satisfy the above constraints? Fig. 1-22 shows the intertemporal budget
constraint. Provided the intertemporal budget constraint is satisfied, even if the central bank falls into
negative equity at some point, it will be able to avoid going bust in the long run through future interest
revenue, the reduction of expenses, etc.
Fig. 1-22 Intertemporal budget constraints of the central bank and government

Intertemporal Budget Constraint

CentralBank

Expenditure

Financial Resources

Purchase of treasury bonds

Issuing of money

Operation cost

Interest income

Interest on excess reserve൑

Net worth

Net worth to next period
Future interest on excess reserveand operationg cost

Future interest income

Future payment to treasury

Issuing of treasury bonds

Tax revenue
Payment to treasury

Operation cost

Government

Treasury bonds interest൑

Future payment to treasury

Future operation cost
Future tax revenue
Future treasury bonds interest
Note: Future values are discounted at the present value.

1-6 What will happen if the BOJ falls into negative net worth? Possibility that the government’s
compensation of losses will develop into a political issue
There is the risk that the BOJ will incur losses on exiting QQE in the future and fall into negative
net worth. Who will compensate the BOJ’s losses? What does the negative net worth of the central
bank mean? The former Bank of Japan Act of 1942 stipulated that if the BOJ incurred losses, thegovernment should compensate an amount equal to the shortfall. However, in the existing Bank ofJapan Act, which took effect in April 1998, there is no provision regarding the compensation of losses.
The existing Act states that the BOJ should pay earnings from monetary policy operations to theTreasury but the Act implicitly says that the Bank will be responsible for dealing with losses should

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they incur. If the BOJ were to receive compensation for losses from the government, measures such as
special legislation are likely to be required.
Some may argue that if the BOJ has paid its profit to the government in the past, it is unfair to
expect it to deal with the losses it will incur in the future by itself. What is more, government
borrowing costs have been kept lower thanks to the BOJ’s pressure on long-term interest rates under
the new phase of monetary easing. As pointed out by Iwata and Japan Center of Economic Research(2014), the issue of compensation of central bank losses is important as it relates to the nature of thecentral bank independence and touches on the distribution of seigniorage and subtleties between
monetary and fiscal policy. Oguri (2010) explains that “even if the central bank has negative net worth,
it can continue operating because it has the right to issue banknotes. However, if, for example, thecentral bank issues more banknotes to cover its own net worth, this will threaten the central bank’s
goal of maintaining price stability, and if the central bank received compensation for losses from thegovernment, this will hurt central bank independence.” If the government compensates the BOJ’slosses, this may lead to a loss of confidence in future monetary policy and the value of the currency
and trigger a sudden rise in interest rates and yen selling. It could also suggest a further increase ingovernment debt, which is already more than 2.5 times the size of Japan’s nominal GDP10.
As a result of the new phase of monetary easing, which has been maintained for five years, theyield on yen-denominated assets on the BOJ’s balance sheet has already fallen below 0.3%. If the BOJ,
with Kuroda at the helm for a second term, maintains the next phase of monetary easing, some kind of
arrangement will need to be reached between the BOJ and the government on how to deal with thelosses that will be incurred on exiting QQE in the future. The details of the arrangement will need to
be spelled out to the Japanese people in advance to prevent chaos on financial markets should the BOJ
fall into negative equity, and the arrangement has to be made public.

1-6-1 The question of monetary policy territory and debt management policy territory - Monetary
policy that is to all intents and purposes monetization
When the BOJ decided to adopt quantitative easing policy in March 2001, it confirmed thebanknote rule which requires that the BOJ ensure that the outstanding amount of long-term JGBs it
holds is less than the outstanding balance of bank notes issued. The banknote rule was adopted to
avoid lock-in of the assets held by the BOJ and to ensure sufficient flexibility in money market
operations. Moreover, “the rule clearly indicates that the Bank’s purpose in purchasing JGBs is neither
to support prices of JGBs nor to finance government expenditures11.” (Bank of Japan Monetary
10
11

