Concluding Panel Discussion:
Financial Markets andthe Real Economy
in a Low Interest
Rate Environment
Introductory Remarks
Stefan Ingves1
Sveriges Riksbank

Let me begin by thanking the Bank of Japan for hosting this conference and organizing
such an inspiring program with high-quality papers on subjects of great interest bothto central bankers and academics. I feel honored to have been given the opportunity
to chair this panel discussion.
The issues that will be discussed here today are challenging and involve questions
that most central bankers have considered and discussed during the last several years.
One question is whether the overall low levels of interest rates have resulted in increased
risk taking in the global financial system—that is, has there been a “search for yield”
among investors? Another important question relates to the intensely debated issue of
how monetary policy should deal with developments in asset markets and whether
there is a trade-off between financial stability and real stability. In my remarks, I would
like to describe my views on these issues, although it should be kept in mind that myremarks have a “home bias” in the sense that they do not deal with a post-bubble period
such as that of Japan.
Concerning the suggested trade-off between financial and real stability, I think it
is reasonable to assume that price stability in the long run promotes financial stability,
for example, by improving the functioning of the price system and thereby reducing
the risk of misallocated investment. This is not to say, however, that price stability isa guarantee of financial system stability.
One type of development that might cause difficulty is when structural factors
dampen inflation and induce central banks to keep interest rates lower than would
otherwise have been justified by, for example, the cyclical position of the economy.
It might be argued that there are some parallels between this description and recent
developments in the world economy. Central banks have certainly kept interest rates
low in recent years as inflation has been restrained. The low rates of inflation are, in
1. These remarks are written based on my introductory discussion given at the conference. The views expressed are myown and do not necessarily reflect those of the other members of the Executive Board of Sveriges Riksbank.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006
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235

turn, probably due in part to structural forces such as the integration of emerging
markets into the world trading system, which has put downward pressure on prices ofmanufactured goods. At the same time, prices of many kinds of assets have surged.
Indeed, the low policy rates may have led investors to “search for yield” in other assets
and markets, potentially with an under-pricing of risk as a result. However, taking alonger-term perspective, volatility in most markets has not been extremely low the last
few years—in fact, there is only one market where volatility has been unusually low inrecent years, and that is the money market.
Perhaps the area where the current low interest rate regime, outside of Japan,
has had its most marked impact is in residential property prices, and given the attention it has received from policymakers, academics, and the general public, I would
like to briefly comment on this. The rise in housing prices during the last 10 years
has indeed been unprecedented in duration, magnitude, and synchronization acrosscountries.2 This has led some commentators to label it history’s first global housing
bubble.3 Given the falling level and volatility of interest rates during the last few
years, it is no wonder that housing prices have surged. But a number of important
structural changes have occurred in the global housing finance market. The functioning of mortgage markets has improved, with, for example, technological advances,
new instruments, and better risk pricing and risk modeling.4 However, importantdifferences remain among domestic housing markets, and residential property
markets are to a large extent local markets; thus, prices are heavily influenced bydomestic factors such as developments in the real economy and structural differencesamong housing markets.
So, given the low inflation rates and surging asset prices, and again—this excludes
Japan—what does this mean for the conduct of monetary policy? It can be claimed thatthe inflation-targeting framework that most central banks follow today, explicitly or
implicitly, is—at least in principle—designed to deal with asset price developments
and financial imbalances “automatically.” If policies are applied with a high degreeof flexibility and the policy horizon is sufficiently long, it is in principle possible totake account of the full effects of financial imbalances accumulated over many years
on inflation and the real economy.5
In practice, of course, this task is far from easy. Since it can be quite difficult totell whether a financial imbalance is building up, let alone how and when it willunwind, it is inherently hard to incorporate these types of developments in a central
bank’s conventional analyses and forecasts. Yet, even though they are difficult totranslate into quantified forecasts, concerns about imbalances in asset markets must
be addressed somehow. One way to do this could be to let them affect somewhat
the timing of interest rate changes, for example, by starting a tightening cycle
somewhat earlier than would be justified by conventional forecasts of inflation andreal economic developments alone. It seems that this is essentially the way in which

2. See OECD (2005).
3. See, for example, The Economist, “In Come the Waves,” June 16, 2005.
4. See Committee on the Global Financial System (2006).
5. See, for example, Bean (2004) and White (2006).

236 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

central banks have tended to deal with, for example, the sharply rising housing prices
in some countries.
This is, however, hardly the last word on this matter, and I suspect that thequestion of how monetary policy best should deal with asset price developments inpractice will be on the agenda for quite some time yet.
One important channel through which monetary policy works is by shaping
long-term interest rates, which in turn affect the level of economic activity. Regardlessof whether a central bank conducts monetary policy in a traditional way (i.e.,
by adjusting the policy rate) or by a more unconventional method such as, for example,“quantitative easing,” shaping long-term interest rates has never been easy.6 In fact,
the empirical support for the expectations hypothesis—the crucial link between acentral bank’s instrumental rate and long-term interest rates—is rather mixed.7 And,of course, when it comes to long-term real interest rates, one can only hope for a
temporary effect anyway, since in the really long run, monetary policy cannot affectreal variables.
A further complication is that the monetary transmission mechanism may also
have changed. Housing finance is at least one area where the lower interest rateenvironment potentially has had a rather substantial effect. As mentioned earlier,
lower and less variable interest rates have increased the demand for housing loans,particularly the demand for adjustable rate loans.8 Hence, there has probably been afundamental change in the way monetary policy works, with the household sector
nowadays exhibiting more sensitivity to changes in the policy rate.9
In any case, it is quite likely that we must get used to a situation where domestic
long-term real interest rates are largely determined in a global market. This may have
implications for how we ought to look upon the interest channel of the transmission
mechanism.10 If long-term real interest rates are determined in the global market,
the central banks’ scope for affecting domestic real long-term yields—and hence
economic activity—through monetary policy would be reduced. However, since ourknowledge of the transmission mechanism in general is far from perfect, it is difficult
to infer today what the final consequences for monetary policy will be.
These are but a few reflections before the discussion starts.

References

Bean, C., “Asset Prices, Financial Imbalances and Monetary Policy: A Central Banker’s View,” remarks
at the American Economic Association Annual Meeting, San Diego, California, January 3, 2004
(available at http://www.bankofengland.co.uk/publications/speeches/2004/speech207.pdf ).
Bernanke, B. S., and V. R. Reinhart, “Conducting Monetary Policy at Very Low Short-Term Interest
Rates,” American Economic Review, 94 (2), 2004, pp. 85–90.

6. See Bernanke and Reinhart (2004) for an overview of monetary policy strategies that do not target the policy rate.
7. See, for example, Thornton (2004).
8. See Committee on the Global Financial System (2006).
9. See Sellon (2002).
10. See Thornton (2005).

237

Committee on the Global Financial System, “Housing Finance in the Global Financial Market,” CGFS
Paper No. 26, Bank for International Settlements, 2006.
Organisation for Economic Co-operation and Development, “Recent House Price Developments: The
Role of Fundamentals,” OECD Economic Outlook No. 78, December, 2005 (available at
http://www.oecd.org/dataoecd/41/56/35756053.pdf ).
Sellon, G. H., Jr., “The Changing U.S. Financial System: Some Implications for the Monetary
Transmission Mechanism,” Economic Review, Federal Reserve Bank of Kansas City, First
Quarter, 2002, pp. 5–35 (available at http://www.kc.frb.org/PUBLICAT/ECONREV/PDF/
1q02SELL.pdf ).
Thornton, D. L., “Predictions of Short-Term Rates and the Expectations Hypothesis of the Term
Structure of Interest Rates,” Working Paper No. 2004-010A, Federal Reserve Bank of St. Louis,
2004 (available at http://research.stlouisfed.org/wp/2004/2004-010.pdf ).
———, “The Monetary Policy Transmission Mechanism?” Monetary Trends, Federal Reserve Bank of St.
Louis, September, 2005 (available at http://research.stlouisfed.org/publications/mt/20050901/
cover.pdf ).
White, W. R., “Is Price Stability Enough?” BIS Working Paper No. 205, Bank for International Settlements,
2006 (available at http://www.bis.org/publ/work205.pdf ).

Panelists’ Remarks
Christine M. Cumming
Federal Reserve Bank of New YorkLet me thank the organizers of the conference for inviting me to speak today about
the U.S. experience with low interest rates in 2003.
To set the stage, consider the economic circumstances in early 2003. The recessionthat began in the spring of 2001 and the recovery that began late that year deviatedsubstantially from the average cycle since 1960 in the key dimensions of real GDP,
real business fixed investment, and nonfarm payroll employment. In Figure 1, each ofthese dimensions is indexed to one at the trough of recessions prior to 2001 to create
an average path of recession and recovery observed since 1960. The comparable paths
around the trough in 2001 are shown in Figure 2, and quarters 4 through 6 after
the trough correspond to late 2002 and early 2003.
In early 2003, the quality and durability of the recovery was in question. RealGDP had grown more slowly than in the average cycle. More striking, employment
had failed to grow at all, creating the so-called “jobless recovery.” Subsequent research
has suggested that at least part of the anomalous behavior of employment at thattime related more to changes in the trend participation rate and less to cyclicalfactors, but that determination was not possible at the time. Business fixed investment, a major driver of the U.S. expansion in the 1990s, continued to decline steeply
after the recession’s trough. The challenge was to determine whether the sluggish
recovery in investment reflected “overhang” from the boom of the late 1990s, or amore fundamental retrenchment in sentiment or underlying opportunities.

238 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

Figure 1 Average of Cycles since 1960

1.40

Ratio
Real business fixed investment

1.32

1.24
Real GDP
1.16

1.08
Nonfarm payroll employment
1.00

0.92
–8

–4

0

4

8
12
16
20
Quarters since business cycle troughNote: Series set to one at National Bureau of Economic Research (NBER) businesscycle trough. Shaded area represents average length of NBER recession.
Source: Bureau of Economic Analysis.

