MONETARY AND ECONOMIC STUDIES
2001
Opening(SPECIALSpeech byEDITION)/FEBRUARY
Governor Masaru Hayami

Opening Speechby Governor Masaru Hayami

Good morning, ladies and gentlemen.
It is a great pleasure to have an opportunity to meet such distinguished guests
from academic circles and various central banks on the occasion of the Ninth
International Conference hosted by the Institute for Monetary and EconomicStudies. I would like to welcome all of you who have kindly found time out of yourbusy schedules to participate in this conference.
The topic of the conference is “The Role of Monetary Policy under Low
Inflation,” which is the very problem that the Bank of Japan has faced since the1990s and perhaps what many central banks might face in the future.
The 1990s is often referred to as the “lost decade” for Japan’s economy. Duringthat period, Japan’s real GDP growth was next to last among G-7 countries and also
recorded the largest drop compared with the 1980s. Inflation declined to almost zero,and at times we faced the danger of falling into a deflationary spiral. In response, theBank of Japan conducted aggressive monetary easing. In particular, since February
1999 the Bank has pursued the unprecedented policy of guiding short-term money
market rates down to virtually zero percent to prevent the economy from tumbling
into a deflationary spiral and also to support a recovery.
What are the factors behind Japan’s lost decade of the 1990s? One basic structural
factor is that a variety of systems which had supported the postwar development ofJapan’s economy became unsustainable. Another factor is the emergence and burstingof the bubble. While the emergence of the bubble led to many much needed
structural reforms being postponed, its bursting brought Japan’s economy to theverge of falling into a deflationary spiral.
Though the main purpose of this conference is not to discuss the emergence andbursting of the bubble, when we at the Bank of Japan discuss the role of monetary
policy under low inflation, we cannot but refer to the problems we experienced
during the bubble period.
In this regard, let me outline some lessons from the bubble period that I findimportant in an individual study made by Bank staff relating to monetary policy inthe late 1980s.
One prominent feature that characterized the bubble period in Japan was theeuphoric sentiment which prevailed in every segment of society, and which led
to extremely bullish expectations. In this regard, we think it is not sufficient tounderstand the bubble solely in terms of the rise in asset prices such as property
and equity prices. In the study I mentioned, the bubble economy is defined as a9

combination of the rapid increase in asset prices, the expansion of monetary
aggregates, and the overheating of economic activity. Japan’s economy did indeed
experience such developments from 1987 through 1990.
A number of factors were intertwined in the background of such euphoria, andmonetary easing was certainly one of them. Monetary easing was a necessary condition for the emergence of the bubble, and to that extent should be held responsible.
But in our defense, I have to say that if we had tried to prevent the emergence andexpansion of a bubble by monetary policy alone, we would have had to raise interest
rates to levels which could not be justified because of the relatively stable prices at thetime. This is one of the difficulties we face in dealing with a bubble.
The next question is: In what respect was monetary policy responsible for theemergence and expansion of the bubble? It is true that we had maintained low
interest rates for a relatively long period, even after the summer of 1988 when theeconomy was clearly on a recovery path, and allowed unfounded expectations to beembedded in the market and society that such low interest rates would continue for aconsiderable period. We should take it seriously that this was undeniably one of thedriving forces behind the expansion of the bubble.
What should be done to avoid repeating such an experience? We hear a variety
of suggestions: For example, “The Bank of Japan should have paid more attention
to the movement of money supply or the rise in asset prices,” and “It has made a
mistake by putting too much emphasis on the foreign exchange rate in the conductof monetary policy.” Unfortunately, these are reflections and lessons with the benefitof hindsight, and we cannot fully use them as a practical guideline for making policy
on a real-time basis.
We need a more pragmatic approach. From such a viewpoint, the most significant
lesson that we should keep in mind is the importance of evaluating risks to theeconomy at an early stage, and of dealing with them in a preemptive manner. AsI have said, it would not have been possible for monetary policy alone to have
prevented the bubble from emerging. However, if we had conducted monetary policy
in a preemptive manner by taking into account future risks over the long run,economic fluctuation during the bubble period might have been less.
As a matter of fact, it is extremely difficult to identify whether it is a bubble or
not when we are actually experiencing bubble expansion. One of the reasons for thisdifficulty is that we cannot exclude from the observed reality the impact of changes
in economic structure. For example, during the bubble period many presented aseemingly plausible argument that a rapid rise in property prices in Tokyo could bejustified in view of the increasing role of Tokyo as an international financial center,but which could not be proved to be true at the time.
Inevitably, the central bank faces two risks. They are similar to statistical errors.
One risk is that the Bank might mistakenly tighten monetary policy when theeconomy is about to benefit from a marked improvement in productivity, and as
a result suppress the growth potential of the economy. The other risk is that itallows the bubble to expand by wrongly interpreting the supposed improvementin productivity as real. When we make a policy decision, we should evaluate not
only which one of these two risks has the greater probability of emerging, but also

10 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Opening Speech by Governor Masaru Hayami

the socioeconomic cost of each. Our experience of the bubble period seems toindicate that we did not fully recognize that the risk of wrongly interpreting a
supposed productivity improvement could deliver such a serious blow to the sounddevelopment of the economy over the long run.
What should have been done to calm the euphoric sentiment at that time andturn the focus of society to the potential risk facing the economy from a longer-term
perspective? The important lesson from such a viewpoint is that we need to clearlystate the objective of monetary policy; in other words, we need to substantiate theabstract concept of price stability.
Looking back at Japan’s economy during the bubble period, consumer price index(CPI) inflation had been stable until 1987, began to gradually rise in 1988, andrecorded a year-on-year increase of about 1 percent in March 1989, which wasimmediately before the introduction of the consumption tax. Adjusted for the impactof the consumption tax, it continued to rise after April 1989, reached the 2 percent
level in April and the 3 percent level in November 1990, and remained at that level
until August 1991.
Since such a price hike considerably lagged the rise in asset prices and could not
be regarded as particularly high compared with the figure before the bubble period,
the threat of inflation did not constitute a valid argument in convincing the publicthat monetary conditions needed to be tightened. While inflation during the bubble
period was relatively mild, Japan’s economy had been brought to the verge of falling
into a deflationary spiral in the 1990s. The deflation we observed at that time waslargely the result of the bubble economy that had emerged in the late 1980s.
Such an experience suggests that we as the central bank should aim at pricestability which supports medium- to long-term sustainable growth, not price stability
at a particular point in time. In this context, even if measured inflation is stable,
we need to promptly alter interest rates once we judge that the risk of damaging
sustainable price stability has become higher. According to this criterion, we havenot, to our regret, sufficiently succeeded in maintaining price stability in Japan sincethe bubble period.
So far, I have mainly described the lessons for monetary policy derived from ourexperience during the period when the bubble emerged. Of course, we also need tolearn from the experience after the bursting of the bubble. It may be too early tosummarize the experience and draw lessons, but I am sure we will learn quite a lot
from the discussion at this conference.
It is true that there is yet another major factor behind worldwide disinflation. It is
the revolutionary progress of information technology, which we may perhaps call a
new industrial revolution, and the resulting improvement of productivity. To findanswers to what is price stability and an appropriate monetary policy in the face ofrapid disinflation due to higher productivity are difficult but positive challenges.
In conclusion, I sincerely hope that through fruitful discussion at the conference,both those from academic circles and central banks will learn more, share the fruit,and make use of the wisdom obtained for the future conduct of monetary policy.
Thank you for your attention.

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