February 6, 2018
<Verifying QQE of the 5-year period >Yield Curve Control Has Enhanced Policy Sustainability— Exit Made More Difficult by Continuing Purchases of Risky Assets
JCER Financial Research Team1
Kazumasa IWATA (President of JCER)
Ikuko FUEDA-SAMIKAWA (Principal Economist)
Tetsuaki TAKANO (Economist)

The Bank of Japan’s (BOJ’s) quantitative and qualitative monetary easing (QQE) with yield
curve control (YCC) is not merely a matter of switching the operating target for monetary
policy from quantity to interest rate. Rather, it is a major policy shift in terms of enhancing
policy sustainability. The BOJ is rapidly reducing purchase amounts of Japanese government
bonds (JGBs) and heading for a “stealth exit.” Nevertheless, purchases of risky assets such as
exchange traded funds (ETFs) and real estate investment corporations (J-REITs) continue,
which raises concerns that any exit will be difficult. In the near term, natural rates of interest
are already negative, and for the long term, halting the decrease in productive workers is an
issue. Who will benefit from inflation in Japan with its rapidly aging population? Is there nota risk that financial intermediary functions will decline under a prolonged ultra-loose
monetary policy? In the phase of exit from current QQE when the BOJ start raising its policyrate, the Bank could incur massive losses from negative spreads between investment yields
and interest payments. Is there still a margin for public finances in Japan to shoulder theburden of additional fiscal costs? A comprehensive discussion is needed.

1

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

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

(Summary)○ Since the Bank of Japan (BOJ) introduced “quantitative and qualitative monetary easing (QQE)with yield curve control (YCC)” in September 2016, the Japanese government bond (JGB)
market has stabilized under YCC. The so-called stock effect has come into play as a result of the
BOJ holding in excess of 40 percent of the JGB issued. The BOJ is rapidly reducing JGB
purchase amounts and 10-year JGB yields are kept around zero percent. On the other hand, pricefluctuations for long-term JGBs are scanty under YCC, and the BOJ trade, which sells newly
issued JGB to the BOJ, is picking up speed. This is likely to reduce the liquidity of JGBs.
○ How long will the BOJ continue to buy risky assets such as exchange traded funds (ETFs) andreal estate investment corporations (J-REITs)? There has been no noticeable reduction in the risk
premium since the launch of QQE in April 2013. Since the BOJ tend to purchase ETFs whenstock prices are falling, there is a clear upward tendency in the rate of stock price rises inafternoon trading on the day of the BOJ’s carrying out purchases. Purchases of risky assets arealso tinged with fiscal policy and it induces the Bank’s financial health to be continuously
exposed to risks so long as the BOJ holds these assets. It is necessary to increase transparency
including indicating the policy for use of voting rights to management companies.
○ The price stabilization target of 2 percent has not yet been achieved due to the decline in thenatural rates of interest at which the economic activities neither accelerate nor decelerate. Naturalrates of interest are also falling in the key nations and areas in Europe and the United States. As aresult of estimating natural rates of interest in Japan using the Dynamic Stochastic General
Equilibrium (DSGE) model, we can confirm a decline since the late 1990s. In the near term, therate is falling to negative 0.4% (on a quarterly basis), suggesting a decline in the time preference
rate among consumers (the degree whereby current consumption is favored over future
consumption). There is the impact of rising unease over the future due to the decreasing
population and increasing longevity.
○ The decrease in the population of productive workers is linked to a decline in natural interest
rates. Simulations using actual numerical values based on the Solow Model and Diamond
Overlapping Generations (OLG) model, which are the basic model of economic growth theories,
reveal that natural interest rates in Japan will remain at a low level in the future due to thedecrease in the working-age population. The issues are to raise the retirement age and to halt the
population decline.
○ Is the 2 percent inflation target, the international standard, high or low amid the difficult outlook
for raising natural interest rates? In the United States, there is a lively debate about raising
inflation targets and introducing price level targets to ensure future means of easing. Meanwhile,during the lost two decades, the population composition in Japan has become increasingly
weighted toward the elderly who are vulnerable to inflation. Who will benefit from inflation?

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

1. Verifying the 5-year period since the introduction of QQE
1-1 Yield curve control has enhanced policy sustainability
Haruhiko Kuroda, Governor of the Bank of Japan (BOJ), will finish his five-year term in April
2018. The BOJ pioneered the use of unconventional monetary policy in the closing years of thetwentieth century. Since then the framework has repeatedly changed. Under the “quantitative andqualitative monetary easing (QQE)” introduced in April 2013, the BOJ aimed to influence theexpectations of corporations and households by purchasing large-sized JGBs, to put downward
pressure on long-term interest rates, and to work on risk premiums of various assets. The focus on
influencing expectations was due to the strong awareness of the Zero Lower Bound (ZLB) that had
been preventing nominal interest rates from falling below zero. Since then, the BOJ decided “QQE
with a Negative Interest Rate” in January 2016, introducing Japan to the negative interest rate policy
already adopted by central banks in north European countries and the European Central Bank (ECB).
As a result of setting short-term interest rates below zero, long-term interest rates fell even further,
causing a sudden flattening (bull flattening) of the yield curve (Fig. 1-1). When the BOJ broke throughthe ZLB and introduced negative interest rate policy, expectations for further easing, i.e., to further cut
the negative policy rate, spread through the financial market and investors rushed acquisitions oflong-term bonds with positive yield to obtain a slight return over the negative yield for short-termbonds.
Fig. 1-1 The introduction of YCC steepens the yield curve
2.0(%)
Jan 2016 (Pre-NIRP)

1.5
Aug 2016 (Pre-QQE with yield curve control)
1.0
Jan 2018 (Present)
0.5
0.0(Year)

-0.5
1

2

3

4

5

6

7

8

9

10

15

20

30

40

Source: Bloomberg

After the introduction of QQE with yield curve control (YCC), the JGB yield curve rose steeply forterms in excess of ten years. The shrinking spread between long and short-term interest rates meant
contracting lending margins for banks, which operate long-term lending or bonds with short-term
deposits. Even when the policy rate dropped into negative territory, interest on deposits did not
become negative. Considering expenses such as personnel costs, lending margins at all banks for theterm ended March 2017 were at a low level on a par with the early 1990s (Fig. 1-2). There is a rising

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

specter of deterioration of the financial intermediary function under the new phase of monetary easing
with no exit in sight.
Fig. 1-2 Low level of loan margins at a par with the early 1990s
1.2

(%)

【Deposit Loan Margin by Business (after expenses)】

1.0
0.8
0.6
0.4
0.2

Major Banks

Regional Banks

Second-tier Regional Banks

0.0

(FY)

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Note: 1.Deposit loan margin (after expenses) = "Yields on loans" - "Yields on lending" - "Expense ratio".
2. Regarding FY 2013, figures from the former Mizuho Bank before the merger are not included.
Source: Japanese Bankers Association

In order to ease the negative impact of the bull flattening yield curve on financial institutions andinvestors, the BOJ followed up the negative interest rate policy with YCC. In addition to short-term
interest rates, the BOJ also started to control long-term interest rates. As a means of maintaining theyield for ten-year JGBs at the zero percent level, the BOJ also introduced the fixed-rate full-allotment
operations -- through which it can purchase an unlimited amount of JGBs at a certain interest ratelevel2. By introducing fixed-rate purchase operations as a complementary tool in addition to YCC, theyield curve has remained stable with the exception of a period of time after the presidential electionsin the United States (Fig. 1-3). So far, it would seem that the handling of long and short-term interest
rates has been successful.
Fig. 1-3 Yield on ten-year government bonds
1.2

(%)

0.2

Long term interst rate(%)
Long term interest rate

0.8

0.1
YCC

0.4

0.0

0.0

-0.1

-0.4
13/04

(Daily)

14/04

15/04

16/04

-0.2
17/04 18/02
16/09(Daily)
16/12

17/03

17/06

17/09

18/02
17/12

Note: Data is until Feb 2, 2018.
Source: Bloomberg
2

As of February 2018, the BOJ carried out unconditional buying of government bonds on a total of four occasions: (1)November 17, 2016, (2) February 3, 2017, (3) July 7, 2017, and (4) February 2, 2018. No bids were tendered for the first,
third, and fourth occasions.