Figure 2 The Current Cycle

1.40

Ratio

1.32

1.24
Real business fixed investment

1.16

1.08

Real GDP

Nonfarm payroll
employment

1.00

0.92
–8

–4

0

4

8
12
16
20
Quarters since business cycle troughNote: Series set to one at NBER business cycle trough. Shaded area represents
average length of NBER recession.
Source: Bureau of Economic Analysis.

239

Inflation measured by the core personal consumption expenditure (PCE) deflator
and the core consumer price index (CPI) ebbed after the 2001 recession, falling
toward 1 percent. Figure 3 places the behavior of inflation measured by the core PCE
deflator during this episode in the broader context of extensive disinflation in the
1980s and 1990s.
The Federal Open Market Committee (FOMC) of the Federal Reserve System
had already responded very aggressively to economic weakness in 2001. As shownin Figure 4, the FOMC reduced the federal funds target from 6.5 percent at its
mid-2000 peak to a low of 1.75 percent by the beginning of 2002.
What these data cannot fully convey is the substantial uncertainty faced by policymakers in early 2003. A full year after the recession had ended, both employment
and investment were below their levels at the trough and core inflation was falling.
The unsatisfying economic performance occurred despite aggressive easing by the Fed
and substantial federal fiscal stimulus. With the potential need for further monetaryeasing, the zero bound on interest rates appeared as a significant future constraint,even if some distance away. A related practical question was how monetary policy
should best utilize the remaining distance between prevailing rates and the zerobound, should it prove necessary. In the event, the FOMC reduced its federal funds
target twice more, in November 2002 and June 2003.
The developing academic literature on monetary strategies in the presence of low
interest rates was influential in the face of this uncertainty. An important case study
Figure 3 Core PCE Inflation

10

Year-on-year percentage change

9
8
7
6
5
4
3
2
1
0
1979

84

89

94

99

Note: Shaded areas represent NBER recessions.
Source: Bureau of Economic Analysis.

240 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 20062004

Concluding Panel Discussion

Figure 4 Monetary Policy Challenges

7

Percent

6
5
Federal funds rate target

4
3
2
1

How to avoid
the zero bound?

0
1995

96

97

98

99

2000

01

02

03

04

05

06

Note: Shaded area represents NBER recession.
Source: Federal Reserve Board.

for the literature was the experience of Japan since its recession in 1991. One strandof research examined how an already slow economy would respond at low interest
rates to more or less aggressive central bank interest rate reductions in the face of anegative shock, and, among other analyses, assessed the risks of slipping into a serious
deflation. That work suggested the desirability of avoiding the zero bound. Anotherstrand considered what policy options were available once the zero bound wasreached.11 That strand described how central bank actions to influence expectations of
future policy could effect monetary policy easing in the presence of the zero bound.
The influence of this literature can be seen in the near-contemporaneous discussion of monetary policy issues by senior Fed officials Ben Bernanke and Vincent
Reinhart in late 2003.12 Bernanke and Reinhart noted that it was not necessary to
wait until the policy rate had reached the zero bound before influencing expectationsof future policy by choosing among various types of unconditional and conditional
commitments. They also suggested an assisting role for open market operations as ameans of demonstrating commitment to a communicated strategy.
The FOMC on August 12, 2003, incorporated forward-looking language into its
post-meeting press release, often called the “statement,” in what I would describe as
an implicit conditional commitment. Unlike the Bank of Japan around this time, the
FOMC did not provide a quantitative description of the economic conditions it was
11. Most notably, Eggertsson and Woodford (2003).
12. See Bernanke and Reinhart (2004).

241

seeking to achieve. Rather, its statement highlighted the “risk of inflation becoming
undesirably low” as the “predominant concern” of monetary policy “for the foreseeable future” and concluded that monetary policy accommodation “can be maintained
for a considerable period.”13 Over time, the evolution of the language of this implicit
commitment (“it [the FOMC] can be patient,” “at a measured pace”) evolved in linewith the changing assessment of the risk of an unwelcome further fall in inflation.
The behavior of asset prices in those financial markets that can be interpreted
as gauges of future expectations of monetary policy suggests that it took some time
for market participants to absorb the FOMC’s implicit conditional commitment.
When the Fed inserted the “considerable period” language into the August 12, 2003,
statement, the federal funds futures curve initially forecast higher forward interest
rates for a time, as shown in Figure 5, perhaps reflecting increasing signs of a morerobust economic recovery. Measures derived from the Eurodollar market, depicted in
Figure 6, provide additional context.14 The implied skewness measure derives fromthree-month to nine-month maturities of Eurodollar options and captures the implieddifference in probability between a rise and a fall in short-term interest rates; a negativevalue signifies that the probability of a decline outweighs the probability of a rise ininterest rates. The sharp rise from negative values of this measure in the summer of
Figure 5 Expected Federal Funds Target Rate, Fall 2003

3.0

Percent
Aug. 4, 2003 (Before “considerable period” statement)
Sep. 2, 2003
Oct. 2, 2003 (After statement)

2.5

2.0

1.5

1.0
1

5

9

13
Months forward

Note: Calculations by the Federal Reserve Bank of New York based on Eurodollar futures.

13. The August 12, 2003, and subsequent statements can be found at www.federalreserve.gov/fomc/.
14. I am grateful to my colleague Josh Rosenberg for bringing these measures to my attention and providing thecomputations for Figure 6.

242 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

Figure 6 Gauging the Stance of Monetary Policy

10

Percent

Percent“Consider- “Patient”
able period”

90“Measured pace”

5

75

0

60
Impliedskewness(left scale)

–5

45
30

–10
–15

15

Implied volatility(right scale)

–20
Aug.
2002

0
Feb.
03

July

Jan.
04

July

Dec.

June
05

Nov.

Note: Calculations by the Federal Reserve Bank of New York using Chicago
Mercantile Exchange data.

2003 suggests that market expectations were shifting from expectations of further
easing to an assessment that the next move in short-term interest rates could justas likely be a rise or a fall, even before the August statement. Implied volatilities
measured for the same instruments and maturities had begun to fall in early 2003,
but initially rose after the August statement and remained elevated for a time thereafter.
But with the repetition of the FOMC’s message in its subsequent statements, impliedskewness eventually turned mildly negative and implied volatility began a steep
decline—with much of the change occurring after FOMC statements had moved from“considerable period” to “measured pace.”
Another set of concerns in early 2003, reflected by Bernanke and Reinhart in late2003, involved how well institutional arrangements in the financial markets might fareat very low short-term interest rates. The United States had not experienced short-term
interest rates below 2 percent since the pre-inflationary period of the 1950s and early
1960s. Considerable transformation had occurred within the financial system in theintervening years. In the core markets of concern to central banks, the money market
mutual fund industry had developed as a substitute for bank deposits and expanded
substantially; the volume of securities lending and repurchase (repo) and reverse repo
transactions in the U.S. Treasury securities markets had grown exponentially; andcompetition in the U.S. banking industry had intensified at all levels.
Analysis and some experience in 2003 suggested that financial markets and market
infrastructures and arrangements were flexible enough to accommodate a return tovery low short-term interest rates and thus should not be an impediment to pursuing
an appropriate low interest rate policy. Consider money market mutual funds. By
convention, the returns earned by money market mutual fund shareholders are243reduced by the amount of fees and expenses. A risk existed that as interest rates on the
short-term investments made by money market mutual funds fell below 1 percent,money market fund shareholders would observe returns net of fees approaching zeroand shift their assets from money market funds to bank deposits. The risk appeared
low because (1) most money market funds had very low fees; (2) the convention on thetreatment of fees could be changed to an explicit charge, if necessary; and (3) a scenario
analysis of the impact of a major shift into deposits suggested that larger commercial
banks and their holding companies would be able to manage the major consequenceof an expansion of deposit liabilities, a reduction in capital ratios.
Actual experience in the Treasury markets provided a lesson in financial market
adaptation to the low-rate environment. A marked increase in Treasury security settlement fails occurred in the summer of 2003, as seen in Figure 7. The repo and reverse
repo markets are key funding markets for securities dealers and banks, and the Treasury
market is the baseline for pricing U.S. dollar securities; thus, the settlement issues wereof interest to the central bank. A securities seller typically fails to deliver securities
because of an operational problem. Under almost any other circumstance, the seller
can borrow the securities in the market and deliver them. However, if the cost of
borrowing the securities approaches the rate of return on general collateral repurchaseagreements, the seller becomes indifferent in choosing between a fail, where the seller
forgoes the general collateral rate, and borrowing the securities.15
Figure 7 Treasury Fails

1,800

Billions of fails

Total treasury receive
Total treasury deliver

1,500

1,200

900

600

300

0
Jan.
1995

Dec.
96

Nov.
98

Oct.
2000

Sep.
02

Aug.
04

Note: Calculations by the Federal Reserve Bank of New York.

15. For a discussion of why securities settlement fails occur, see Fleming and Garbade (2005). For a description of thefails problem in 2003, see Fleming and Garbade (2004).