Based on general government (central government, local government, social security fund).
Article 5 of the Public Finance Act states that “All the matters concerning the issue of public bonds shall be undertaken by

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Affairs Department (2004)) However, the banknote rule was also to all intents and purposes shelved
under QQE adopted in April 201312. The outstanding amount of long-term JGBs held by the BOJ was
423 trillion yen as of the end of January 2018, ballooning to 4.1 times the outstanding balance of banknotes issued.
A breakdown of the long-term JGBs held by the BOJ by type shows that the BOJ holds around 70%
of outstanding 5-year coupon-bearing JGBs and around 50% of outstanding 2-year bonds (Fig. 1-23).
5-year bonds accounted for a 69.2% share of the BOJ’s bond portfolio as of the end of December 2017,
which is the highest level since July 2015 when this data first became available. The share of 10-year
JGBs, which have been issued in large quantities, also rose to 50.8%, and the BOJ has bought up halfof the total amount issued.
Fig. 1-23 The BOJ holds around 70% of outstanding 5-year JGBs
80(%)
5-Year70
60

2-Year50

10-Year

40
20
10
0

40-Year

20-Year30

Floating-rate bond(Monthly)

Inflation-indexed bond
30-Year

15/07
15/10
Source: Bank of Japan

16/01

16/04

16/07

16/10

17/01

17/04

17/07

17/10

18/01

The monetization of government bonds is also referred to as monetary financing, and means that thecentral bank directly underwrites government bonds issued by the government and purchases them inthe open market. Okina (2011) states that monetization differs from conventional monetary control inthe sense that monetization considers increased government spending and government bond purchases
as one set. Based on the forecasts for prices indicated in the Outlook Report and consensus forecasts,
expansion of the monetary base under the BOJ’s inflation-overshooting commitment can be expected
to continue for the time being. Money supply will be accompanied by purchases of assets such as
long-term JGBs and ETFs. If the government increases spending in the meantime, there is theundeniable possibility that the BOJ’s monetary operations will look more and more like monetaryfinancing.
Also from the perspective of debt management policy, YCC is a policy that reduces government

The Bank of Japan (The BOJ), but The BOJ shall not lend money. However, in special circumstances The BOJ shall be able
to lend money within the amount approved by the Diet resolution,” and the BOJ is prohibited from underwriting JGBs.
12
On adopting QQE, the BOJ said that it would “temporarily suspend” the banknote rule.
April 4, 2013, Bank of Japan “Introduction of the ‘Quantitative and Qualitative Monetary Easing’”(https://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf)

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borrowing costs (the interest on 10-year long-term JGBs) to zero. Under YCC, unless government
debt grows significantly, the government’s interest expense is unlikely to increase sharply. Surely thisindicates that monetary policy is encroaching on the territory of Japan’s debt management policy.
What is more, “qualitative easing,” which includes purchases of risk assets such as ETFs and
J-REITs in addition to purchases of long-term JGBs, is a policy that can bring about fiscal cost in the
future. If the BOJ continues to purchase ETFs at the current pace, it may have difficulty selling themupon exiting QQE, while continuing to hold them could jeopardize its financial soundness (Fig. 1-24).
It has been pointed out that by increasing the share of indirect holdings in its portfolio, the BOJ
hollows out its market supervisory role and may affect corporate management (Samikawa and Takano(2017)).
Fig. 1-24 Expansion in the size of the ETF market in line with the BOJ’s purchases
25(Trillion yen) 【Value of ETFs held by the BOJ】

20

500

【BOJ's J-REIT Holdings】

400

Book Value
Market Value

15(Billion yen)

300

10

200

5

100

0
11/03

(Semi-annualy)
12/03

13/03

14/03

15/03

16/03

(Monthly)