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

BOJ policy switch: Shifting monetary policy target from quantity to yield with YCC
In the three and a half years between the introduction of QQE in April 2013 and the introduction of
YCC (September 2016), the BOJ targeted quantity, or an increase in the monetary base. The main
method of increasing quantity was to purchase long-term JGBs. Even under the negative interest rate
policy decided in January 2016, the BOJ stated that it would increase the net supply of the monetarybase at a pace of 80 trillion yen per year, but the QQE policy which increases the monetary base, andthe negative interest rate policy which imposes a penalty on the resulting rise in the BOJ’s current
account balances, were an inherently incompatible combination (Okina (2016)). As previously pointed
out by Iwata, Samikawa, and Japan Center for Economic Research (2016), and by Samikawa,
Takahashi, Saito, Shiraishi, Nomura, and Hakubi (2016), the BOJ was approaching the limit forpurchasing JGBs as a result of spending 120 trillion yen a year on JGBs when the amount ofamortization is included. Taking into consideration the need for collateral when banks procure foreign
currency, there was scant margin for financial institutions to dispose of JGBs under BOJ operations.
The minimum amount of JGBs that financial institutions need to hold in view of the requirement forcollateral or ALM is referred to as the “bedrock (lower limit)” at the BOJ3. Sato (2017) points out thatthe BOJ is approaching the bedrock as a result of large-scale purchases of JGBs.
With the introduction of YCC, the BOJ eliminated the descriptions of quantity (the monetary base),
which had been the guideline for money market operations, and switched the monetary policy target
from quantity to interest rate. When the amount for purchases of long-term bonds became fixed, thegoal of purchasing 80 trillion yen of long-term JGB annually became a “goal” as it was not possible toform the ideal yield curve. As a result, the quantity of long-term JGB purchases was determined
endogenously. In the first year after the introduction of YCC, the JGB market was comparatively
stable and the BOJ reduced the annual amount of increase in JGB holding necessary to maintain theyield on 10-year bonds at the zero percent level to 60 trillion yen (Fig. 1-4).

3

The BOJ seems to frequently use the expression bedrock in the sense of a lower limit. In June 2006, three months after thecancellation of quantitative easing, Toshihiko Fukui, then BOJ governor, said in a press conference that “the reduction in the
BOJ current account balance was moving ahead and had nearly reached the bedrock.” Summary of press conference held on
June 16, 2006. (http://www.boj.or.jp/announcements/press/kaiken_2006/kk0606c.pdf)
At the Monetary Policy Meeting chaired by then-governor Masaaki Shirakawa in October 2012, the minutes of theproceedings indicate that one member expressed the view that lending rates were approaching a "bedrock" as the averagecontracted interest rates on both short- and long-term loans and discounts had been at around 1
percent, and thus were at levels below the lowest rates recorded during the period of quantitativeeasing.” (http://www.boj.or.jp/mopo/mpmsche_minu/minu_2012/g121005.pdf)

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

Fig. 1-4 Stealth exit: Pace of long-term JGB increase slowing down after YCC
85(Change from previous year, Trillion yen)
BOJ's JGB Holdings (Change from previous year)

YCC

80
75
70
65
60
55
16/01

16/03

16/05

16/07

16/09

16/11

17/01

17/03

17/05

17/07

17/09 (Monthly)
17/1117/12

Note: Change in JGB outstanding in the BOJ's balance sheet from previous year.
Source: Bank of Japan

Although market players refer to the covert winding down of asset purchases at the BOJ as stealthtapering, tapering refers to cases when the target of monetary policy operations is quantity. Since yieldis the present operational target for the BOJ, is it not a case of a “stealth exit” where the BOJ is
tiptoeing for the exit from unconventional monetary easing (Iwata (2017)) if the pace of future(covert) decisions to purchase JGBs slows as a result of maintaining long-term interest rates at aroundzero percent level? The return to conventional interest rate policy framework from the QQE
framework, which focused on the quantity, i.e., the monetary base, is highly significant in terms ofincreasing policy sustainability4.
The effect of lowering long-term interest rates depends on JGB holdings at the BOJ: The stock
view approachLong and short-term interest operations by the BOJ are supported by the stock view approach.
According to this approach, it is not the amount of government bond purchases by the central bankthat have a strong influence on long-term interest rates, but stock such as the central bank’s share ofgovernment bond holdings or outstanding balance. By purchasing JGBs on a large scale and over
several years, the BOJ now maintains a large presence in the JGB market. According to the Flow ofFunds Accounts published in December 2017, the BOJ is the largest holder of JGBs, holding 413
trillion yen as of the end of September 2017 when the BOJ share of total issuance rose to 42% (Fig.
1-5). When the ratio of BOJ holdings of amounts outstanding and total issuance increases, the stock
effect is activated, making it possible to achieve the same interest rate level by purchasing smaller
amounts of JGBs.

4

However, qualitative easing still involves purchases of ETFs and other risky assets.

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

Fig. 1-5-1 BOJ holdings of JGB exceed 400 trillion yen
500(Trillion yen)Central bankDomestic banks

Financial institutions for small businesses

Insurance

Pension funds

Overseas

400
300
200
(Quarterly)100
000:1 01:1 02:1 03:1 04:1 05:1 06:1 07:1 08:1 09:1 10:1 11:1 12:1 13:1 14:1 15:1 16:1 17:1
17：3

Fig. 1-5-2 Ratio of JGB holdings by sector at the end of September 2017
Agriculture, Forestry
and Fisheries financial
institutions 3% Pension funds 4%

Households
1%

Mutual aid insurance
4%
Overseas 6%
Public pension 5%
Domestic banks 9%
Financial institutions forsmall businesses
9%

Central bank42%
Insurance
21%

Note: JGB includes FILP (fiscal investment and loan program) bonds and excludes Treasury discount bills.
Source: Bank of Japan, Flow of Funds AccountIn the era of conventional monetary policy, the assumption was that the central banks were able tocontrol short-term interest rates, but not long-term interest rates. In contrast to short-term interest rates
where central banks have the monopoly on decision-making, long-term interest rates are determinedby market predictions for future short-term interest rates and various risk premiums. However, thestock view approach became prevalent when the principal central banks started to increase holdings ofgovernment bonds under the unconventional monetary policy. After the introduction of YCC, theprevalent thinking in Japan was that the BOJ had started to reduce purchases, but as matters now stand,the assumption is that the lack of widespread confusion in the monetary markets is due to the stock
view approach permeating the markets. Takahide Kiuchi, executive economist at Nomura ResearchInstitute and a former member of the BOJ policy board, made this point during his time as a board
member5. In October 2017, a year after the BOJ introduced YCC, Hiroshi Nakaso, Deputy Governor
at BOJ, commented “It is obvious from the past year's experience that the answer is "yes"” on the
topic of whether it is possible to control long-term interest rates in practice6.
5

February 23, 2017, “Recent Developments in Economic Activity, Prices, and Monetary Policy- Speech at a Meeting with
Business Leaders in Yamanashi-” (http://www.boj.or.jp/en/announcements/press/koen_2017/data/ko170223a.pdf)
6
October 18, 2017, “Evolving Monetary Policy: The Bank of Japan's Experience-Speech at the Central Banking Seminar
Hosted by the Federal Reserve Bank of New York-”(http://www.boj.or.jp/en/announcements/press/koen_2017/data/ko171019a1.pdf)

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

1-2 What are the changes in the JGB market in the year since the introduction of YCC
Policy sustainability has been enhanced thanks to YCC, but on the other hand, the BOJ trade isaccelerating in the JGB market. The BOJ trade is the method whereby banks, securities companies,
and other financial institutions settle capital gains by selling immediately to the BOJ after a successful
bid for newly issued JGBs from the Ministry of Finance. In a phenomenon known as sudden
evaporation, new issues of long-term JGB disappear from the secondary market in a mere one to twomonths due to the “BOJ trade”. According to Fig. 1-6, which looks at the market survival rate, or how
long newly issued 10-year JGBs stay on the market after issuance, more than 70 percent of the No.
346 JGBs issued in March 2017 were bought by the BOJ by April, leaving only less than one third in
the secondary market. The sudden evaporation of new bond issues has also been observed for otherlengths of time. If JGBs slated for future purchases become scarce, (assuming all other condition are
settled) the downward effect on interest rates due to the purchase of one unit of JGB will be greater,
but on the other hand, liquidity in the JGB market will decline and the risk of volatile long-term
interest rates will increase. In addition to the BOJ temporarily supplying scarce JGBs through buyback
operations, under the JGB issuance plan for fiscal 2018, the Ministry of Finance will also increase thelimit for the auction for enhanced liquidity, which issues noticeably scarce JGBs, by 1.8 trillion yen toa record 12.6 trillion yen7.
Fig. 1-6 Length of time until the BOJ purchases newly issued 10-year JGBs (market survival rate)
10-yearIssue Date
Issue Number(reference:320) Jan-12
328
Mar-13329
Jun-13330
Sep-13331
Nov-13332
Dec-13333
Mar-14334
Jun-14335
Sep-14336
Dec-14
337
Jan-15338
Mar-15339
Jun-15340
Sep-15341
Dec-15342
Mar-16343
Jun-16344
Sep-16345
Dec-16346
Mar-17347
Jun-17348
Sep-17