244 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

The incentive for fails increased substantially in the summer of 2003 as interest
rates fell to very low levels, so that the gap between borrowing rates and generalcollateral rate was compressed, and technical factors associated with interest rate expectations increased the demand for borrowing. The result was a prolonged period ofhigh settlement fails. The concern at the time was that persistent fails could create
large counterparty credit risks and operational inefficiencies. A natural limit to theaging of fails results from high capital charges imposed on dealers after 60 days,
but substantial risk could accumulate before then. When the problem was at its
height, dealers innovated by creating a repurchase agreement with a stronger delivery
commitment (the guaranteed-delivery special collateral repo). This innovation
alleviated some market pressure, as did concerted industry efforts to clear the backlog
and the auctioning of new Treasury securities.
A final concern was the impact on depository institutions of a prolonged periodof low interest rates, especially since the maturity transformation involved in commercial lending occurs in the short end of the yield curve. In a normal business cycle,
short-term interest rates are low when the economy is weak, but the yield curve
typically becomes fairly steep. Flat yield curves tend to occur when the economy
is expanding, and net interest margins remain large because banks assume morecredit risk. Scenario analysis conducted by the Federal Reserve Bank of New Yorksuggested that a prolonged period of low growth accompanied by very low interest
rates and spread compression would put significant pressure on commercial banks.
The pressures seemed greatest for smaller, more traditional institutions focused
primarily on commercial lending, where margins were already thinning, while bankswith a larger share of non-interest income in revenues would fare better. As in the caseof mutual funds, it seemed likely that banks might cover the costs of collecting andmanaging deposits by raising deposit fees, if market interest rates were too low to allowbanks to absorb those costs. Banks pursuing a traditional commercial lending franchisewould also have the option to shift into other banking-related fee-based businesses.
How did the period of low interest rates come to an end? By the end of 2003, theeconomy showed signs of improvement, including growth in both employment andinvestment; inflation began to pick up by early 2004. The low growth, low interest
rate scenario did not materialize. By mid-June 2004, the FOMC began to raise thefederal funds rate target.
What lessons can be learned from the 2003 episode? These are my personal views.
First, the zero bound is a macroeconomic issue, a practical concern related to theability of the central bank to offset a negative shock if interest rates are already low.
It is an issue that is likely to stay with central bankers, at least in the background,as long as they are successful in keeping inflation rates low, a sort of dark lining to asilver cloud. With the policies undertaken in the summer of 2003, the FOMC
avoided reaching the zero bound. In large part, this appears to reflect the FOMC’s
success in altering market expectations. Distinguishing how much of the overallmacroeconomic impact to ascribe to monetary policy strategy and how much to thegreatly delayed but ultimately emergent forces of recovery in place before 2003 isa subject for future research. However, without those pent-up natural forces of245

economic recovery, it is possible that the monetary policy strategy might not have
had the same short-run impact.
Second, the FOMC made important changes in the manner in which it communicated policy during this episode that persist to the present. A question to be resolved
over time by future monetary policymakers and interpreted by monetary historians is
the role of the specific innovations in the policy statement in 2003–04 within the
FOMC’s long-term advances toward greater transparency.
Third, institutional arrangements in the financial system can adapt to a low interest
rate environment, but require timely engagement and coordination by financial market
participants, something the central bank can encourage.
Finally, in my personal view, the 2003 U.S. experience of low short-term interest
rates seems to support the case that central banks should aim for a low positive rate of
inflation, rather than zero. Data alone cannot recall the very considerable uncertainty
and concern about the efficacy of monetary policy at low short-term interest rates.
The principal reason for targeting a low positive inflation rate is to stay safely awayfrom the zero interest rate bound and the potential for deflation resulting from asevere negative shock. Moreover, research suggests that the economic costs of a low,
positive rate of inflation are small.
Economic research has an important role to play in illuminating the question of
low versus zero inflation. Central bankers would benefit from a concise descriptionof the dynamics of the macroeconomy at very low short-term interest rates in orderto understand the opportunities and risks in that setting. Such a description mightin turn lead to a very practical addition to monetary policymaking techniques.
If the concern about the zero interest rate bound is likely to recur sometime in
the future given successful pursuit of the goal of low long-term inflation, central
bankers would benefit from a clearer definition of deflation risk in terms of its
consequences for real incomes and employment and a robust measurement of thatrisk. A definition and measurement of deflation risk would be especially helpful
in communicating to the public a monetary policy strategy designed to combat
deflation, if and when necessary.

References

Bernanke, Ben S., and Vincent R. Reinhart, “Conducting Monetary Policy at Very Low Short-Term Interest
Rates,” American Economic Review, 94 (2), 2004, pp. 85–90.
Eggertsson, Gauti B., and Michael Woodford, “The Zero Bound on Interest Rates and Optimal Monetary
Policy,” Brookings Papers on Economic Activity, 1, 2003, pp. 139–233.
Fleming, Michael J., and Kenneth D. Garbade, “Repurchase Agreements with Negative Interest Rates,”
Current Issues in Economics and Finance, Federal Reserve Bank of New York, 10 (5), 2004.
———, and ———, “Explaining Settlement Fails,” Current Issues in Economics and Finance, Federal
Reserve Bank of New York, 11 (9), 2005.

246 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

Lucrezia Reichlin
European Central Bank

I. Introduction
I wish to thank the Bank of Japan for inviting me to this very interesting conference.
There are many reasons why central banks should understand monetary policy ina low interest rate environment, and one aspect of the problem is related to the zerobound on interest rates. This issue has received a lot of attention, particularly inJapan, and has been addressed by the previous panelist.
I will focus my remarks on a different issue, namely, the global decline of realinterest rates in the last 15 years, its possible causes, and the problem that this may
raise for the conduct of monetary policy, in particular, in the euro area.

II. A Few Facts and Questions
There are three facts I would like to focus on. First of all, nominal and real rates
have declined since 1990 and, in particular, since 2000. Second, there has been alarge increase in cross-country correlations of these rates, suggesting that these
dynamics are driven by a global factor which is quite independent from local developments in real economic growth. Third, in 2004–05 we observed a resilience of thelong-term nominal rate with respect to changes in the short-term rate in the UnitedStates and possibly elsewhere (this is what then-Federal Reserve Chairman Alan
Greenspan called the “conundrum”).
Figure 1, which plots the ex ante (survey-based) 10-year real interest rates forGermany, the Euro area, Japan, the United Kingdom, and the United States since
1990, illustrates the decline in real rates and their cross-country correlation.
These facts have been extensively commented on in the policy and academic
debate, but it is still difficult to develop an analysis that can account for all of them.
Can we learn anything by looking at euro area developments within the global
economy context?
Several factors have been discussed to explain declining long rates: declining risk
premiums due to decreasing real (great moderation) and nominal volatility (monetary
policy), global liquidity, or real global developments. As for global developments, thesavings glut hypothesis has received particular attention.
It is very difficult to identify these factors separately.
Part of the difficulty is that in the period we are considering we have seen both adecline in the variability of output growth and inflation and a decline in the level ofinflation. Estimated risk premiums capture all these phenomena, but are they driven
by monetary policy, which has stabilized inflationary expectations, the decline ofglobal inflation driven by increasing competition from emerging markets, or by thedecrease in the volatility of exogenous shocks?

247

Figure 1 Survey-Based 10-Year Real Interest Rates

9

Percent

8

GermanyEuro areaJapan
United Kingdom
United States

7
6
5
4
3
2
1
0

–1
Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan.
1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05
Note: Calculations by the European Central Bank.

Estimates based on micro-founded models linking macroeconomic and financial
factors typically find declining risk premiums for the euro area as well as for the UnitedStates, but these estimates are very uncertain and the extent of the decline varies acrossdifferent specifications.16
Another problem with risk premium estimates is that they are difficult to interpret.
Risk premiums are a black box, often capturing misspecification error, and they are very
sensitive to the parametrization of the model. Again, are these estimates reflecting realor nominal uncertainty, smaller exogenous shocks, or more virtuous policy?
It is always a good idea to give the simplest explanation a chance. Therefore,
I want to start from the hypothesis that the dynamics of the real rate reflect anequilibrium phenomenon.

III. The Real Equilibrium Rate and Heterogeneity inReal Developments
Does the decline in real rates in the United States, the euro area, and Japan reflect a
decline in their equilibrium value?
If yes, how is this possible given that the dynamics of real developments (output
growth, savings, and investment) have been heterogeneous across countries? Figure 2
illustrates some aspects of the euro area and U.S. heterogeneity in real developments
16. For euro area estimates, see Carsten Detken’s discussion in this volume (Detken [2006]).

248 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

by plotting the investment ratio (I/Y ) and the savings ratio (S/Y ) since 1990 against
the real 10-year interest rate. Both areas have experienced a decline in the real interest
rate, but while in the euro area we have seen a downward trend in the investment
and savings ratios, in the United States the savings ratio has no clear trend, while theinvestment ratio points upward.
Is this a puzzle? Let us suppose that the demand for investment has been declining
in Japan and Europe for autonomous reasons, either temporarily or permanently. In aclosed economy, this downward shift would reduce equilibrium savings and interest
rates only in these two blocs. In an open economy with capital mobility, on the other
hand, if the decline is big enough to affect the global demand for investment, theglobal interest rate would also fall. However, there would be heterogeneous effects, as
Figure 2 Euro Area and U.S. Savings and Investment Ratios[1] United States
0.24

7.5
Investment (left scale)
Savings (left scale)Real 10-year (right scale)

0.22

6.5

0.20

5.5

0.18

4.5

0.16

3.5

0.14

2.5

0.12

1.5
1990 91

92

93

94

95

96

97

98

99 2000 01

02

03

04

[2] Euro Area
0.24

7.5

0.22

6.5

0.20

5.5

0.18

4.5

0.16

3.5
Investment (left scale)
Savings (left scale)Real 10-year (right scale)

0.14

2.5

0.12

1.5
1990 91

92

93

94

95

96

97

98

99 2000 01

02

03

04

Source: OECD.