17/09
17/03

0

10/12

11/12

12/12

13/12

14/12

15/12

16/12

18/01
17/12

Source: Bank of JapanThe maturity mismatch between assets and liabilities on the BOJ’s balance sheet has widened
because the BOJ has supplied a huge amount of monetary base through purchases of long-term JGBs.
Whereas the average maturity of long-term JGBs on the assets side was 7.5 years as of the end of
2017, the bank’s current account which shares the majority of BOJ’s liability is ultra-short-term debt.
What does the expansion of the BOJ’s balance sheet mean? As a result of the BOJ’s large scale JGB
purchases, the BOJ has replaced the private sector as the recipient of government interest payments.
Some take the view that because the BOJ’s profit flows back to the government as payments to theTreasury, there will not be a financial crisis in the future even if interest rates do rise if the bankretains its earnings. However, in terms of integrated government, i.e. general government (central
government, local government, social security fund) and the BOJ combined, government deposits(government assets and BOJ liabilities) and the JGBs held by the BOJ (government liabilities and BOJ
assets) cancel each other out and fall off the integrated government’s balance sheet (Fig. 1-25). This
leaves the monetary base i.e. the sum of banknotes and reserve balances, and JGBs held by the private
sector on the liabilities side of the integrated government balance sheet.

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Fig. 1-25 Integrated government balance sheet (conceptual diagram)【Government's Balance sheet】
ASSETS【BOJ's Balance sheet】

LIABILITIESASSETS

Japanese government
securities（BOJ's
holdings）

Assets

Deposits of theJapanesegovernment
securities (Private
sector holdings)

LIABILITIES【Integrated government balance sheet】
ASSETSBanknotes＋

Japanesegovernment
securities
Loans and bills
discounted etc.

Current accounts
deposits

Assets

Deposits ofthe government

Loans and bills
discounted etc.

Excess debt

LIABILITIESBanknotes
Current accountdeposits

Monetary
Base

Japanesegovernment
securities (Private
sector holdings)
Excess debt

Source: Adding to Iwata, Samikawa and Japan Center for Economic Research (2016)

Since November 2008, under the Complementary Deposit Facility, the BOJ has been paying intereston excess reserves, which are bank reserves above and beyond the legal reserve requirement. In
addition, under the negative interest rate policy which the BOJ decided to adopt in January 2016, theBOJ incorporated a three-tier structure for interest payment on reserves and decided to apply anegative interest rate of minus 0.1% to policy-rate balances13. The balances to which the negativeinterest rate is applied account are equivalent to just 5% of total bank reserves (out of bank reserves of
349 trillion yen (as of the end of January 2018), policy-rate balances amount to 18 trillion yen).
While the government has increased debt with relatively long maturities within an ultra-low interest
rate environment, the BOJ has purchased large amounts of long-term JGBs in the new phase ofmonetary easing. That said, the integrated government balance sheet shows that the maturities of
liabilities have just become shorter and it is certainly not the case that interest-bearing debt i.e. JGBs
has disappeared. The BOJ’s raising of the policy rate on exiting QQE means that the government’s
JGB interest payments will be replaced with the BOJ’s IOER payments. As Ikeo (2014) points out,
“from an integrated government perspective, the government and the BOJ are working at crosspurposes.”
Until now, the government and the BOJ have both aimed to overcome deflation. The BOJ has
expanded the supply of the monetary base for early achievement of the price stabilization target, andin the meantime, the government has issued JGBs at low rates of interest and managed to curb the
expansion of interest payments. However, when the BOJ switches to monetary tightening in theprocess of normalization, the government will have to borrow at higher rates of interest than now.
What is more, if the BOJ incurs losses, payments to the Treasury will decrease, or in the worst casescenario, the BOJ will need public funds to cover the losses. To prepare for such a scenario, thegovernment and the BOJ need to come to some kind of arrangement about the allocation of profits and
13

The BOJ says that it will maintain the policy-rate balances at around 10 - 30 trillion yen and ensure that the negativeinterest rate does not excessively impact on the earnings of financial institutions.