Market survival rate of newly issued government bonds
M

M＋1 M＋2 M＋3 M＋4 M＋5 M＋6 M＋7 M＋8 M＋9 M＋10 M＋11 M＋12
1 0 0 %

1 0 0 %

1 0 0 %

1 0 0 %

1 0 0 %

9 7 %

9 7 %

9 6 %

9 6 %

9 6 %

9 6 %

9 6 %

9 6 %

1 0 0 %

8 3 %

8 3 %

8 1 %

8 1 %

8 1 %

8 1 %

8 1 %

7 9 %

7 5 %

6 5 %

6 5 %

6 5 %

7 0 %

5 7 %

5 8 %

5 5 %

5 5 %

5 5 %

5 5 %

5 5 %

5 5 %

5 5 %

5 5 %

5 5 %

5 4 %

7 1 %

6 4 %

5 7 %

5 6 %

5 0 %

4 7 %

4 5 %

4 5 %

4 5 %

4 5 %

4 5 %

4 5 %

4 5 %

5 6 %

4 5 %

4 5 %

4 5 %

4 5 %

4 5 %

4 5 %

4 4 %

4 4 %

4 4 %

4 4 %

4 4 %

3 9 %

8 9 %

8 0 %

6 0 %

5 8 %

5 8 %

5 7 %

5 3 %

5 3 %

5 3 %

5 3 %

5 3 %

5 3 %

5 3 %

6 8 %

5 8 %

4 7 %

3 8 %

3 8 %

3 8 %

3 4 %

3 2 %

3 2 %

3 2 %

3 1 %

3 1 %

3 1 %

5 5 %

4 9 %

4 6 %

4 0 %

3 3 %

3 3 %

3 3 %

3 3 %

3 3 %

3 0 %

3 0 %

3 0 %

2 9 %

7 8 %

6 6 %

5 7 %

4 1 %

4 1 %

4 1 %

4 1 %

3 9 %

3 9 %

3 9 %

3 5 %

3 5 %

3 3 %

7 6 %

6 4 %

6 0 %

4 6 %

4 6 %

4 2 %

4 0 %

4 0 %

3 8 %

3 8 %

3 8 %

3 8 %

3 8 %

5 4 %

3 6 %

3 4 %

3 3 %

3 0 %

3 0 %

3 0 %

3 0 %

3 0 %

3 0 %

3 0 %

2 8 %

2 6 %

5 7 %

4 3 %

5 1 %

3 8 %

3 6 %

3 6 %

3 5 %

3 2 %

3 0 %

2 7 %

2 5 %

2 5 %

2 3 %

7 9 %

7 3 %

6 5 %

4 7 %

4 7 %

4 7 %

4 3 %

4 3 %

4 3 %

3 8 %

3 8 %

3 8 %

3 6 %

6 4 %

5 4 %

3 8 %

3 1 %

3 1 %

2 8 %

1 9 %

1 9 %

1 9 %

1 9 %

1 9 %

1 9 %

1 9 %

8 6 %

6 0 %

5 3 %

4 6 %

3 9 %

3 9 %

3 7 %

3 7 %

3 7 %

2 8 %

2 8 %

2 8 %

2 8 %

7 3 %

5 3 %

4 4 %

2 5 %

2 4 %

2 3 %

2 1 %

2 1 %

2 1 %

2 1 %

1 8 %

1 5 %

1 4 %

7 5 %

4 6 %

3 4 %

2 8 %

2 8 %

2 2 %

2 0 %

1 9 %

1 9 %

1 5 %

1 5 %

1 5 %

1 5 %

8 0 %

4 8 %

4 7 %

3 7 %

3 6 %

3 1 %

2 9 %

2 7 %

2 7 %

2 7 %

2 7 %

2 7 %

7 6 %

5 4 %

4 1 %

4 0 %

4 0 %

3 9 %

3 3 %

3 3 %

3 3 %

3 3 %

3 3 %

3 3 %

6 7 %

2 8 %

2 5 %

2 2 %

1 7 %

1 7 %

6 3 %

4 8 %

3 1 %

2 0 %

2 0 %

2 0 %

3 6 %

3 1 %

6 9 %

0-33%

-

34-66%

-

1 4 %

-

1 3 %

-

1 3 %

-

-

-

-

2 4 %

-

67-100%Note: 1. M is the end of month that 10-year JGBs were issued. M + 12 represents 12 months after the issue month end.
2. The red color indicates that the period of staying in the secondary market is short.
Source: Ministry of Finance, Bank of Japan

7

December 22, 2017, Ministry of Finance “Planned Issuance Amount of Japanese Government Guaranteed Bonds(JGGB)
for FY2018” (http://www.mof.go.jp/english/jgbs/debt_management/plan/e171222overview.pdf)

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

The policy switch has enhanced QQE sustainability
At present, the BOJ is thought to be moving stealthily toward the exit, but 51.3 trillion yen,corresponding to 12%, of the 418.6 trillion yen of long-term JGB holdings (as of end November 2017)is due for amortization in 2018 (Fig. 1-7 left). Under YCC, the JGB purchase amount is determinedlater contingent on interest rate levels, but if the BOJ continues to buy JGBs at the current pace of 60
trillion yen (a year-on-year increase in the amount of outstanding long-term JGBs), the bank will buy
more than 110 trillion yen of JGBs from the secondary market in 2018. However, the monthly
purchase amount was approximately 7.5 trillion yen in November 2017. If this pace continues, theannual increase in outstanding JGB will fall below 40 trillion yen in year’s time, or to around half ofwhat it was at the peak (Fig. 1-7 right).
Fig. 1-7 Fifty-one trillion yen of BOJ holdings of JGBs due for amortization in 2018
【BOJ's Holdings of JGBs】【Amount of Redemption JGB Held by BOJ (as of Nov 30, 2017)】(Trillion yen)
(Change from previous year, Trillion yen)
60
100

YCC

50

80

40

60

30

40

20
10

20

0

0

18

19

20

21

22

23

24

25 (CY)The monthly purchase amount decreases
The monthly purchase amount stays at 7.5 trillion yen(Monthly)

13/04

14/04

15/04

16/04

17/04

18/0418/12

Source: Bank of JapanThe stock effect, which is the cumulative effect of JGB purchases, is expected to act more strongly
the closer to the bedrock (lower limit) mentioned above. If the BOJ continues to focus its buying on
scarce issues, it might be possible to manipulate long and short-term interest rates with even smallerpurchases. If the annual increase in outstanding JGBs at the BOJ is around 40 trillion yen, the BOJ
will be able to continue to increase the JGB balance until the first quarter of 2024. There is ample
potential that the BOJ will finish the tapering -- the reduction of amounts of JGB purchases -- earlier
and move to the re-investment stage to maintain the balance sheet. In the near term, the pace of
reduction is fast. Supposing that the pace of reduction since the YCC is continued, the annual increase
will fall below 30 trillion yen at the end of 2018 with the discontinuation of the increase in purchaseamounts coming into view during 2020. There is a risk of a sharp rise in interest rates, but it is safe to
say that the introduction of YCC has caused the limit on JGB purchases to recede and enhanced thesustainability of the policy.