249

investment will fall more than savings in Japan and Europe, whereas it will be abovesavings in the rest of the world. Therefore, in this case, a declining global equilibrium
real rate would be consistent with the observed growth differentials between the
United States on the one hand and Japan and the euro area on the other. In this
scenario, global growth would generally be below potential, since global demand
driven by investment has decreased.
This is indeed what may have happened in the global economy. Figure 3 plots theOECD average saving-output ratio. Since the OECD is roughly a closed economy
and roughly represents the world economy, the picture can be taken as describing the
dynamics of the savings-investment equilibrium, and it shows that on the whole thelatter has been declining over the period.
Yet actual world growth is quite robust, and this may seem to pose a challenge forthe equilibrium explanation of declining real rates. However, world growth is robust
mainly because of countries like China, which are mainly financing their investment
with domestic savings. Investment demand originating in these countries is therefore
not putting an upward pressure on interest rates; on the contrary, perhaps suchcountries are contributing to the downward pressure through high savings.
Although the savings glut hypothesis has received a lot of attention, I would liketo stress the importance of declining investment as an alternative explanation: theobserved dynamic of the real rate reflects an equilibrium phenomenon driven by
declining global investment.
Figure 3 OECD Average Saving-Output Ratio

0.24
0.23
0.22
0.21
0.20
0.19
0.18
1990 91

92

93

94

95

96

97

98

99 2000 01

Source: OECD.

250 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

02

03

04

05

Concluding Panel Discussion

IV. Global Long-Term Rates
The next point I would like to make is that the influence of global factors on long-termyields has increased over time.
I will report the results from two panel regressions.
Let us first consider the benchmark regression of nominal long interest rates on
short-term rates and estimate it for the panel of OECD countries:
I j,tL =  j + I j,tS + j,t ,(1)

where I j,tL represents nominal long-term and I j,tS nominal short-term interest rates incountry j at time t. The term  j controls for country fixed effects. The coefficient 
is common across countries and gives a measure of the average association of longand short interest rates across countries in the panel.
Let us then augment the benchmark regression by a measure of the global nominal
long interest rate to estimate the contribution of the global factor to the determinationof long-term interest rates in the OECD as a whole and in the subset of euro area
countries. The global long-term interest rate, I tW, is constructed as a weighted averageof countries’ long-term interest rates.17
The regression equation is
I j,tL =  j + I j,tS + j I tW + j,t ,(2)where j is the country-specific effect of the global factor.
Regressions (1) and (2) are run for a group of countries, including the 15 largest
OECD countries18 and a group including the largest euro area countries,19 for the fullsample 1974–2004 and for the three subperiods 1974–83, 1984–93, and 1994–2004.
Results from the two panel regressions for the OECD and euro area panels arereported in Table 1.
Table 1 Regressions 1 and 2: Estimated  Coefficients
Country group and regression
OECD regression 1
OECD regression 2
Euro area regression 1
Euro area regression 2

1974–2004
0.8(0.02)
0.5(0.02)
0.8(0.03)
0.4(0.07)

1974–83
0.6(0.04)
0.5(0.05)
0.7
(0.1)
0.4
(0.13)

1984–93
0.6(0.03)
0.5(0.03)
0.6
(0.1)
0.3
(0.1)

1994–2004
0.8(0.04)
0.2(0.03)
0.9(0.06)
0.2(0.08)

Note: Standard errors in parentheses.

17. The weights for country-specific interest rates are derived by principal components.
18. Australia, Austria, Belgium, Canada, Finland, France, Germany, Italy, Japan, the Netherlands, New Zealand,
Portugal, Switzerland, the United Kingdom, and the United States.
19. France, Germany, and Italy.

251

Clearly, the global factor has become increasingly important to explain interest
rate dynamics. In particular, once the global factor is included, the effect of thecountry-specific short rate on the long rate becomes insignificant. This implies thata key element of the national monetary transmission mechanism has disappeared.
Notice that this is true even before 2004–05 (the U.S. “conundrum” episode).
In these simple regressions, the global factor is just a weighted average. The question
remains open as to whether this average captures a nominal common factor driven
by inflation-stabilizing monetary policies or a real phenomenon, as I suggested earlier.
To the extent to which our average captures a nominal factor, the world real interest
rate would have to be adjusted by the global inflation premium. To quantify theseeffects is an important area of research for central banks.

V. Implications for Monetary Policy
To the extent to which low real rates and their decline over the last 15 years reflect anequilibrium phenomenon, there is no reason for concern for monetary policy. Fromthe euro area perspective, the real cause of concern is what is behind the declining
real rate, which, I conjectured, is decreasing investment.
Moreover, the increasing influence of global phenomena and the weakening of thelink between short and long rates at the country level has at least two consequences formonetary policy. First, national monetary policy may have become less effective and,second, global links have increased the degree of uncertainty in the assessment of the
stance of monetary policy at the national level, since the estimates of the equilibrium
real rate are affected by factors that are determined at the world level.

Reference

Detken, Carsten, “Comment on The Bond Yield ‘Conundrum’ from a Macro-Finance Perspective,”
Monetary and Economic Studies, 24 (S-1), Institute for Monetary and Economic Studies, Bankof Japan, 2006, pp. 109–119 (this issue).

Masaaki Shirakawa
Bank of Japan20
Between March 2001 and March 2006, a careful observer of the Japanese economy
and financial markets would have seen many interesting developments under thequantitative monetary easing policy (QMEP) framework adopted by the Bank ofJapan (BOJ), or more broadly, under a zero interest rate environment. Today, I will
run through a list of what we saw in the Japanese economy and financial markets
over this period as a basis for the discussion in this session. The views expressed here
are solely my own and do not necessarily reflect the official views of the BOJ.
20. Currently, Kyoto University.

252 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

I. The Japanese Economy since 2001
First of all, it is useful to briefly review how the Japanese economy has performed
since 2001. I have chosen this year as a reference point because the bursting of the IT
bubble worked as a common downside factor for the global economy, and hence theyear presents us with a convenient starting point to compare the economies that were
facing and not facing a zero lower bound of nominal interest rates.
The Japanese economy slipped into a downward cycle like other major economies
in 2001. The slump was rather short-lived, however, and the Japanese economy
began a gradual recovery in 2002. Although the average growth rate is by no means
spectacular, this expansionary phase will become the longest expansion in postwar
Japan if it continues beyond November 2006.
The momentum of the current recovery phase is now most evident in the profitability of Japanese firms. The profit to sales ratios of Japanese firms currently exceed
the levels reached in the bubble years of the late 1980s. Reflecting the recovery, theoutput gap has closed, in contrast to the significant negative gap around 2002.
Turning to price developments, the consumer price index (CPI) emerged from along declining trend at the end of 2005, and for the January–April 2006 period wesaw a year-on-year increase of 0.5 percent (Figure 1). The actual decline was rather
mild, however. The cumulative decline in the CPI over the seven years since the peakFigure 1 Consumer Price Index

120

Seasonally adjusted, CY 1985 = 100

Percent108110
Level (left scale)
100

90

Peak tobottom:–2.6 percent

64Year-on-year rate of change (right scale)

80

2

70

0

60
CY 1980

–2
82

84

86

88

90

92

94

96

98

2000

02

04

06

Note: The effects of the changes in the consumption tax rate are adjusted.

253

in 1998 was slightly below 3 percent, which I think is somewhat different from thewidely cited view stressing the specter of deflation.
As for the growth patterns of major economies since the bursting of the IT bubble,
the Japanese recovery has lagged behind the United States and the United Kingdom.
It has been about as good as that of the euro area.

II. Why Did the Japanese Economy Not Fall into a
Deflationary Spiral?
The most striking feature of this period was that, until quite recently, the Japanese
economy recovered steadily under persistently declining prices, although the rate of
decline was mild. I would say that this was another conundrum worth exploring.
After all, from a viewpoint stressing the deadly combination of deflation and thezero lower bound of nominal interest rates, the Japanese economy was doomed
to fall into a deflationary spiral: a vicious cycle of falling prices and stagnating
economic activity.
There are several possible explanations of this puzzle. First, as we can see from thegraph of distribution of nominal wage changes,21 Japanese nominal wages were flexible,
at least in recent years. The vicious cycle I have just mentioned may result from thedownward rigidity of nominal wages: as prices fall, real wages and thus unemploymentrise, which in turn exerts additional downward pressure on prices. In contrast, since1998, the downward rigidity of nominal wages has not been observed in disaggregateddata. Nominal wages in Japan are more flexible than in other major economies.
Consequently, the increase in unemployment was relatively mild compared with theUnited States and the euro area during this period.
The second explanation focuses on the long-term expected growth rate, whichfell only moderately. Surveys show that the long-term growth outlook of corporate
executives was not depressed as much as their short-term growth outlook (Figure 2).
Although there was an inflection in the medium- to long-term growth rate expectedby corporate executives, it was not as severe as to push the expected medium- tolong-term growth rates below market interest rates in real terms. In other words,
we did not experience the unwelcome situation in which the natural rate was below
the market real interest rate.
The third explanation focuses on the fall in the real exchange rate, which helped
stimulate exports. Although the calculation is influenced somewhat by the base year,
the real effective exchange rate of the yen has fallen 21 percent since 2001. Two-thirdsof this fall is attributable to the differences in inflation rates, and the remaining
one-third to the changes in nominal exchange rates.

21. See Kuroda and Yamamoto (2005).

254 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

Figure 2 Firms’ Expected Real GDP Growth Rate and Real Interest Rate

6
5

Annual average, percent

Short-term real interest rate
Firms’ expected real GDP growth rate:4

One year from now
Three years from now
Five years from now

3
2
1
0

–1
FY 1985 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05 06
Notes: 1. Firms’ expected growth rate (in the Annual Survey of Corporate Behavior[Economic and Social Research Institute, Cabinet Office]) is supplemented
with linear interpolation.
2. Short-term real interest rate = call rate (overnight, uncollateralized) −year-on-year rate of change in the CPI (excluding fresh food).

III. The Role of Monetary Policy
The fourth explanation is that despite the zero lower bound of policy rates, monetary
policy was effective in retrospect. Faced with the risk of deflation, the BOJ has experimented with various monetary policy measures, including quantitative easing.22
The quantitative easing framework consists of two distinctive elements: the provisionof ample liquidity in excess of required reserves and a commitment to maintain it
until the CPI inflation rate becomes positive on a sustainable basis.
The increase in the provision of liquidity was most useful when there were strong
concerns about the stability of the Japanese financial system. Ample liquidity satisfied
the liquidity demands of financial institutions, and helped maintain the stability of
the financial system as well as sustain accommodative monetary conditions, which inturn contributed to preventing a contraction of economic activity. Given that most
episodes of deflation in history were accompanied by financial turbulence or crises,
I believe that we should give credit to the mitigation of concerns about the availabilityof liquidity.