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losses. The Bank of England (the “BOE”) has in the past come to an arrangement with the Treasury
before introducing its quantitative easing policy. The arrangement was that (1) asset purchases would
be made using an Asset Purchase Facility (APF) that is separate from the BOE; (2) the amount andscale of purchases and the assets to be purchased would be determined by the UK Treasury; and (3) all
losses incurred in the future would be borne by the Treasury. Iwata and Japan Center for Economic
Research (2014) mentions the fact that former BOE Governor Mervyn King said about loss
compensation that “the Bank has no democratic mandate to put taxpayers’ money at risk.” Thequestion of central bank independence raises its head.

1-7 Why did prices stubbornly refuse to rise under QQE?
Almost five years have elapsed since the introduction of QQE but the 2% price stability target has
yet to be reached. Widely identified reasons for the failure to reach the price target include a halt inthe yen’s depreciation, falling commodity prices, and sluggish wage growth. Meanwhile, structural
factors preventing prices from rising include (1) insufficient adjustment of service prices for changes
in quality, (2) public utilities charges that rise slower than in other countries, and (3) the expansion of
online shopping.
Calculation of the consumer price index includes “quality adjustment” whereby an improvement inquality is deemed to be a reduction in price. In the case of food, etc., a decrease in quantity for thesame price is seen as a price increase in real terms. On the other hand, it has been pointed out that
service prices have always been difficult to adjust for changes in quality. It has been reported that 65%of the services included in the Corporate Services Price Index produced by the BOJ are services forwhich quality adjustment is difficult (Nishioka, Kikegawa and Higo(2010)). Services account for alarge proportion of the CPI, suggesting the possibility that the inappropriate quality adjustment
method is failing to fully capture the real price situation.
In the past few years, the labor market has tightened, and decline in the quality of services as aresult of chronic labor shortages has been pointed out. In view of the current situation where, despitelabor shortages, the rising cost of labor has not been passed through to service prices and services
prices have not risen, it is possible that adjustment for labor shortages is being made by lowering thequality of the services provided. This is an increase in service prices in real terms.
In the System of National Accounts, it is assumed that house-owning households are engaged in thereal estate business (housing rental business) as well as purchasing housing rental services. The
operating surplus and personal consumption expenditures of households include “imputed rent,” andthis imputed rent accounts for around 15% of the CPI. However, private rent, which is the basestatistic for imputed rent, has been in a gentle downward trend since 1999. Even in phases when all
prices excluding imputed rent, were rising, rents have consistently continued to fall. The Statistics
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Commission of the Ministry of Internal Affairs and Communications has been discussing the quality
adjustment of rents, and announced the results of its estimates, saying that if quality adjustment were
made, private rent would be pushed up around 0.7 percentage points on an annualized basis. If quality
adjustment of rents is achieved, the headline CPI is expected to be pushed up by around 0.1
percentage points.
1-7-1 Public utilities charges that rise slower than in other countries
In Japan, public utilities charges have remained flat for many years due to the impact of direct
price regulation (regulation of prices by law and by ordinance) by the Government (Fig. 1-26). In themeantime, in the U.S. and Europe, thanks to public enterprise reforms in the 1990s, public charges
have been raised from the viewpoint of improving fiscal discipline. According to Shintani, Kurachi,
and Nishioka (2016), if Japanese public enterprises raise public charges (excluding expressway tolls,
public senior high school tuition fees, electricity and city gas charges) towards 2020 to balance theiraccounts, the public charges included in the CPI would rise 1.5% on an annualized basis. This may
push up the overall CPI by almost 0.2 percentage points.
Fig. 1-26 Trend of public charges in Japan, the U.S. and Europe (left) and university tuition fees inJapan, the U.S. and France (right)
170
160
150
140
130
120
110
100
90

(CY2002=100)
Japan

U.S.

280

Euro area(CY2000=100)
Japan

U.S.