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Japan Center for Economic Research
Financial Research Team

February 6, 2018

1-3 Exit strategy for risky assets: How long will the BOJ continue to buy ETF and J-REIT?
The BOJ has switched the operating target of its monetary policy from quantity to interest rates, but
the bank continues to purchase risky assets such as index-linked exchange-traded funds (ETFs) andreal estate investment trusts in Japan (J-REITs)8. In particular, ETF purchase amounts (annual increasein amount outstanding of holdings) doubled to approximately 6 trillion yen in July 2016, making the
BOJ the biggest buyer on both the bond market and the ETF market. On an ETF market capitalizationbase (30.0 trillion yen at end November 2017), the BOJ share of holdings rose to 74% (22.2 trillion
yen) and there are also quite a few indicators suggesting some kind of influence on business
management from the perspective of corporate governance. Assuming that the share of holdings on amarket capitalization base is around 3 percent, Governor Kuroda stated that “there are currently nomajor risks”9 at the regular press conference on October 31, 2017. The BOJ is buying ETF on theunderstanding that share prices will fall and empirical analysis has shown BOJ buying is underpinningshare prices. At the press conference, Governor Kuroda said that “the bank does not bear in mind
specific share price levels and maintain such levels when buying,” but the pace of buying slowed in
October when share prices rose for 16 consecutive working days and the BOJ postponed buying (Fig.
1-8). For how long will the BOJ continue to buy risky assets? Will it generate confusion in themechanism for turning toward financial normalization in the future? How will the risky assets beremoved from the balance sheet?
Fig. 1-8 The increasing pace of outstanding ETF holdings slowed
8.0(Trillion yen) 【BOJ's ETF Purchase Expanding】
BOJ's ETFs Holdings(Change from previous year)

25
20

6.0

15

(Trillion yen)【Value of ETFs held by the BOJ】

Book Value
Market Value

4.0
10
2.0
0.0

5
(Monthly)
17/12
16/01 16/04 16/07 16/10 17/01 17/04 17/07 17/10(Semi-annually)0
17/09
11/03 12/03 13/03 14/03 15/03 16/03 17/03

Note: Daily data up to and including December 31,2017.
Source: NEEDS-FinancialQUEST, Bank of Japan

8

Under QQE, the BOJ also bought commercial paper (CP) and corporate bonds (as qualitative easing), but since the current
amounts outstanding remain at approximately 2.2 trillion yen and 3.2 trillion yen respectively, this data was excluded fromthe analysis in this paper.
9Bank of Japan, “Summary of press conference” in Japanese, (November 1, 2017)(https://www.boj.or.jp/announcements/press/kaiken_2017/kk1711a.pdf)

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February 6, 2018

To what degree has the BOJ influenced the risk premium in the stock market?
At a press conference on June 16, 2017, Governor Kuroda said that the ETF purchases “areimplemented from the perspective of influencing the risk premium in the stock market.”10 In response,
Samikawa and Takano (2017a) pointed out the need for a comprehensive understanding of the effectof the BOJ’s ETF purchases from several points). Namely, (1) To what degree has the risk premium
been squeezed, (2) To what degree has this stimulated capital investment at corporations, and (3) Was
the measure really necessary for the early implementation of the 2 percent target for pricestabilization? At the press conference following the Monetary Policy Meeting on December 21, 2017,
Governor Kuroda said, “As mentioned, ETF buying is one element of the Quantitative and Qualitative
Monetary Easing with Yield Curve Control, the current monetary easing framework implemented tohave a positive impact on the economy and the CPI by influencing the so-called risk premium on thestock market. I believe that it has played a major role with respect to the influence on the risk
premium.”11 However, he did not specifically state which indicators the BOJ understands as the risk
premium under QQE. In this report, we define the risk premium as the difference between theearnings yield for share prices (the price-to-earnings ratio (PER) divided by the share price) and theinterest rate for safe assets (yield on 10-year JGBs). We looked at the fluctuations since the start of
QQE, but there was a significant reduction in JGB interest rates during the period, and no downward
trend in the risk premium was observed.
The BOJ has accumulated a balance of ETFs and, by the end of October 2017, the number ofcorporations where the BOJ indirectly owns more than 10 percent of shares had climbed to 24. The(indirect) ownership ratio of shares in Fast Retailing, the umbrella company for the clothing retailer
UNIQLO, is already in excess of 60 percent on a floating stock basis. Central banks are deeply
involved in the allocation of resources to individual companies and industries when purchasing ETFs.
Seeing that it is a policy tinged with fiscal policy12, the BOJ needs to indicate its plans with respect toexercising voting rights at trust banks and other management companies. It is difficult to dispose of
ETFs, J-REITs, and other risky assets that have no maturity or not yet reached maturity on the market
at the stage of financial normalization, but if they remain on the balance sheet, BOJ finances willcontinue to be exposed to risk. Supposing that share prices fall to the levels before additional easing in
October 2014 (Nikkei stock average at the 16,000 yen level), the unrealized gain for ETFs will be lost.
As well as indicating a timely exit strategy, the BOJ must without further delay prepare to put aside
the returns on ETFs, including dividend income, as reserves.
10

Bank of Japan, “Summary of press conference” in Japanese, (June 19, 2017)(https://www.boj.or.jp/announcements/press/kaiken_2017/kk1706b.pdf)
11
Bank of Japan, “Summary of press conference” in Japanese, (December 22, 2017)(http://www.boj.or.jp/announcements/press/kaiken_2017/kk1712c.pdf)
12
According to the provisions of Article 83 of the Constitution, the fiscal policy requires a resolution of the Diet.

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February 6, 2018

1-4 Developed countries are afflicted with a decline in natural interest rates
In the official announcement of the decision to introduce QQE in April 2013, the BOJ clearly statedthat it “will achieve the price stability target of 2 percent at the earliest possible time, with a time
horizon of about two years.” However, in reality, the year-on-year rate of change in the core CPI (allitems less fresh food) was 0.9 percent in December 2017 while the core-core CPI (all items less fresh
food and energy) was in the vicinity of zero percent, so there is still some distance to go before
reaching 2 percent (Fig. 1-9 left). The inflation forecasts in the BOJ Outlook Report are frequently
revised downwards, indicating divergence from the outlook of the private sector (Fig. 1-9 right).
Fig. 1-9 The BOJ inflation outlook is continually revised downward
2.0
1.5【BOJ Policy Board's core CPI outlook】
(%)
2.5
2.0
1.5
1.0
0.5
0.0
FY 2013
FY 2014
FY 2015-0.5
FY 2016
FY 2017
FY 2018(Quarterly)(Monthly)
-1.0
13/04
14/04
15/04
16/04
17/04 18/01
17/01 17/12(YoY、%) 【Consumer Price Index(CPI)】
Core CPI
Core core CPI
BOJ Core CPI

1.0
0.5
0.0
-0.5
-1.0
12/01

13/01

14/01

15/01

16/01

Note: 1.Excludes the effects of the consumption tax rate hike.
2. BOJ Policy Board's core CPI outlook is the median of the cases excluding the effect of the consumption tax hike.
Source: NEEDS-FinancialQUEST, Bank of Japan, Prospects of Economic and Price Situation (Outlook Report)

Why was the 2 percent target not reached at an early stage? For several years now, experts and thecentral banks in Japan and abroad have focused on the natural rate of interest. The natural rate ofinterest is neutral in respect to the inflation rate, causing neither accelerating nor decelerating in theeconomy. If a central bank is able to identify the level of the natural rate of interest, it is possible tostabilize the economy by guiding the policy interest rate to the desirable level.
The natural rate of interest cannot normally be observed but since the early 2000s, Thomas Laubach,an economist and a member of the U.S. Federal Reserve Board (FRB), and John Williams, President
and CEO at the Federal Reserve Bank of San Francisco, have been working on ways to estimate therate (the LW model). Recently, Holston, Laubach, and Williams (2017) showed that the natural rates
of interest in the United States, the Euro zone, the United Kingdom, and Canada have been at
historically low levels since the economic downturn precipitated by the Lehman Brothers bankruptcy.
They have also indicated that there is no outlook for a reversal of the natural rate of interest despite thenear-term economic recovery (Fig. 1-10). In the fall of 2013, Lawrence Summers, former U.S.
Treasury Secretary and professor at Harvard University, caused a stir when he identified the long-term
economic slump associated with the decline in the natural rate of interest as “secular stagnation”.
Natural rates of interest in the key nations still remain at a low level.

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February 6, 2018

Fig. 1-10 In Europe and North America, natural rates of interest have declined sharply since the global
financial crisis
5.0

(%)
U.S.

CanadaEuro area

U.K.