22. For more details, see Baba et al. (2005) and the Outlook for Economic Activity and Prices released by the Bank ofJapan on October 31, 2005 (available at http://www.boj.or.jp/en/type/release/teiki/tenbo/gor0510.htm).

255

Having said this, I should also note that stimulative effects suggested by simplistic
monetary theories were not observed. After the adoption of quantitative easing, basemoney increased by more than 60 percent. Nevertheless, a corresponding increase inmoney supply was not observed, and nominal GDP and prices did not react.
In this context, some observers proposed that the BOJ should aggressively purchaselong-term Japanese government bonds (JGBs) to supply liquidity to the market. The
BOJ did, in fact, increase its purchases, but the motives and actions of its counterparties were not what most proponents had initially expected. Financial institutions
could easily have sold JGBs in the market. The only reason for them to sell the bonds
to the BOJ was that they could adjust the composition of their bond holdings smoothly
without impacting market prices. In other words, financial institutions were looking
for a service that would facilitate adjustment of their bond inventories, and in a sense,
reserve balances provided such a service as a byproduct. Since the cost of carrying
reserve balances was almost zero, it did not matter whether the balances were excessive
or not, and as a result, there was no chance that the purchase would set in motion arebalancing of portfolios.
Meanwhile, the second element of quantitative easing, a commitment to maintainthe provision of ample liquidity until the year-on-year rate of change in the CPI
became positive on a sustainable basis, was more effective in supporting the recovery.23
The BOJ exited from this framework just after confirming that the year-on-year rateof change in the CPI increased to 0.5 percent.
The commitment based on actual CPI figures resulted in a flattening of the yield
curve, especially in the short- to medium-term maturities (Figure 3 [1]). This flattening did not require huge excessive reserves. It was a product of the commitment tomaintain the zero interest rate, and what was crucial was the market participants’belief in such a commitment.24 It seems that the zero lower bound did not preventthe level and volatility of Japanese long-term interest rates from falling. There was avisible fall just after the bursting of the IT bubble, as in other major markets.
Furthermore, the commitment encouraged market participants to take on credit
risks by flattening the risk-free yield curve, which resulted in a tightening of credit
spreads (Figure 3 [2]). Actual lending rates to corporations could still fall eventhough the short-term interest rate fell to zero. Also, the lending attitude of financial
institutions as perceived by firms, which is essentially a “shadow price” for lending,
improved further (Figure 4).
One interesting comparison can be made between the recent Japanese experienceand the U.S. experience in the Great Depression. It is evident that in Japan, the levelof the yield curve was lower and credit spreads were tighter than in the UnitedStates.25 Although it may be an exaggeration to say that monetary policy was effective
after all, even in the face of a zero lower bound, the Japanese experience seems tosuggest that we should reconsider the seriousness of the zero lower bound. This issue
should not be dealt with in isolation or in absolute terms. Rather, it should be dealt
with in context.
23. See Oda and Ueda (2005) for an empirical analysis of the commitment effect.
24. See Baba (2006) for an empirical analysis of the expected duration time of the zero interest rate.
25. See Baba et al. (2005).

256 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

Figure 3 Interest Rates and Credit Spreads[1] JGB Interest Rates
5.0

Percent

4.5
ZIRP

QMEP

4.0
Five years
10 years
20 years
Call rate (overnight)

3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Jan.
1995

Jan.
96

Jan.
97

Jan.
98

Jan.
99

Jan.
2000

Jan.
01

Jan.
02

Jan.
03

Jan.
04

Jan.
05

Jan.
06

[2] Credit Spreads
1.5

Percent

ZIRP

AA
A
BBB

QMEP

1.0

0.5

0.0
Dec.
1997

Dec.
98

Dec.
99

Dec.
2000

Dec.
01

Dec.
02

Dec.
03

Dec.
04

Dec.
05

Note: ZIRP stands for zero interest rate policy, and QMEP stands for quantitative
monetary easing policy.

257

Figure 4 Lending Attitude of Financial Institutions as Perceived by Firms

50

DI (“accommodative” − “severe”), percentage points
Large enterprises
Small enterprises

40
30
20
10

Accommodative0
Severe

–10
–20
–30
–40
CY 1985

87

89

91

93

95

97

99

2001

03

05

Note: The Tankan has been revised from the March 2004 survey. Figures basedon the previous datasets are up to the December 2003 survey. Figures on
the new basis are from the December 2003 survey.
Source: Bank of Japan, “Tankan —Short-Term Economic Survey of Enterprises
in Japan.”

IV. Some Policy Issues
I would like to flag and comment on issues with policy implications.
The first issue is what were the possible side effects of aggressive monetary policythat the BOJ adopted? In this regard, the loss of incentive to trade is often cited. Since
the overnight call rate fell as low as 0.001 percent, interest revenue did not cover thetransaction costs.26 Thus, financial institutions would not trade even if funds in excess
of working balance became available in their current account at the BOJ. Consequently,intermediation was impaired in the short-term funding market.
Increasing the liquidity supply will have net benefits after a certain point, especiallyin light of concern over the financial system. However, we observed an unusual
situation in which more than enough funds were available at the aggregate level,but individual financial institutions had acute concerns about their ability to raise
sufficient liquidity from the market at short notice. This created, so to speak, a selffulfilling demand for liquidity. The commitment to continue the zero interest rate,
which was the main source of the monetary easing effect, was only effective to the extent
that market participants expected a sustained period of very low interest rates. However,a very low interest rate may not necessarily mean a zero interest rate—0.001 percent,for instance.
The tightening of the credit spread may also pose some difficult issues. Some
may argue that if the root cause of the problem is excess capital stock, a prolonged
26. See “Money Market Operations in Fiscal 2003,” released by the Financial Markets Department of the Bank ofJapan on August 31, 2004 (available at http://www.boj.or.jp/en/type/ronbun/ron/research/data/ron0408a.pdf ).

258 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

tightening of the credit spread may eventually lead to a delay in needed adjustment
and hence recovery, although it would help mitigate a large shock to the economy inthe short run. The key is to identify where the possible side effects that I have justpointed out begin to outweigh the benefits.
The second issue is how the central bank should deal with the possible timeinconsistency problem in the commitment. Under the quantitative easing framework,
the BOJ committed to continuing the zero interest rate in relation to the CPI, whose
fluctuations were visible to everybody.
A mechanical reference to a higher rate of CPI change would have increased
uncertainty in the market about the current level of policy rates. Thus, there aretrade-offs. A central bank might be reluctant to adopt too specific a commitment inview of its incomplete understanding of inflation dynamics in the future. At the sametime, the market might begin to harbor doubts about the commitment as developments unfold, if the hurdle for changing the course was set too high at the beginning.
In these instances, volatility will increase with greater uncertainty over the path ofshort-term interest rates, and undermine the effectiveness of the commitment. Sincea binding commitment alone can become an effective policy tool, care must be taken
when designing it in the first place.
The third issue is how much safety margin we should have to reduce the risk offalling into deflation. This may be paraphrased as the question of whether theJapanese economy would have followed a different path if the BOJ had cut policy
rates more aggressively in the early 1990s. Not surprisingly, I am rather inclined toanswer this question negatively.
I would argue that when the capital of financial and nonfinancial firms waseroded to a large extent, a small change in the interest rate would not have resulted ina large change in spending patterns at those firms. After the bursting of the bubble,
capital losses in Japan for both land and stocks together amounted to more than
three times nominal GDP (Table 1). This was really huge. These developments
severely constrained the ability of Japanese firms to respond to challenges posed byongoing globalization and the IT revolution. The result was stagnation of productivity
growth which, I believe, is the most important factor in explaining Japan’s “lostdecade.” Asset price deflation seems to have had far larger negative effects than themild fall in the CPI of less than 3 percent.
In this regard, we can run a counterfactual simulation (Figure 5).27 Monetary
policy in Japan may have been perfect in terms of the Taylor rule, but what would
have happened if the BOJ had cut policy rates more aggressively in the early 1990s, say,Table 1 Capital Gain and Loss for Land and Stock as a Percentage of Nominal GDP
PercentLand
1986–90
1991–2004

Stock
365.3
–260.01986–89
1990–2004

147.2
–89.6

Note: The base years for the figures before 1995 and after 1995 are 1995 and 2000, respectively.
27. See Kimura et al. (2006).

259

Figure 5 Counterfactual Simulation[1] GDP Growth Rate
5

Percent, percentage points
Simulated − actual
Actual growth rate
Simulated growth rate

4
3
2
1
0
–1
–2
–3
FY 1991

92

93

94

95

96

97

98

99

2000

01

[2] CPI Rate of Change
4

Percent, percentage points
Simulated − actual
Actual CPI
Simulated CPI

3

2

1

0

–1

–2
FY 1991

92

93

94

95

96

97

98

99

2000

01

Note: The simulation is done using the Japanese Economic Model. In this simulation,monetary policy follows a simple rule that minimizes a weighted average ofthe variance of inflation and the output gap.
Source: Kimura et al. (2006).

260 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

by lowering them another percentage point in the first half of the 1990s? The results
show that overall economic performance would not have been very different from
actual developments. This seems to underscore the view that unless capital positions offinancial and nonfinancial firms are robust enough to be able to respond to stimulus
from interest rate reductions, little can be expected of a policy that influences the yield
curve, including the commitment to maintain a zero interest rate.
Japan’s experience raises many interesting issues, when we think of deflation as
well as monetary policy in a low interest rate environment. I believe that further
study of our experience by both academia and central banks is needed.