France

240
200
160
120
(CY)

80

（CY）

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 1700 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Note: 1.Utilities charge of U.S. is used from “Fuels and utilities”, and that of Euro area is used from “Administered Price”.
2.The university tuition fee in Japan is weighted average of private and national universities and that in France
includes tuition of short-term tertiary higher education.
Source: Ministry of Internal Affairs and Communications, Consumer Price Index, BLS, Eurostat, Haver Analytics

The public charges that show particularly slow growth compared to other advanced economics areuniversity tuition fees. Fig. 1-26 shows the trend of university tuition fees included in the CPI in Japan,
the U.S. and France. Whereas in the U.S. and France, average annual increases of 5% and 3%
respectively can be seen since 2000, in Japan university tuition fees show only an average annual
increase of 0.4%. Also in Japan, from FY2004, when national universities were incorporated, generalmanagement expenses grants from the government have decreased by 1% annually. However, since
FY2005, the tuition fees of national universities have not once been revised, and the reduction in
grants is thought to be being covered mainly by reduction in personnel expenses. If this reduction was

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covered by an increase in tuition fees, an increase of around 6% each year would be necessary.
Under its “Human Resources Development Revolution” policy, the Abe Administration aims to use
the proceeds from the consumption tax hike planned in October 2019 to eliminate fees for preschool
education and reduce the cost of higher education. Based on the details announced by the government,
the impact of eliminating fees for preschool education on headline CPI inflation was estimated. Whilethe elimination of preschool education fees will put downward pressure on prices, the impact is
expected to be only temporary. However if the policy is implemented a little at a time, with advanced
implementation and then full-fledged implementation, it may continue to push down inflation by
between 0.2 and 0.4 percentage points over two years.
1-7-2 Changes in price competition due to technological innovation
It has been pointed out that one of the reasons prices stubbornly refuse to rise is the spread of online
shopping. In “The Billion Prices Project”14of Alberto Cavallo and Roberto Rigobon of the US
Massachusetts Institute of Technology, online price data was collected every day from the websites oflarge retailers around the world and a price index was created. Fig. 1-27 shows the trend of daily
online price data created by Cavallo et al. and the headline CPI of the various countries. This data
covers at least 70% of the price statistics of each country (weight base) and in the U.S. and Europe,
online prices appear to capture the trend of the CPI. However, the prices in Japan show that there is a
gap between online prices and the CPI and that in recent years online inflation is lower than CPI
inflation.
Fig. 1-27 In-store prices and online prices in Japan, the U.S. and Europe
5.0(YoY, %)

5.0

(YoY, %)

5.0

4.0

4.0

4.0

3.0

3.0

3.0

2.0

2.0

2.0

1.0

1.0

1.0

0.0
-1.0
-2.0

U.S.（CPI）
U.S.（online prices）

0.0
-1.0
-2.0

(Daily)
-3.0
-3.0
10/03
09/07 10/12 12/06 13/12 15/07
15/05
Source: Cavallo and Rigobon (2016)

0.0

Euro area（CPI）
Euro area（online prices）(Daily)

11/08

13/02

(YoY, %)

-1.0
-2.0

-3.0
14/08 15/07
11/11

Japan（CPI）
Japan（online prices） (Daily)
12/10

13/10

14/10 15/07

According to Cavallo (2017), in Japan, online prices are as much as 13% cheaper than the retailprices of physical stores. It has been pointed out that in Japan online shopping has been slow to catchon, particularly among the elderly. Older consumers spend less for online shopping and in Japan, with
14

The Billion Prices Project（http://www.thebillionpricesproject.com/）.