4.0
3.0
2.0
1.0
0.0
(Quarterly)

-1.0
80:1

85:1

90:1

95:1

00:1

05:1

10:1

15:1 17:2

Source: Holston, Laubach, and Williams(2017)

For central banks to stimulate the economy and to create the conditions for easing throughmonetary policy, they need to guide real interest rates (the nominal interest rate minus the expected
inflation rate) to a level below the natural rate of interest. There are only two methods of lowering themarket real interest rate: reducing the nominal interest rate or raising the expected rate of inflation(raising the natural rate of interest is considered to belong in the domain of government growthstrategy or structural reform). Since the economic crisis, the key nations in the West have one by one
reached the Zero Lower Bound (ZLB), making it difficult to further reduce the nominal interest rate.
Even though the ECB and the BOJ have adopted the negative interest rate policies, the cash hoardingby people has made it difficult to reduce nominal interest rates indefinitely, drawing attention to the
Effective Lower Bound (ELB) for operating monetary policy.
What about the situation in Japan? As pointed out by Iwata, Samikawa, and Japan Center for
Economic Research (2016), who measured the natural rate of interest using the technique developedby Laubach and Williams (2003, the LW model), it is possible that the decline in the natural rate ofinterest had begun already in the second half of the 1990s. This paper estimates the natural rate ofinterest using the Dynamic Stochastic General Equilibrium (DSGE) model.
Fig. 1-11 shows fluctuations in the natural rate of interest in Japan since 1981 estimated with the
DSGE model and the impact (contribution) of all types of structural shocks, itemized by natural rateof interest. (Refer to the appendix for the structural shocks and their impact on the natural rate ofinterest). The results of the estimation support the conclusion by Iwata et al. (2016) that Japan’snatural rate of interest has been declining since the second half of the 1990s. In the near term, thenatural rate of interest is negative with the average value at negative 0.4 percent (annualized rate ofnegative 1.6 percent) since 2017.

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February 6, 2018

Fig. 1-11 Estimating natural rates of interest using the DSGE model
2.5

(%)

2.0
1.5
1.0
0.5
0.0
-0.5
-1.0

(Quarterly)

-1.5

17:3
81:1 83:1 85:1 87:1 89:1 91:1 93:1 95:1 97:1 99:1 01:1 03:1 05:1 07:1 09:1 11:1 13:1 15:1 17:1
News
Productivity
Preference
Investment
Exogenous demand
OthersSteady State Value
Natural Interest Rate
Source: Estimated by Japan Center for Economic Research

The decline in the time preference rate, which indicates the degree whereby current purchases arefavored over future purchases (negative preference shock), due to some kind of reasons, is thought tobe behind the decline in the natural rate of interest in recent years. In the era of the 100-year lifespan,
it is possible that human behavior is changing significantly due to worries about the future of thesocial security system including pensions and healthcare.
Have real interest rates been accommodative for prices in Japan? Here, we define the real interest
rate gap as the real interest minus the natural rate of interest. If the real interest rate gap is negative,
demand is stimulated because real interest rates are below the natural rate of interest, applying upward
pressure on prices. We know that the real interest rate gap has moved into the positive since aroundthe end of the 1990s. Around the time of introducing QQE in April 2013, the gap dipped into thenegative, shifting into accommodative phase, but in the near term, it is returning to the 0.4-0.6 percent
level (on a quarterly basis) indicating a tightening with respect to CPI (Fig. 1-12).
Fig. 1-12 The real interest rate gap in Japan (real interest rate minus natural rate of interest)
2.0(%)
Real interest rate gap

Natural interest rate

Real interest rate

1.5
Downward pressure on prices

1.0
0.5
0.0
-0.5

(Quarterly)

-1.0
81:1

85:1

89:1

93:1

97:1

01:1

05:1

09:1

13:1

17:3
17:1

Source: Estimated by Japan Center for Economic Research

Since estimates of the natural interest rate vary depending on the economic model and the method,
we have to allow some latitude when looking at the results. It seems that it is not merely a matter of

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February 6, 2018

understanding the level of the natural interest rate. Based on the shape of the Phillips curve, whichindicates the relationship between the output gap and prices, future discussion must be deepened to thepoint that is the extent of the real interest rate gap to be obtained in order to achieve the target inflationrate.
1-5 The impact of the population decline on natural rates of interest
Under the forward guidance on its inflation over-shooting commitment announced in September
2016, the BOJ committed to expanding the monetary base until the observed consumer price index
exceeds the stability target of 2 percent and stays above the target in a stable manner. However,
Governor Kuroda also recognizes that there is still some way to go before the stability target of 2
percent is realized. The BOJ’s Tankan survey also indicates that the selling price DI (share ofenterprises saying that selling prices will rise minus share of enterprises saying that selling prices willfall) has leveled off close to zero. The inflation outlook for enterprises continues on a downward trend.
In the Tankan survey published in December 2017, the year-on-year forecast for corporate goods is
below 1 percent in a year’s time (Fig. 1-13). The five-year forecast is also only slightly above 1
percent, suggesting weak impact on the downstream consumer index.
Fig. 1-13 Corporations are pessimistic about selling price rises
10(DI, % points)【Output prices DI】

Forecast

0

2.0

(%)

【Inflation Outlook of Enterprises】

1.5

-10
1.0

-20
-30
-40

0.5

Large Enterprises (All industries)
Small Enterprises (All industries) (Quarterly)

1 Year ahead

3 Years ahead

0.0

10:1 11:1 12:1 13:1 14:1 15:1 16:1 17:1 18:1

14:1

15:1

16:1

5 Years ahead(Quarterly)
17:1

17:4

Note: 1. Output prices DI means the share of enterprises who answered their sales price would "Rise" minus the share ofenterprises who answered the price would "Fall".
2. Inflation outlook denotes the average outlook of all enterprises (all industries).
Source: Bank of Japan, Short-Term Economic Survey of Enterprises in Japan

In this paper, the focus is on the possibility of the population decrease pushing down natural rates
of interest as a reason for the sluggish rise in prices. Based on the Solow’s model and Diamond’sOverlapping Generation (OLG) model, which are the basic models of economic growth theories, welook at how changes in the per capita capital associated with population decline, and changes in therate of household savings in the context of an aging society impact on the natural rates of interest.
Both the Solow’s model and Diamond’s OLG model are premised on the negative capital dilution
effect, i.e., per capita capital increases when the labor supply decreases. When marginal profit earned

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February 6, 2018from additional capital investment decreases, capital expenditure is suppressed, and the natural rate ofinterest, which balances capital supply and demand, declines.
In Japan, the population decline and the growing proportion of the elderly will accelerate in the
future (Fig. 1-14). According to the National Institute of Population and Social Security Research,people aged 65 and over accounted for 26.6 percent of the whole population in 2015, rising to 38.4
percent by 2065. In the meantime, the working-age population (aged 15 to 64) will continue to shrink
for the time being. When the second-generation baby boomers born between 1971 and 1974 reach
their retirement age around 2040, the population will decrease at a rapid pace of just short of 2 percent
per annum. After that, the pace of the decrease in the working-age population is expected to drop off,
but the decline will continue. Analyses suggest that the progressively aging population will push downhousehold savings rates by 3 percentage points by 2050.
Fig. 1-14 Aging and declining of the population will accelerate in Japan
1.4(100 million persons)(%)% of Aged Population(Right Hand Scale)

1.2

40

1.0

36

0.8

32

Aged Population (65-)

0.6

28

0.4

24

Working-age Population (15-64)

0.2
0.0

44

20
Child Population (0-14)

16

2015
2020
2025
2030
2035
2040
2045
2050
2055
2060
2065
Source: Ministry of Internal Affairs and Communications, National Institute of Population and Social Security Research

How will the negative capital dilution effect, which is associated with the decrease in theworking-age population and the declining savings rates (the national savings rate) due to the aging
population, influence the natural rates of interest? We have calculated the impact of the population
decrease using actual numerical examples based on Hirata (2012)13. Using the Solow’s model andDiamond’s OLG model, the value of the natural rate of interest in the steady state can be expressed asfollows.
( +
∗

=

+ )

−

(1 + )(1 + )(2 + )−1−(Solow s model)(Diamond’s OLG model)

13

Hirata (2012) adjusted the basic models (Solow, Ramsay, and Diamond) for economic growth theories that address the
population issue, and verified the size of the negative dilution effect due to the decline in the labor supply growth rate basedon actual numerical examples. The study concludes that “in view of the coming population decrease, there is at least
reasonable potential for the natural rate of interest to drop to near zero.”