References

Baba, Naohiko, “Financial Market Functioning and Monetary Policy: Japan’s Experience,” Monetaryand Economic Studies, 24 (S-1), Institute for Monetary and Economic Studies, Bank of Japan,
2006, pp. 39–71 (this issue).
———, Shinichi Nishioka, Nobuyuki Oda, Masaaki Shirakawa, Kazuo Ueda, and Hiroshi Ugai, “Japan’s
Deflation, Problems in the Financial System, and Monetary Policy,” Monetary and Economic
Studies, 23 (1), Institute for Monetary and Economic Studies, Bank of Japan, 2005, pp. 47–111(also available as BIS Working Paper No. 188, Bank for International Settlements, 2005).
Kimura, Takeshi, Ippei Fujiwara, Naoko Hara, Naohisa Hirakata, and Shinichiro Watanabe, “Baburu
Houkaigo no Nihon no Kinyuseisaku: Fukakujitsuseika no Nozomashii Seisaku Unei wo megutte ”(Japanese Monetary Policy in the Lost Decade: Searching for the Optimal Monetary Policy under
Uncertainty), Bank of Japan Working Paper No. 06-J-04, 2006 (in Japanese).
Kuroda, Sachiko, and Isamu Yamamoto, “Wage Fluctuations in Japan after the Bursting of the Bubble
Economy: Downward Nominal Wage Rigidity, Payroll, and the Unemployment Rate,” Monetaryand Economic Studies, 23 (2), Institute for Monetary and Economic Studies, Bank of Japan,
2005, pp. 1–30.
Oda, Nobuyuki, and Kazuo Ueda, “The Effects of the Bank of Japan’s Zero Interest Rate Commitment
and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach,” Bank ofJapan Working Paper No. 05-E-6, Bank of Japan, 2005.

Comments
Bennett T. McCallum
Carnegie Mellon University
The conference organizers have arranged for an excellent set of panel speakers.
I will comment on their presentations in order, beginning with the remarks ofChristine M. Cumming. Her discussion provides a nice overview of the period during
which the Federal Reserve was concerned about the possibility of hitting the zerolower-bound (ZLB) constraint. It seems to be an informative and accurate review, butthere is one aspect of the experience about which my evaluation of the Fed’s behavior
is less positive than hers. I have in mind the communication strategy, beginning in
2003, by which the Fed sought to convey to the financial markets that it intended tokeep policy easy for some significant amount of time into the future. That was aworthwhile intention, but unfortunately the Fed chose to implement it by making

261

“semi-promises” regarding future values of the federal funds rate. In other words,
these values were expressed in an unconditional manner, rather than in conditional
statements that would explain how the Fed would react to various specified conditions,
if they occurred. The former type of procedure seems suboptimal for any sensible
policymaker, public or private, for it commits the policymaker to actions that could
be highly inappropriate if conditions turn out to differ from those expected. It is myimpression that this way of communicating intentions regarding monetary policy inthe future has created various difficulties for the Fed, of which the flap in May 2006
over a statement of Chairman Ben Bernanke’s is just the most recent example. Why
does the Fed persist in its reluctance to make conditional statements? My guess isthat one part of the reason is that conditional policy statements naturally pertain todifferences between prevailing values of “target variables” (especially inflation) and thespecific values targeted (desired). In this way, the Fed’s unwillingness to adopt an
explicit objective (target value) for long-run average inflation leads to unfortunate
consequences in terms of communicating its strategy, as well as in other ways. This is,of course, a point of view frequently expressed by academics.
Next, Lucrezia Reichlin’s interesting charts present some striking facts about
interest rates in the United States, the United Kingdom, the euro area, and Japan, witha major conclusion being that there has been a substantial fall in real interest rates over
the years 1990–2006. I had not thought about these facts, and am glad to have themcalled to my attention. My initial reaction is, however, to recall that if nominal interest
earnings are taxed, a fall in expected inflation will produce a fall in measured realinterest rates if taxes are ignored, even if there is no change in after-tax real rates.
Consider, for example, that nominal 10-year rates for the United States were approximately 9 percent in 1990 and 4 percent in 2006, whereas real rates are reported
as 4 and 2 percent for these dates in her Figure 1. Thus, expected inflation rates were
5 and 2 percent, respectively, if Figure 1 neglected taxes, as I am assuming. But if
nominal interest is taxed at a rate of 40 percent, then the after-tax yield in 1990 was
9(1 − 0.4) − 5 = 0.4 and the after-tax yield in 2006 is 4(1 − 0.4) − 2 = 0.4, that is, thesame. More generally, recognition of taxes implies that there may have been much lesschange in the relevant (after-tax) real rates of interest over the period than is suggested
in the discussion. Whether this is relevant to the matters at hand, I am not certain.
Finally, I will comment at slightly greater length on Masaaki Shirakawa’s spirited
and authoritative review of the policy of the Bank of Japan (BOJ) during the period ofquantitative easing. As it happens, I have some different perceptions that, as a panelist,
it is my duty to mention. Of course, I was glad to hear an upbeat and optimistic report,
but surprised by its tendency to sound as if the Japanese economy had been thriving inrecent years. This tone is probably due in part to the fact that his review begins with
March 2001, when the economy had already been in a slump for about eight or nine
years, so it correctly reports considerable improvement. If that figure of eight or nine
years sounds like an exaggeration, I recall that there was much concern about Japan’sslow growth and high unemployment expressed at the IMES Seventh International
Conference on October 26–27, 1995, and also that there were many expressions ofgreat concern among participants and speakers at the Jackson Hole conference of theFederal Reserve Bank of Kansas City in August 1996.

262 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Concluding Panel Discussion

I was not at the IMES Ninth International Conference held in July 2000, when theentire program focused on the role of monetary policy under low inflation and was
designed to begin the process of drawing lessons from the Japanese experience. But my
impression is that at the time most BOJ economists and officials were optimistic thatthe BOJ had done almost everything it could to bring the economy out of its slump.28
The slump continued, of course, and subsequently the quantitative monetary easing
policy (QMEP) was introduced in 2001, together with the commitment that theovernight call rate would be kept at zero until consumer price index (CPI) prices wererising. To me, it seems likely that if these steps had been taken in 1996, rather
than 2001, the duration of the Japanese slump might have been considerably shorter,
perhaps only five or six years, instead of 13 or 14. Shirakawa has presented somereasoning (and simulation results) that disagree with this judgment, but I am not entirely
persuaded. Instead, I think that the expectational effects of the 2001–06 policy actions
would have been greater if they had not been preceded by years of BOJ statements tothe effect that such actions would probably not be effective.
There is one other pessimistic point that I feel compelled to bring up. Shirakawa
has reported that Japan’s output gap is now positive, that is, output is slightly above its“potential” level. To me that seems surprising, so I have looked at a recent and relevant
BOJ publication, “The New Estimates of Output Gap and Potential Growth Rate,” byHara et al. (2006). It contains an important item, that the structural unemployment
rate is now estimated to be about 3.7 percent, almost twice as high as over 1975–91.
The major increase in this estimated structural unemployment rate occurred between
1992 and 2002, the same period as the rise in the actual unemployment rate. If that
increase was not actually structural, but instead was induced by a low rate of growth of
nominal demand, then the new output gap measure would be conceptually incorrect
and the economy not yet back to potential. (The possibility of such an estimation error
is mentioned by Hara et al. [2006, p. 9].) Furthermore, the situation would be evenworse in this regard if the major fall in labor force participation rates between 1996 and2005 (i.e., from 63 percent to 60 percent) was itself induced by weak demand, rather
than demographic trends. In short, despite the analytical disaggregation and detrending steps taken by the BOJ authors, I have some concerns about the validity of the newmeasure of the output gap. I hope that these concerns are misguided.

References

Beebe, Jack H., “Comment on ‘Further Monetary Easing Policies under the Non-Negativity Constraintsof Nominal Interest Rates: Summary of the Discussion Based on Japan’s Experience,’” Monetaryand Economic Studies, 19 (S-1), Institute for Monetary and Economic Studies, Bank of Japan,
2001, pp. 365–368.
28. It should be noted that the Ninth International Conference included a paper by Oda and Okina (2001) whichcontained a careful and extensive discussion of the potential effectiveness and risks of various policy actions that
could have been considered by the BOJ. I would agree with Beebe (2001), however, in his suggestion that Oda andOkina may have overestimated the risks to the BOJ of more aggressive action while underestimating the potential
benefits. On the other hand, I am pleased to acknowledge that in July 2001 Okina encouraged consideration of an
expansionary policy stance involving purchases of foreign exchange, the strategy that I consider to have been mostpromising. On this matter, see McCallum (2003).

263

Hara, Naoko, Naohisa Hirakata, Yusuke Inomata, Satoshi Ito, Takuji Kawamoto, Takushi Kurozumi,
Makoto Minegishi, and Izumi Takagawa, “The New Estimates of Output Gap and Potential
Growth Rate,” Bank of Japan Review Paper No. 06-E-3, Bank of Japan, 2006, pp. 1–9.
McCallum, Bennett T., “Japanese Monetary Policy, 1991–2001,” Economic Quarterly, 89 (1), Federal
Reserve Bank of Richmond, 2003, pp. 1–31.
Oda, Nobuyuki, and Kunio Okina, “Further Monetary Easing Policies under the Non-Negativity
Constraints of Nominal Interest Rates: Summary of the Discussion Based on Japan’s Experience,”
Monetary and Economic Studies, 19 (S-1), Institute for Monetary and Economic Studies, Bank ofJapan, 2001, pp. 323–360.