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April 6, 2018its rapidly aging population, stores on the streets are perhaps not as exposed to price competition with
online stores as their counterparts in other countries. Older consumers tend to shop at general retailers
close to where they live, and their presence may make general retailers stronger in price negotiations.
The online shopping rate is rising especially among younger generations. Once groups of consumers
who are not reluctant to shop online become older, the prices of physical stores may converge toonline prices. If this trend grows, it may become a structural factor that pushes down consumer priceinflation in the future.
1-8 The monetary policy dilemma – The BOJ has backed itself into a corner.
Since the late 1980s, there was growing international recognition of the need to delegate monetary
policy to a central bank that is removed from short-term interests, i.e. politics, in order to achieve pricestability, and many central banks have been allowed a degree of independence. The BOJ was also
granted independence in a legal sense with the revision of the Bank of Japan Act in 1997. However,the BOJ is now in a situation where its independence will once again be called into question. This isbecause the BOJ is expected to incur losses in the process of monetary normalization. What is more,on exiting monetary easing in the future, the large amounts of JGBs held by the BOJ as well as risk
assets such as ETFs that track a stock index and do not mature may threaten the BOJ’s financial
soundness. Iwata and Japan Center for Economic Research (2014) pointed out soon after the adoptionof QQE that the compensation of the BOJ’s losses is a problem that touches on the distribution ofseigniorage and the subtleties between fiscal and monetary policy, and is an important problem that
relates to the nature of central bank independence.
If the BOJ issues more banknotes in an attempt to cover the losses itself, price stability will bethreatened. What is more, the size of seigniorage revenue greatly depends on the economic growthrate and long-term interest rates. If long-term interest rates increase in a low-growth environment, theBOJ’s potential seigniorage revenue will be limited. On the other hand, if the BOJ were to receive
compensation for losses from the government, the government may make increasing demands and the
BOJ’s independence may be harmed. The BOJ will face a dilemma: does it opt for financial soundness
or prioritize price stability?
The BOJ issues currency and purchases assets such as JGBs without obtaining the approval of theDiet. Especially since the adoption of QQE, it shelved the banknote rule and the JGB purchase rule,and relaxed voluntary methods on the purchase of JGBs itself. Almost five years have elapsed since
the adoption of QQE, and the BOJ now holds more than 40% of the outstanding amount of JGBs andis accelerating “BOJ trade,” which entails purchasing new JGBs that have just been issued fromfinancial institutions. This is why it has been pointed out that both in terms of the quantity and the
speed of purchases, the BOJ’s JGB purchases are “to all intents and purposes monetization.” If the
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BOJ had held its JGB holdings of more than 400 trillion yen until maturity, it may have been able toreduce the impact on the JGB market to some extent because the bonds would roll off the balance
sheet naturally without being sold. But under qualitative easing, the BOJ lengthened the maturity of its
JGB purchases to around 7 - 12 years. On the adoption of YCC, the BOJ did away with provisions on
the maturity of purchases, but the average remaining maturity of its JGB holdings lengthened to 7.5
years. If the BOJ tries to shrink its balance sheet simply by allowing maturing bonds to roll off, it willtake the Bank more than five years to reduce the amount of JGBs it holds by half.
Of the JGBs held by the BOJ, long-term JGBs that will reach maturity in 2018, for example, areestimated to exceed 50 trillion yen (Fig. 1-28). If the BOJ starts to shrink its balance sheet
immediately, the government, unable to expect purchases by the BOJ, will have to have the private
sector underwrite JGBs. It is preferable for the government to issue long-term debt in ultra-low
interest rate conditions, but the BOJ, looking for an exit, will want to guide interest rates higher, andthere is, therefore, the risk that the government and the BOJ will not be on the same page. The
boundary between government functions and central bank functions will become blurred, possibly
raising the question of where coordination between the government and the central bank finishes andwhere fiscal dominance begins.
Fig. 1-28 51 trillion yen of the JGBs held by the BOJ will reach maturity in 201860

(Trillion yen)

50
40
30
20
10
0
2018
19
20
21
22
23
24
Note: The outlook is based on the amount of the BOJ’s JGBs outstanding as of the end of December 2017.
Source: Bank of Japan

25

(CY)

In a democracy, independent organizations have inherent accountability. The Fed explained losses
that would be incurred in the normalization process in the House of Representatives, etc. at an earlystage and has sought understanding from the US public and market participants. It was in the FOMC
on December 2012 that it began discussions based on forecasts of actual losses. This was as much as
one year before it decided to start tapering quantitative easing in December 2013. In the meantime,
according to the Outlook Report presented by the BOJ in January this year, Japan will not reach its 2%
price stability target before “around FY2019.” What is more, under the YCC, the BOJ has quietly
begun to slacken the pace of its JGB purchases. If this is “stealth tapering” towards normalization as