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Here,

February 6, 2018is the capital share,household discount rate,is the rate of capital depreciation,is the rate of technology progress, andis the savings rate,is theis the rate of the population

growth. For each value, we calibrated the appropriate values in the near term and looked at the impactof the above-mentioned changes in the population growth rate and the savings rate. As a result, boththe Solow’s model and Diamond’s OLG model indicated that the population decrease would pushdown the natural rate of interest (Fig. 1-15). The extent of the decline is particularly large around theyear 2040 when the second-generation baby boomers exit the labor market. On the other hand, when
the ratio of the population aged 65 or over approaches 40 percent in 2050, the effect of the population
decline pushing down the natural rate of interest, and the effect of the decrease in savings rates in an
aging society pushing up the natural rate of interest will nearly balance each other out, and the naturalrate of interest will remain at the same level as the baseline scenario.
Fig. 1-15 The decline in the working-age population applies downward pressure on the natural rate ofinterestCapital share
Captal depreciation rate
National savaing rate
Time preference rate
Technology progress rate
Working-age population growth rate

α
δ
s
ρ
g
n

Reference
Hirata(2012)
0.30
0.05
0.250
0.02
0.02
0

Natural interest rate (Solow)
Natural interest rate (OLG)

ｒ*
ｒ*

3.4%
3.0%

Baseline
2017
0.30
0.05
0.250
0.02
0.007
-0.008Population
decline1%
2030
0.30
0.05
0.241
0.02
0.007
-0.011Baby boomers'
retirement
2040
0.30
0.05
0.235
0.02
0.007
-0.016

Population
decline1%
2050
0.30
0.05
0.232
0.02
0.007
-0.011

0.9%
1.1%

0.7%
0.8%

0.2%
0.4%

0.9%
0.8%

Source: Hirata(2012), Cabinet Office, National Institute of Population and Social Security Research, Estimated by Japan
Center for Economic Research

Supposing that the retirement age is gradually raised to 75 by 2050, the natural rate of interest willrise because the pace of the decrease in the labor supply will slow. If, in addition to raising theretirement age, the brakes are applied on the population decrease in Japan by accepting immigrants
and raising the birthrate, the natural rate of interest will be around 2 percent (2.4 percent in the
Solow’s model, 1.8 percent in the OLG model). To secure some scope for future monetary easing, it isimportant to raise the natural rate of interest by applying the brakes on the decrease in the working-age
population.
1-6 Is the 2 percent inflation target high or low?
In the context of the worldwide stagnation in the rate of inflation, there is a lively debate in the
United States concerning the 2 percent inflation target, which is regarded as a global standard. Is the 2
percent inflation target high or low? In June 2017, twenty-two noted US economists including Joseph
Stiglitz, winner of the Nobel Prize in economics and professor at Colombia University, signed an open
letter addressed to Janet Yellen, Chair of the Board of Governors of the Federal Reserve System of thetime, and other members of the Board. Stiglitz and the others who signed the letter demanded a rise in

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February 6, 2018

the inflation target claiming that “To ensure the future effectiveness of monetary policy in stabilizing
the economy after negative shocks - specifically, to avoid the zero lower bound on the funds rate - thisfall in the neutral rate may well need to be met with an increase in the long-run inflation target set by
the Fed”.
The flattening Phillips curve provides the context for this development. In Fig. 1-16, we compare
United States and Japan using the Phillips curve to indicate the relationship between the inflation rate
and the output gap, which is the difference between demand (real GDP) and supply (latent GDP) in
the economy. When the economic climate improves and the demand-supply tightens in the labormarket and in the goods and services markets, the output gap develops in a positive direction, raising
the upward pressure on prices. In Fig. 1-16 the horizontal axis is the output gap, and the vertical axis
the inflation rate. It is assumed that the relationship between the two is positive (rising to the right).
Comparing the Phillips curve under traditional monetary policy with the Phillips curve after the
introduction of unconventional monetary policy, we can confirm that the Phillips curves in both Japanand the United States are flattening after the introduction of unconventional monetary policy. Even if
the output gap develops in a positive direction, it is difficult to make the connection to a rise in the
inflation rate. Since stagnating inflation rates (nominal interest rate minus expected inflation rate)
make it difficult to bring down real interest rates, it is possible that adequate easing cannot be obtainedeven if policy rates are pushed down should the economy fall into recession in the stage of financial
normalization in the future. If the policy interest rate reaches ZLB as a result of a gradual reduction ofinterest rates, unconventional monetary policies such as quantitative easing and forward guidancemust be scrutinized again.
Fig. 1-16 The Phillips curves for Japan and the United States
4.0(Core Core CPI Inflation, %)＜Japan＞

3.0

3.0＜United States＞(Core PCE Inflation, %)

2.5

2.0
2.0

1.0
0.0

1.5

-1.0

1.0

-2.0
1983-99

-3.0

0.5

1999-

-4.0
-8.0

-6.0

2008-

(Output gap, %)

-4.0

-2.0

0.0

2.0

2000-08

0.0
4.0
-8.0

-6.0

(Output gap, %)

-4.0

-2.0

0.0

2.0

4.0

Note: We select the lag period of the output gap where the time difference correlation with the consumer price is highest ineach period.
Source: Ministry of Internal Affairs and Communications (MIC), Cabinet Office, BEA, CBO

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February 6, 2018

For central banks to create easing conditions by means of monetary policy, real interest rates mustbe guided to a lower level than the natural rate of interest. To do so, they must either reduce thenominal rate of interest, or raise the expected inflation rate (raising the natural rate of interest is
considered to belong in the domain of government growth strategy or structural reform). Since theeconomic crisis, the key nations in the West have one by one reached the Zero Lower Bound (ZLB),
making it difficult to further reduce the nominal interest rate. Even though the ECB and the BOJ haveadopted a policy of negative interest rates, the presence of cash has made it difficult to reduce nominalinterest rates indefinitely, drawing attention to the Effective Lower Bound (ELB) for operating
monetary policy. Even when the option of a negative interest rate policy is considered, there is
growing interest in how to raise the expected inflation rate, assuming there are limits to lowering theinterest rate in a low-inflation environment. If central banks are able to convince people of future
inflation, it is possible to lower the real interest rate even if the nominal interest rate is constrained by
the ZLB (currently, the ELB) leading to an expansion in aggregate demand (Mishkin (1996)).
However, from the perspective of purchasing power parity, raising the inflation target in one
country alone can lead to weakening of currency in one’s own country. Also, when the inflation rate
target is higher, the fluctuations in the inflation rate get bigger, creating the risk that central banks willfind it difficult to achieve their mandate of price stability.
Ito and Mishkin (2005) have previously proposed price level targets. When past deflation causes
price levels to drop and to diverge from the preferred price path, the price level target aims to raise
prices to the price level that would likely have been achieved had there been no deflation to start with,and tolerates a higher inflation rate until that is achieved (Fig. 1-17). For example, a price level targetof 100 for this year may be set at 102 for next year and 104 for the year after next. If prices rise in linewith the target, inflation will stand at 2 percent next year. However, if, for argument’s sake, next year’s
price level is 101, falling short of the target, the aim for prices in the year after is still a rise of 2
percent under the inflation target, but now 3 percent inflation is needed since the price level target is104. In some opinions, a forward-looking inflation target, which lets bygones be bygones, is notnecessarily effective for extracting the economy out of the deflation trap. On the other hand, withprice level targets, there is also the historical effect of trying to recover the share that has fallen below
the target in the past (Eggertsson and Woodford (2003), others).