Maurice Obstfeld
University of California at Berkeley
Rather than commenting separately on each of these excellent presentations, I am
going to look at three themes that have also been major themes of the papers at theconference. My points will, I think, be closely related to the ideas that have just been
heard from the panelists. The topics I would like to cover are, first, the issues of communication: inflation targeting by central banks, and Japan’s exit from the quantitative
monetary easing policy (QMEP). Second, the possible effects of quantitative easing andthe zero interest rate policy on credit spreads in the financial sector. Finally, the issue ofconundrums regarding long-term real interest rates. I apologize if my observations
seem somewhat disjointed, but I do want to try to bring together some of the disparate
strands of the discussion we have had over the last couple of days.
Christine M. Cumming stressed the evolution of the Federal Reserve’s communication strategies in an environment of feared deflation and a feared approach to the zerobound in the United States. And indeed, the power of communication was also a major
theme of the paper by Gauti B. Eggertsson and Benjamin Pugsley on the “mistake of1937.” Earlier today, I was struck by our discussion of the possible “mistake of 2000”
by the Bank of Japan (BOJ)—and naturally there was disagreement on whether the
restrictive monetary shift in that year should be considered a mistake: the high-tech bustof 2001 was not foreseen. Unfortunately, Masaaki Shirakawa’s presentation covers theperiod that starts more or less in 2001; although you can see the 2000 episode in the
figures, it is not taken up in his narrative. In my opinion, exiting from the zero interest
rate policy in 2000, with deflation still underway, must be counted as a mistake. True,the immediate measured effects on output were not the disastrous ones we see in the1937 U.S. episode, but I think that the policy signal sent in 2000 might well haveslowed down, by several years, the recovery that we now seem to be seeing in Japan.
Cumming also referred to the importance of a positive inflation target rather thanan inflation target of zero. Her argument is one that has often been made; for example,
Summers (1991) recommends maintaining a buffer of safety to reduce the chanceof hitting the zero bound. But there is another important reason for the central
bank’s having a well-understood tolerance for some positive inflation. Simply put, thattolerance increases the bank’s credibility in taking measures and making announcements in situations of unwelcome ongoing deflation. In that connection, I believe it isimportant to consider the evolution of the BOJ’s thinking on inflation over the last few
years. The developments have been important and positive.

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Concluding Panel Discussion

I think it is fair to say that, prior to quite recently, the BOJ did not have a publicly
stated and operationally meaningful interpretation of its mandate of “price stability,”
unlike some other central banks. It is very significant, and this is a developmentthat Kunio Okina referred to in his discussion this morning, that in March 2006
the BOJ’s Policy Board finally, and for the first time to my knowledge, put forward
a fairly precise definition of “price stability.” That step, had it been taken earlier,might have hastened the exit from Japan’s deflation. This wording is available in the
Minutes of the Monetary Policy Meeting on March 8 and 9, 2006. The entire
document is of immense interest, but here I will refer only to its Attachment 2. A key
statement is the following: “It was agreed that, by making use of the rate ofyear-on-year change in the consumer price index to describe the understanding, anapproximate range between zero and two percent was generally consistent with the
distribution of each Board member’s understanding of medium- to long-term pricestability.”29 To specify such a range of nonnegative inflation rates so precisely is a major
departure for the BOJ. And I think it will prove a valuable tool in its managementof expectations going forward, for reasons I have spelled out in previous years’ panels
at this conference.
There are, however, two unfortunate accompaniments to the presentation ofthis new thinking. Those qualifications may well have blunted the primary message.
First of all, in the same attachment, there is the repetition of a statement the BOJ
had made several times before, a nonoperational definition of price stability as“conceptually, a state where the change in the price index without measurement bias
is zero percent.” That interpretation is not terribly useful as a guide to policy, andalso suggests that positive inflation is not to be tolerated over the medium term.
Also included earlier in the minutes is a discussion of various views on the natureof price stability among Policy Board members. The worrisome component is theassertion that because Japan has had very low inflation for some time, the definitionof “price stability” should entail a lower inflation rate than would pertain elsewhere.
This view misses the point that deflation can be problematic, and is analogous(though even less defensible) to asserting that a period of lower growth such as Japan
has experienced necessarily should lower the path of potential output.
In sum, there has been some progress in communicating a quantitative measure ofprice stability, but with ambiguities in communication that could cause trouble later
on. The BOJ also has reserved the option of revising this indicative inflation range
down the road. That action gives a degree of flexibility, but at the cost of weakening
the anti-deflation commitment.
Let me turn to a second topic, the apparent effects of quantitative easing and zerointerest rates in compressing financial-sector risk premiums. I found the discussion at
the conference, in Shirakawa’s presentation as well as in the papers by Naohiko Baba
and Jun Pan and Kenneth J. Singleton, quite illuminating. These papers suggest
strongly that one of the mechanisms through which quantitative easing may haveworked is in supporting a very shaky financial system. Now, as has been pointed out by

29. Bank of Japan (2006, p. 61).

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a number of participants, this may also have had costs in terms of resource allocation,
moral hazard, and so on. It also could be, however, that the factor really compressing
credit spreads was regulatory forbearance, not zero interest rates, and that the end ofthat forbearance had something to do with the rise in risk premiums, such as we see,for example, in the paper by Pan and Singleton.
In line with this latter interpretation, Kazuo Ueda referred yesterday to the “riskbubble” and the end of government protection of bank debt. Considering Shirakawa’s
comparison in his remarks of the higher credit spreads in the United States in the
1930s with the low ones in Japan more recently, those in the United States may
well have been higher because there were not the same sorts of protections andexpectations of bailout that there have been in Japan. This seems a fruitful area for
future research.
I would like to add to this discussion the following hypothesis. Aside from its othernegative effects, regulatory forbearance and official support of troubled institutions
may have actually compromised the credibility of anti-inflation policy, and again
prolonged the period of deflationary pressures in Japan. In combating inflation, theBOJ must be prepared to raise interest rates, perhaps sharply. To do so presupposesa resilient financial system. In a situation where a financial system is not resilient,a central bank must be more worried than otherwise about inflation down the road;and that is the case even in a situation where currently there is deflation. So I would
hazard a guess that the excessively prolonged financial restructuring period, aside fromthe direct effects that may have occurred in credit markets, also had a very direct effecton the BOJ’s attitude toward future inflation and toward the way the market viewed
measures that it was taking. Again, this is a hypothesis that could be testable in someway, and it would be interesting to look at it empirically.
The final topic I want to take up is that of conundrums, and of low real interest
rates, and of the effectiveness of monetary policy. This was highlighted in Lucrezia
Reichlin’s presentation, and it has also been discussed in the papers at this conference.
I find fascinating the idea that in a globalized environment, national monetary policy
may become less effective. This is apart from reasons having to do with the zerobound, which has been the focus of much of our discussion both at this and at
previous conferences.
This is again an empirical hypothesis. It is certainly true that there is greater
financial globalization, with stronger linkages among long-term real interest rates,
and that to fully explain real interest rates in any of the major industrial areas weneed to look to global factors. But I question whether this means that monetary
policy has become ineffective or even less effective than previously. Certainly overthe long term, real interest rates will contain an important global component, andthis global component of the interest rate reflects integration with the world capital
market and the process of financial trade from which come international gains fromtrade. But this does not mean that monetary policy, in the short to medium term,
cannot engineer short-term deviations from world rates due to both price rigidities
and also to the segmentation of national goods markets. Even though financial
markets are much more closely integrated than in the past, goods-market segmentation is still a very important factor. Even in a closed economy, long-term real interest

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Concluding Panel Discussion

rates will be determined by the forces of thrift and productivity, which we do notbelieve are functions of monetary policy. So if we think about an open economy
where the long-term real interest rate is a global phenomenon to a large extent, we
still have only the short term to work with. But that is not necessarily much of animpediment provided that there is enough segmentation among goods markets toallow substantial real exchange rate fluctuations. These we still see in the data. So I
look forward to more discussion of this point, and to more rigorous empirical andtheoretical thinking about it.
I would like to introduce another conundrum into the discussion—one related tolong-term interest rates—and in that way to tie into the discussion in both my presentation and that of Fabrizio Perri earlier today. The conundrum relates to the global
imbalances. The pictures that Reichlin showed us indicated that the gaps between
long-term real interest rates in the major countries are relatively small. Japan is a bit
lower than the rest, maybe by 100 or so basis points, but the gaps are fairly narrow, andthere is almost none between the United States and the euro area.
If we think that to a first approximation, long-term real interest differentials reflect
expected real exchange rate changes, then we need to ask the question whether the realexchange rate changes implicit in these real interest differentials are consistent with theelimination of the very large global imbalances that we see today. I would argue thatthe answer is no, unless these imbalances are to be eliminated extremely gradually, so
gradually that resources have time to move between sectors and between countries in a
way that obviates the standard sorts of transfer problems and thus most of the need forreal exchange rate adjustment. It is a major question whether the greater depth offinancial markets indeed will allow for a much more gradual adjustment of very large
imbalances than we would have thought possible in the past—this is an argument that
Alan Greenspan30 has made—or whether, on the contrary, they will allow an excessive
expansion of these imbalances leading ultimately to some sort of reversal and crisis.
The question is open. It is related to the issue of low real interest rates, in the sense thathigher rates down the road will certainly accentuate the imbalances and make themharder to reduce gradually.

References

Bank of Japan, “Minutes of the Monetary Policy Meeting on March 8 and 9, 2006,” Bank of Japan
Quarterly Bulletin, 14 (2), Bank of Japan, 2006, p. 61 (also available in Bank of Japan, Annual
Review 2006, p. 45, and at www.boj.or.jp/en/type/release/teiki/giji/g060309.htm).
Greenspan, Alan, “The Evolving U.S. Payments Imbalance and Its Impact on Europe and the Rest of
the World,” Cato Journal, 24 (1–2), 2004, pp. 1–11.
Summers, Lawrence, “How Should Long-Term Monetary Policy Be Determined? Panel Discussion,”
Journey of Money, Credit and Banking, 23 (3), 1991, pp. 625–631.