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April 6, 2018

pointed out by market participants, or a “stealth exit,” it is surely not premature for the BOJ to present
some kind of estimate about the losses that will be incurred on exiting and to start smoothing the way
for the incurrence of fiscal costs (the burden on the nation). The BOJ would also probably prefer toavoid a repeat of Ben Bernanke’s shocking announcement in May 2013. BOJ Executive Director
Masayoshi Amamiya said as a nominee for the BOJ deputy governor, in a speech at the beginning ofMarch, that it was not the exit strategy but rather communicating the exit strategy to the markets thatwas really important. He also commented on past monetary policy, saying “the BOJ did not formulate
policy with the aim of surprising the markets – the effects of surprising policies probably will not lastlong.” Dialogue with the markets will become more and more important.

1-8-1 Will the BOJ put its foot on the gas? – Policy options if expansion of monetary easing
becomes necessary
Waseda University professor Masazumi Wakatabe, who was nominated as deputy governor
alongside BOJ Executive Director Masayoshi Amamiya, distanced himself from discussions of an exit,
saying “the nub of the problem is the length of the delay in achieving the main scenario (reaching 2%
by FY2019).” Indeed, there is a large gap (inflation forecast gap) between the timing of achievementof the 2% price stability target indicated in the BOJ’s Outlook Report and the inflation forecasts of 41
private sector economists (Fig. 1-29). Whereas, in the January 2018 Outlook for Economic Activity
and Prices (Outlook Report), the BOJ forecast that it is possible to reach the 2% price stability target
at around FY2019, according to the ESP Forecast, the average inflation projection for FY2019 does
not even reach 1%.
Fig. 1-29 The gap between the inflation forecast of the BOJ Outlook Report and the ESP Forecast(BOJ versus private sector)
2.0【FY17 Inflation Forecast】(YoY,%)

2.0【FY18 Inflation Forecast】(YoY,%)

2.0

1.5

1.5

1.5

1.0

1.0

1.0

0.5

0.5

0.5

(Quarterly)
0.0(Quarterly)

0.0

18:1
15:2 15:4 16:2 16:4 17:2 17:4
16:2
16:4
17:2
17:4 18:1
BOJ (Outlook for Economic Activity and Prices, Median)
Source: Bank of Japan, Japan Center for Economic Research

0.0【FY19 Inflation Forecast】(YoY,%)(Quarterly)
17:2
17:3
17:4
ESP Forecast (Average)

18:1

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1-8-2 Can Japan bear additional fiscal costs?
While the BOJ is required to maintain QQE without any prospect of 2% inflation, the side effects also
give cause for concern. The BOJ finds itself in a completely hopeless situation. The prolongation ofmonetary easing risks fostering a bubble and reducing the financial intermediary function as a result of
the weakening of financial institutions. If the Next Crisis after the Global Financial Crisis occurs and theeconomy falls into recession, the options open to the BOJ will be limited.
There has also been discussion about the Next Crisis in the U.S. Reifschneider (2016) says that the best
way forward in the event of recession would be quantitative easing (large-scale asset purchase program or
LSAP) and forward guidance. However, Reifschneider (2016) explains that these would only be effective
in a normal economic environment (full employment and 2% inflation), and in an environment such as
the present, action in terms of fiscal policy would be necessary. The Fed is currently shrinking its balance
sheet, but Reifschneider (2016) suggests that if the Next Crisis comes, there is every chance of a return toquantitative easing.
But in its current financial condition, could Japan bear additional fiscal costs? In January 2018, thegovernment deferred its goal of achieving a primary surplus. While the banner of fiscal restoration has
not been dropped, if doubts over the government’s financial health arise and financial risk increases, themarkets may start to send warnings signs, including loss of confidence in JGBs, undesirable interest rises
and the plunge of the yen. But the question is whether Japan in its current state has enough strengthen left
to bear additional fiscal costs. In the monetary policy operations of the BOJ led by Kuroda in his second
term, a sense of distance from fiscal policy (the independence of the BOJ) is likely to become important.

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Japan Center for Economic Research
Financial Research Team

April 6, 2018

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