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Fig. 1-17 The difference between the inflation target and the price level target
price level： The path of the price level in the future（Slope: inflation target rate）： The path of the price-level target policy(committing to higher inflation rate than target)③②①

Reference time

time

In 2010, Charles Evans, President and CEO of the Federal Reserve Bank of Chicago, proposed theintroduction of price level targets because of prolonged low inflation rates in key countries following
the Lehman Brothers bankruptcy. John Williams, President and CEO of the Federal Reserve Bank of
San Francisco, has also said that price level targets have more effect than specific inflation rates suchas 2 percent. A reasonable policy interest rate is the natural rate of interest plus the expected inflation
rate. If, for argument’s sake, the inflation target is raised from 2 percent to 4 percent, the reasonable
policy rate level also rises creating that much scope for future decreases in interest rates.
In a lecture at a symposium hosted by the Peterson Institute for International Economics in the
United States in October 2017, Ben Bernanke, the former Chair of the FRB, proposed temporary pricelevel targets to be introduced only at times when the economy approaches ZLB. This is a kind of
hybrid price level target that cherry-picks the best of the inflation target and the price level target. The
price level target is also under discussion within the FRB. The context for both the increase in the
inflation target and the price level target is to secure some scope for lowering the policy rate in the
future. When the U.S. economy slows down in the process of financial normalization in the future andthe FRB must lower interest rates, they will have to once again expand the scaled-back balance sheet
for a time if there are limited tools for monetary easing. In October 2017, Christine Lagarde,
Managing Director of the International Monetary Fund (IMF), compared the upswing in theinternational economy to the sun saying, “When the sun is shining, we must repair the roof.” Thesame is true of the debate concerning inflation targets.
Meanwhile, the BOJ forward guidance states that the bank will continue to expand the monetarybase until the year-on-year rate of increase in the CPI (all items less fresh food) exceeds 2 percent andstays above the target in a stable manner, authorizing temporary upward adjustments in the inflation
rate by means of its inflation-overshooting commitment. However, there is still a long way to go to 2
percent. With an aging population and long-term decline in the working-age population, the outlook is

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February 6, 2018

for future demand to shrink in Japan. As a result of the corporate sector holding off on capital
investment, the sector now has excess savings and, in actual fact, half the listed corporations have no
debt to manage. We need comprehensive discussions about who will benefit and who will lose out
from inflation.
1-7 Outcome and issues with QQE
The Japanese economy is steadily improving under Abenomics and the new phase of monetaryeasing. The quarter-on-quarter growth rate for real GDP was 0.6 percent for the July-September 2017
quarter, marking the seventh consecutive quarter of positive growth (Fig. 1-18). The economic
expansion phase, which started in December 2012, enters its fifth year in December 2017. Having
already exceeded the Izanagi economic boom during the period of rapid economic growth, this is thesecond longest expansion in the postwar era. Considering that fourteen recovery periods in the past
had a duration of 36 months (3 years), this is a sustained economic expansion. The output gap(calculations by the Cabinet Office), which indicates the balance between supply and demand in theeconomy, is now developing in a positive direction after exceeding the long-term average of 0 percent
in the second quarter of 2017.
Fig. 1-18 Seven consecutive quarters of positive real GDP growth rate—the second longest economic
expansion in the postwar era
1.5(YoY, %)
7 consecutive quarters positive growth

1.0
0.5
0.0
-0.5
-1.0

Real GDP growth rate

-1.5

(Quartely)-2.0

12:1 12:2 12:3 12:4 13:1 13:2 13:3 13:4 14:1 14:2 14:3 14:4 15:1 15:2 15:3 15:4 16:1 16:2 16:3 16:4 17:1 17:2 17:3

Source: Cabinet Office

Shares are also bullish in reflection of the record-high levels of corporate earnings (Fig. 1-19).
Toward the end of October 2017, the Nikkei Stock Average marked its longest ever winning streak
lasting sixteen consecutive days, and in November, the Nikkei Stock Average and the Tokyo Stock
Price Index (TOPIX) rose to 26-year highs. In the BOJ’s Tankan survey for the quarter ending
December 2017, the business sentiment index, which indicates corporate confidence, showed adiffusion index of 25 among major manufacturers and corporations, the highest level in the elevenyears since December 2006. The improvements have continued for five consecutive quarters.

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Fig. 1-19 The Nikkei Stock Average rising to a 26-year high40,000（Yen）
Nikkei 225

30,00020,00010,000（Daily）
0
90/01
94/01
Source: NEEDS-FinancialQUEST
Note: Data is until Feb 2, 2018.

98/01

02/01

06/01

10/01

18/02
18/01

14/01

There are also significant improvements in the employment environment, which is now
experiencing a shortage of labor. In December 2017, the overall unemployment rate fell below 3
percent to 2.8 percent. In addition, the jobs-to-applicants ratio for December stood at 1.59, the highest
level in 43 years and 11 months (Fig. 1-20). It has been a long time since full employment whenanyone who is willing to work can find a position. The cyclical business recovery is overlapping withthe structural factor of a shrinking population.
Fig. 1-20 Unemployment rate falls below 3%, jobs-to-applicants ratio at highest level in 44 years
6.0

(%)

1.8
Active job openings-to-applicants ratio

5.0

1.5

4.0

1.2

3.0

0.9

Unemployment rate

2.0
1.0

0.6
(Monthly)

0.0

0.3

(Monthly)

0.0

17/12
00/01
04/01
08/01
12/01
16/01
00/01
04/01
08/01
Source: Ministry of Internal Affairs and Communications, Ministry of Health, Labor and Welfare

12/01

17/12
16/01

Worsening earnings at financial institutions
In the BOJ’s Tankan survey for the quarter ending in December, the cash flow management
diffusion index, which indicates corporate cash flow management, was 17 (all scales, all industries),
the highest level since 1991 (Fig. 1-21). Viewed from the perspective of corporate financing, theeasing conditions are on a par with the period of the asset-inflation bubble.

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February 6, 2018

Fig. 1-21 Financial Position DI at levels equal to the period of the asset-inflation bubble
20(D.I., % point)
All Enterprises, All industries

15

Manufacturing

Nonmanufacturing"Easy"

10
5
0
-5
-10

"Tight"-15(Quarterly)

-20
85:1

88:1

91:1

94:1

97:1

00:1

03:1

06:1

09:1

12:1

15:1

17:4

Source: Bank of Japan, Tankan survey

Corporations are posting record-high gains. In actual fact, nearly half of listed companies in Japan
have no debt to manage, which means that competition is intensifying among financial institutions
with regard to lending. As mentioned above, the prolonged low interest rate has not halted theshrinking lending margins at banks. The impact of the shrinking lending margins on the resilience offinancial institutions and the financial intermediation function is thought to depend on the length ofthe easing phase. In a speech at the University of Zurich in Switzerland in November 2017, Governor
Kuroda mentioned about the reversal rate by quoting from an academic paper by Professor
Brunnermeier and Professor Koby at Princeton University in the United States (Brunnermeier andKoby (2017)). This refers to the possibility that, when interest rate falls below a certain level, thebanking sector’s capital constraint tightens through the decline in net interest margins, impairing
financial institutions’ intermediation function, so that the effects of monetary easing on the economy
reverses14. The reversal rate became a buzzword on the financial markets at the end of 2017, but
Governor Kuroda has for some time been alluding to earnings at financial institutions. Following an
address at the annual meeting of the National Association of Shinkin Banks in June 201715, he also
sounded the warning bells at his address at the convention of the Community Bank Shinyo Kumiai in
October saying, “Looking at earnings at regional financial institutions, the fundamental earning
capacity is declining in the context of shrinking profit margins on loans and other factors. As for the
future, the expectation is for continued depopulation and a shrinking business base in the regions,creating an increasingly tough business environment for credit unions due to the continued structural
downward pressure on earnings.”16 Shortly before, Deputy Governor Nakaso alluded to adverse

14
November 13, 2017, “Quantitative and Qualitative Monetary Easing and Economic Theory -Speech at the University of
Zurich in Switzerland-” (http://www.boj.or.jp/en/announcements/press/koen_2017/data/ko171114a1.pdf)
15
July 21, 2017, “Speech at the Annual Meeting of the National Association of Shinkin Banks” in Japanese(http://www.boj.or.jp/announcements/press/koen_2017/ko170621a.htm/)
16
October 20, 2017, “Speech at the Annual Meeting of the National Association of Shinkin Banks” in Japanese(http://www.boj.or.jp/announcements/press/koen_2017/ko171020a.htm/)

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February 6, 2018

reactions that may occur in the future when he said “If an excessive decline in and a flattening of theyield curve were to last for too long under powerful monetary easing, risks of a pullback in financial
intermediation and of destabilizing the financial system through downward pressure on financial
institutions' profits could not be ignored. If these risks were to materialize, the transmission
mechanism of monetary easing would be hampered and it would become more difficult to achieve
price stability and sustainable economic growth in a self-fulfilling manner.” at a seminar in New Yorkhosted by the Federal Reserve Bank of New York.
Losses at the BOJ
The BOJ balance sheet is already expanding on a scale that is on a par with nominal GDP, toweringover the other principal central banks (Fig. 1-22). Although the bank has switched the target for its
monetary policy from quantity to yield, the expansion in the BOJ balance sheet continues for the time
being. Even if the bank heads toward financial normalization, the next exit for the BOJ is the first one
that the bank approaches while having interest-bearing debt (current accounts). The bloated balance
sheet conjures up the difficulties of the BOJ exit strategy.
Fig. 1-22 The scale of the balance sheets at the major central banks (total assets to nominal GDP)100(% of Nominal GDP)
BOJ