30. Greenspan (2004).

267

General Discussion
I. Discussion among Panelists
Against Bennett T. McCallum’s review on unconditional statements, Christine M.
Cumming explained that statements by the Federal Reserve Board (FRB) about
inflation risks could be interpreted as a sort of “inferred conditional commitment.” She
stated that two interesting questions were “What did the market ultimately infer fromthe statements about the FRB’s actions?” and “How long did it take it to settle on an
inference?” Concerning Maurice Obstfeld’s discussion of the relationship between
long-term real interest rate differentials and the global imbalances, Cumming remarked
that grasping how the adjustment process of global imbalances would work became
more difficult each year, given the magnitude of the imbalances and their growth.
In response to McCallum’s question, Lucrezia Reichlin answered that the realinterest rates shown in her presentation were calculated using a survey-based measureof headline inflation that would be subject to tax effects. In response to Obstfeld’squestion about the effectiveness of monetary policy, Reichlin explained that, at least
empirically, her regression results suggested that the transmission channel throughthe term structure seemed to have become less effective. She then pointed out thefact that, in contrast to the nominal convergence, real convergence had not been
observed across countries, and suggested that something might be learned from thisreal heterogeneity. Finally, in connection with monetary policies, Reichlin stressed
the importance of accurate estimation of the equilibrium real interest rates, andnoted that all the issues discussed in relation to the international environment
became sources of uncertainty about equilibrium rates.
With regard to McCallum’s comments, Masaaki Shirakawa made it clear that
although the Japanese economy had returned to a sustained growth path under pricestability, such a judgment did not mean he was optimistic about the long-run trend ofJapan’s economic activity. Then he explained that within the new framework adopted
in March 2006, the Bank of Japan (BOJ) carefully assesses economic conditions
based on a two-perspective approach. One is to examine, as regards economic activity
and prices one to two years in the future, whether the outlook deemed most likely
by the BOJ follows a path of sustainable growth under price stability. The second is
to examine, over the longer term, risk factors that significantly affect economic
activity and prices when they materialize even if the probability is low. Shirakawa
also stressed the importance of deflation in asset prices, which had severely affected thereal economy, not only through the demand side but also through the supply side.
Although Shirakawa admitted the difficulty of measuring the exact size of the output
gap, he argued that the output gap measure recently estimated by the BOJ has closed,
which was quite consistent with some alternative measures, such as the BOJ’s Tankan
survey. With regard to price stability, Shirakawa noted that the BOJ had a clear
mandate to attain price stability over a medium- to long-term horizon. Then he
explained that, given the large uncertainty around the Japanese economy, it was quite
natural for each Policy Board member to have a different view about the consumer

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Concluding Panel Discussion

price index (CPI) inflation rate corresponding to price stability, so the BOJ decided todisclose the distribution of the Policy Board members’ views. Regarding the role of thequantitative monetary easing policy (QMEP) to address the banking problems, thepanel chairperson, Stefan Ingves, emphasized the importance of financial stimulation
as the first-best solution when the problems were serious, especially at an early stage.
Shirakawa agreed with Ingves, but also remarked that we should explore the channel
through which quantitative easing could affect the real economy.

II. General Discussion among Participants
A. Reflections on Monetary Policy in a Low Interest Rate Environment
Regarding the effectiveness of monetary policy in a low interest rate environment,
Hans Genberg (Hong Kong Monetary Authority) suggested that the decreasing effects
of interest rate policies could be interpreted differently. Since central banks communicate their policy intentions well ahead of time, the economy will have already reacted
by the time the interest rate decision is actually implemented. It would then appear
as if the policy action did not have much of an influence. In this connection, Genberg
conjectured that when a central bank starts to focus on a particular policy instrument,
this variable will have less and less influence on the ultimate objective of the central
bank’s policy. On similar grounds, José Luis Malo de Molina (Banco de España)
claimed that by reducing uncertainty and enhancing investment, monetary policy
could be made effective even under globalization.
Reichlin responded that the apparent decrease in the effectiveness of monetary
policy could be the result of the fact that inflation expectations were anchored. Inthat case, monetary policy might be actually effective. Reichlin noted, however, that
we should still worry about the effectiveness unless central banks successfully guided
the real interest rate close to the neutral interest rate.
Jan Marc Berk (De Nederlandsche Bank) asked about the consequences of a lowinterest rate environment on the development of money and credit. Andrew Filardo(Bank for International Settlements) pointed out that far too little is known from thehistorical record about the range and relative effectiveness of all the options open tomonetary policymakers when short-term interest rates are at zero but before theeconomy gets caught in a liquidity trap.
Toshihiko Fukui (Bank of Japan) remarked that the quantitative easing framework
implemented by the BOJ showed visible effects in stabilizing the financial system andcreating and maintaining a very accommodative environment that supported therecovery of Japanese firms. He noted, however, that the portfolio rebalance channel,
as one of the potential transmission channels of the quantitative easing, remained tobe questioned. McCallum commented that the effects of the quantitative easing weremore attributable to the expectation channel than the portfolio rebalance channel,
although he stated that the latter channel had more or less worked through a substantial amount of purchase of long-term Japanese government bonds. Filardo commented
that the monetary policy transmission mechanism, especially the portfolio rebalancechannel, was effectively jammed by various nonmonetary problems, such as the deep269

structural problems in the financial system that arguably were prolonged by regulatory
forbearance; it was conceivable that more aggressive central bank actions could havefurther weakened the resolve of regulatory bodies to deal with the root causes of thethese structural problems. Keimei Kaizuka (Chuo University) stated that the structuralchange in the Japanese labor market was an important example of a factor that madeJapanese monetary policy more difficult to implement.
B. Communication Policy by Central Banks
Against McCallum’s critical review of unconditional statements by the Fed, Glenn D.
Rudebusch (Federal Reserve Bank of San Francisco) argued that, in principle, there
was nothing wrong with producing unconditional forecasts. He claimed that unconditional forecasts would actually be preferable to the conditional forecasts currently
produced by many central banks, conditioned on an unchanged interest rate path.
He then stressed the importance of central banks’ clear explanation to market participants about the meaning of unconditional forecasts, based on the FRB’s experience.
Shirakawa agreed with Rudebusch, saying that although he had some sympathy
with forward-looking language, central banks should not go too far. He noted thatforward-looking language could become misleading if it was understood as an
unconditional statement, while it tended to become meaningless if its conditional
nature was emphasized too much, because too much emphasis on the conditionality
tended to make the statements somewhat meaningless.
Kazumasa Iwata (Bank of Japan) remarked that the effectiveness of the FRB’s
forward-looking language might have been complemented by market participants’recognition of the FRB’s implicit expression of price stability, which was indicated as
2 percent of the CPI in the transcript of the Federal Open Market Committee (FOMC)
meeting in 1996. He then explained that the BOJ’s new framework for the conduct ofmonetary policy, which was adopted at the Monetary Policy Meeting on March 8
and 9, 2006, consisted of three parts: (1) a disclosure of the understanding of mediumto long-term price stability; (2) an examination from two perspectives, examining
economic activities and prices one to two years in the future and examining various
risks in the longer term; and (3) a disclosure of the outline about the current view onmonetary policy in the Outlook for Economic Activity and Prices. He then stated thatthe first component meant a kind of provision of common knowledge, which enhanced
the BOJ’s transparency and the coordination with market participants’ views. He also
explained that, in the most recent outlook, the Policy Board members took into accountmarket participants’ views regarding the future course of the policy interest rate inmaking economic forecasts.
Kiyohiko G. Nishimura (Bank of Japan) explained that the important backgroundfor the BOJ’s new framework was a high degree of uncertainty over the Japanese
economy that included not only the uncertainty expressed as a fat tail in a distribution,
but also the uncertainty in a distribution itself, which had been argued by Frank
Knight. He clarified that it was the fundamental reason why the BOJ took its
two-perspective approach. He then explained that the BOJ decided to disclose each
Policy Board member’s view on price stability, because the collective wisdom wasconsidered superior to any one particular view under this kind of uncertainty. Finally,

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Concluding Panel Discussion

he mentioned that the BOJ’s understanding of price stability might change due topossible changes in the Japanese economy in the future.
C. Remaining Conundrums
Genberg asked about the reasons for the increased cross-country correlations of
nominal and real interest rates. Reichlin responded that there were several explanations
including anchored inflation expectations, the decreased inflation risk premium, andglobal factors such as competition effects coming from emerging countries. She addedthat the explanations related to monetary policy seemed convincing, whereas there
was little empirical evidence pointing to a huge competition effect.
Filardo remarked on the implications of financial globalization for the increased
correlation of interest rates. In a small open economy, trying to raise interest rates
above the prevailing rates in the world or to cut rates below the prevailing rates could
lead to a policy dilemma, because of the resulting financial inflows or outflows. The
options might be best characterized as a “damned if you do and damned if you don’t”
situation. Filardo argued that even the G-3 countries would not remain completely
immune to such pressures in an increasingly globalized world.
Ulrich Kohli (Swiss National Bank) agreed with Obstfeld that there remained“another conundrum” on the consistency between the correlation of long-term interest
rates and movements in real exchange rates. Kohli pointed out, however, that the
preclusion of transformation possibilities between outputs in Obstfeld’s model might
have distorted its quantitative implications. Obstfeld responded that he ignored several
factors in his model because his purpose was a short-term analysis.
Kenneth J. Singleton (Stanford University) stressed the role of the inflation risk
premium in the movements in the real interest rate. He pointed out that both Reichlin
and Obstfeld implicitly assumed that the inflation risk premium was constant and thesame across countries in their arguments. Singleton argued that a consideration of
the risk premium could resolve “another conundrum” suggested by Obstfeld, that is,rationalizing the departures of exchange rate movements from interest rate differentials
on an expected basis. Singleton commented that the next question to be addressed
would be the macroeconomic story behind the risk premium. Obstfeld responded that
it would still be questionable whether the implied exchange rate paths were consistent
with sustainable current account adjustment even if the risk premium was consideredin his model.

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