FRB

ECB

80
60
40
20
(Quarterly)
0
05:1

06:1

07:1

08:1

09:1

10:1

11:1

12:1

13:1

14:1

15:1

16:1

17:117:3

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

The scale of the balance sheet at the BOJ is proportionate to the amount of long-term JGB holdings.
In a future exit phase when the BOJ announces the disposal of its JGB holdings, that alone is likely tocause the government bond market to crash. Assuming that the bank holds JGBs until maturity, theBOJ will have defined the final profit and loss at the time of purchasing JGBs from the market. Fig.
1-23 shows the preliminary calculations of the final yield for the long-term JGBs that the BOJ
purchased under QQE. This shows that immediately after introducing the negative interest rate policy,
the BOJ bought JGBs above par value (at a significantly higher price than the face value) to the extent
that the bonds will generate final losses if held to maturity. After the introduction of YCC, the Bank
continued to buy to avoid losses, but even so, the yield was a mere 0.06 percent, barely rising above

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February 6, 2018

zero percent, in December 2017. According to the BOJ financial statements for the period ended
September 2017, the average yield on 404 trillion yen of long-term JGB holdings continued to decline
at 0.326 percent. At present, the BOJ is paying 0.1 percent interest on a part of the debt (the basicbalance in current accounts held by financial institutions). If the current account interest rate starts torise in the process of interest normalization, the BOJ will fall into a negative spread in the blink of aneye.
Fig. 1-23 The average yield on successful bids for JGB holdings has risen since YCC
12
10
8
6
4
2
0

(Trillion yen)

NIRP

YCC

(%)

0.6
0.4
0.2
0.0
-0.2

13/04

13/10
14/04
14/10
26 years～
4 years～5 years
Average rate of yield(RHS)

15/04
15/10
11 years～25 years
2 year～3 years

16/04

16/10
17/04
6 years～10 years～1 year

17/12
17/10
(Monthly)-0.4

Note: 1. The bar chart shows the amount of BOJ's purchase of JGBs and the line chart (RHS) shows the average rate of thewinning bid yield.
2. Data excludes Floating-rate JGBs and Inflation indexed bonds.
3. As for detailed estimation method, see the appendix 4 of Samikawa and Takano(2017b)
Source: Bank of Japan, Japanese Government Bonds Held by the Bank of Japan, Operations,
The Japan Securities Dealers Association, Reference Statistical Prices (Yields) for OTC Bond Transactions/Rating
MatrixThe rise in long-term interest is linked to expanding profit margins at banks since the yield curve
grows steeper. On the other hand, long-term JGBs held by investors and financial institutions generatea paper loss. Concerning the pros and cons of continuing the new dimension of easing, acomprehensive decision must be taken based on loss and gain at the BOJ and private financial
institutions as well as households, corporations, the government, and other economic entities.
Is the government prepared to pay compensation in case of losses at the BOJ? If the interest rates
rise at exit, the cost of the government’s interest payments will also start to rise. Does the government
have the fiscal space to absorb losses at the BOJ amid fears that the fiscal balance for social insurance
centered on healthcare, nursing care, and welfare services will crumble in 2025 when the entire baby
boomer generation is aged 75 or older? The problems generated at the exit from the monetary policy
will change into the fiscal problem of whether it is possible to continue to issue JGB without causing
fiscal inflation.

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Japan Center for Economic Research
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February 6, 2018

Appendix -Fluctuating natural rate of interest in the DSGE model
In the DSGE model, structural shocks (exogenous factors that cause economic cycles) bringfluctuations in the endogenous variables. In the New Keynesian model, which consists of three simple
equations, the natural rate of interest ( ∗ ) is expressed as
shocks are considered. Here,∗=is the productivity shock and+ (1 −)

when structuralis the preference shock. A

productivity shock is, for example, a shock that impacts on productivity such as the emergence of PCs
and mobile phones. A preference shock is, for example, a shock that impacts on the time preference
rate (the degree whereby current consumptions are favored over future consumptions) such as
cash-for-clunkers, which offered vouchers for newer fuel-efficient vehicles within a specific timeframe.

(> 0) is the inverse of the elasticity of intertemporal substitution, and

,

(0 <

< 1) isa persistence parameter for each shock. Since there are limitations on the values that parameters can
extract from economic models, it is clear that positive productivity shocks, which raise productivity, as
well as preference shocks become factors that push up the natural rate of interest.
On the other hand, a model consisting of three equations falls short in the sense that it is unable toadequately explain fluctuations in real data. Christiano, Eichenbaum, and Evans (2005, hereinafterCEE) introduced endogenous labor supply and capital accumulation and a mix of frictions such as
habit formation in consumption preferences or adjustment costs in investment to the model. Smets andWouters (2003, 2007) applied Bayesian estimation methods to the model to find that there is no majordifference with the results obtained from the reduced form VAR model.
As a result of the consideration by CEE of a mix of frictions in the DSGE model, we know that the
impact of each shock on the natural rate of interest differs from the conventional three equations
model. Similarly to CEE, the model used for the estimations in this paper 17 includes capital
accumulation as well as a mix of frictions (e.g. habit formation in consumption preferences,adjustment costs in investment, or rigidity of wages). Appendix Fig. 1 shows the impact of each typeof shock on the natural rate of interest using parameters obtained from Japanese data (mean for
posterior distribution).

17
The model used in this paper is identical to the DSGE model used by Hirose and Kurozumi (2012) excluding
investment-specific technologies. However, where their model uses a stochastic trend, we have switched to a deterministic
trend for this analysis. Following Fujiwara, Hirose, and Shintani (2011), we have also introduced news shocks into theprocess of productivity shocks. We selected a model using marginal likelihood to support news up to one period ahead.

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February 6, 2018

Appendix Fig. 1 Impact of each type of shock on the natural rate of interest (impulse response)
Preference shock

0.04

Investment adjustment cost shock

0.04

0.03

Exogenous demand shock

0.06

0.02
0.04

0.02

0

0.01

-0.02

0.02

0

-0.04
0

5

10

15

20

Productivity shock

0

0
0

5

10

15

20

15

20

0

5

10

15

20

News shock

3.0
2.0

-0.1
1.0
-0.2
0.0
-0.3

-1.0
0

5

10

15

20

0

5

10

Let us look at the impact of each type of shock on the natural rate of interest while focusing on the
demand-supply aspect of fund. First, when a preference shock (Fig. 1 top left) occurs, the utility of
consumption in the present period are valued higher. As a result, there is upward pressure on thenatural rate of interest due to the increase in consumption in the present period (demand) and thedecrease in savings (supply). The shock of adjustment costs in investment occurs when costs rise
following an adjustment of the capital amount (stock adjustment). Despite the rise in the required
amount of capital, investment demand is reduced due to the difficulty of implementing large
investments all at once and then the natural rate of interest is pushed down. The exogenous demand
shock refers to government expenditure including public investment. The upward push in demand due
to such a shock causes the natural rate of interest to rise.
The productivity shock (Fig. 1 bottom left) obtained a result that is the reverse of the threeequations model. When productivity rises, production increases immediately. Based on the principleof the equivalence of three aspects, distribution also increases at the same time. On the other hand, as
Neiss and Nelson (2003) point out, when adjustment costs for investment exist, there is downward
pressure on the natural rate of interest because the increase in investment demand does not draw levelwith the income increase. Similarly, according to Andrés, López-Salido, and Nelson (2009),
consumption does not grow as much as income because households have little appetite for changing
consumption levels from the previous period when a strong degree of habit formation in consumer
preferences is present. Therefore, it suggests that a positive productivity shock is a factor that pushes
down the natural rate of interest.
The news shock refers to news of a future rise in productivity received in the current period. In such
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Japan Center for Economic Research
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February 6, 2018

cases, the income does not increase at the time of the shock since the rise in productivity is delayed by
one period. On the other hand, due to the adjustment costs in investment, investing in the current
period is the optimal behavior for firms since costs are incurred when suddenly increasing capital in
the following period when productivity rises. Under habit formation in consumption preferences, ifhouseholds know that incomes will increase in the next period, it would be optimal behavior toincrease consumption in the present period to average out consumption levels as much as possible.
The natural rate of interest will rise as a result of stimulating demand in the current period ahead of theincome increase in the following period.

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