Kikuo Iwata: Quantitative and qualitative monetary easing and Japan's
recent economic and financial developments
Speech by Mr Kikuo Iwata, Deputy Governor of the Bank of Japan, at the International
Centre for the Study of East Asian Development (ICSEAD), Kitakyushu, 24 March 2014.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
I express my thanks for having such a large audience gathered from Kitakyushu and other
regions, and also for giving me an opportunity to speak in front of you.
About a year ago, I was appointed as Deputy Governor of the Bank of Japan, on March 20,
2013. In the 40 years up to that time, I had been teaching in college while studying as an
economist within academia, and in the latter half of those years I consistently emphasized
that the biggest challenge for Japan's economy was to overcome deflation at the earliest
possible time, and that the role of monetary policy to that end was critical.
On April 4, 2013, shortly after the current governor and deputy governors, including myself,
assumed their duties, the Bank of Japan decided to introduce an unprecedented scale of
accommodative monetary policy called quantitative and qualitative monetary easing (QQE),
and so far, it has been pursuing the policy as scheduled.
Today, I will explain the aim of the QQE in light of recent developments in Japan's economy.
To understand the QQE, it is necessary to gain your understanding of the price stability
target of 2 percent in terms of the year-on-year rate of change in the consumer price index
(CPI) that the Bank aims at - or, in other words, the Bank's inflation targeting policy - and
the thinking behind the policy. Let me start with this point (Chart 1).
I. Price stability target
A. Why is deflation problematic?
I mentioned earlier that overcoming deflation at the earliest possible time was the biggest
challenge for Japan's economy.
While deflation is "a persistent decline in prices", it often seems to have been used to refer to
"a situation in which the economy is in a vicious cycle of price decline and recession" - that
is, the same meaning as "deflationary recession".
In terms of sentiment toward spending in everyday life, you might often think that a decline in
prices is a favorable thing. As prices of various goods and services decline, you can get
more at the same price. What is the problem (Chart 2)?
Decline in aggregate demand due to deferred spending
At the outset, we need to acknowledge the difference between prices in general and those of
individual goods and services.
As for the former, there are indicators such as the CPI and the domestic corporate goods
price index. Price stability that the Bank aims at is defined by the CPI. The CPI shows
changes in the total amount of expenditure required to purchase the equivalent goods and
services purchased by households at a given time, which is called the "reference period".
The CPI is calculated by giving a value of 100 for the reference period and comparing prices
of the observation period with those of the reference period. Inflation is defined as a situation
in which the CPI persistently rises; on the contrary, deflation is defined as a situation in which
the CPI keeps falling. A price rise or fall of individual items such as vegetables and television
sets does not constitute either inflation or deflation.
Keeping that in mind, let me now explain what the consequence of a persistent decline in
general prices - rather than price declines in individual goods and services - will look like.
To be sure, a decline in prices itself will have the effect of raising your real income. However,
a persistent decline in prices means that the more you wait, the more goods and services
you can get at the same price. In other words, it means that the value of cash and deposits
increases just by holding them. Thus, firms and households will hoard money as much as
possible and defer actions that are associated with spending, such as consumption and
investment. Put in the jargon of economics, aggregate demand will decline. That is a
problem.
If aggregate demand declines and sales of goods and services decrease, firms will reduce
production to a level consistent with the decline in sales. As corporate profits will decline and
employee income will fall accordingly, people's consumption and housing investment - as
well as firms' business fixed investment - will further stagnate. Namely, aggregate demand
will further decline, and that will induce a further decline in price levels. Thus, the economy
will be trapped in a vicious cycle of price declines and recession (Chart 3).
Increase in effective debt burden
In addition, as a decline in prices means that the value of money for goods and services will
increase, for those who borrow money, the value of money that they will have to repay in the
future will increase. Thus, that represents an increase in the effective debt burden.
It might be easier to understand if you consider a case in which you have a mortgage. As the
amount to be repaid is fixed while wages and real estate prices decline due to deflation, you
feel the debt service burden gradually increase.
The effective burden of debt you already have will become heavier and, even for future
borrowings, somewhat more than nominal interest rates suggest. Therefore, firms and
households will become cautious about borrowing money. In addition, households and firms
that have already borrowed will try to repay their debts as soon as possible, even by
restraining their consumption and investment.
Thus, housing investment and firms' business fixed investment will stagnate and aggregate
demand will become compressed, thereby resulting in a vicious cycle of recession and price
declines (Chart 3).
B. Why is stable and moderate inflation desirable?
By contrast, in an environment of stable and moderate inflation, for example, in a case where
the CPI rises about 2 percent year-on-year, the mechanism that is a reversal of what I have
just explained under deflation will work (Chart 4).
Increase in aggregate demand due to rejuvenated spending
Namely, if you can envisage that prices will rise, many of you might wish to purchase things
that you can buy as much as possible before the prices rise. A front-loaded increase in
demand ahead of the consumption tax hike next month has often been referred to these
days, and a similar mentality works in a consistent manner.
Of course, like perishables, there are a number of goods that cannot be purchased in
advance, and most services cannot be brought forward. Here, I am just talking about the
trends as a whole.
Unlike a consumption tax hike, which is a one-off event that alters prices at a certain point of
time, the price level will gradually rise. Therefore, the incentive to bring spending forward will
not work as powerfully as in the case of a front-loaded increase in demand ahead of the tax
hike, but rather slowly and constantly.
As spending in terms of consumption and investment is stimulated due to the future price
outlook, aggregate demand in the economy as a whole will increase. Sales of goods and
services will rise and firms will expand their production to a level consistent with the
increased sales. As corporate profits improve and employee income increases, consumption
and housing investment, as well as firms' activity - including business fixed investment -
becomes further rejuvenated. In other words, aggregate demand will further increase and
prices will rise accordingly. A virtuous cycle of a buoyant economy and inflation will be
generated (Chart 4).
Costs of rapid inflation
As a matter of course, what I have in mind here is stable and moderate inflation, not
unexpected rapid inflation or so-called hyperinflation.
As you are well aware of, hyperinflation is the last thing we want.
If a rise in wages and pensions cannot keep up with rapid inflation, your real income will
decline and the real value of cash and deposits saved will also decline rapidly. Through
reducing the effective debt service burden of past debt, an unexpected income transfer, so to
speak, from creditors to debtors will occur, in which creditors will lose and debtors will gain.
By contrast, in case you wish to newly borrow money, the lender will require a high interest
rate in preparation for future high inflation, making your fund-raising difficult.
If rapid inflation goes on, there is the need to frequently revise the prices of goods and
services. As it becomes ever more difficult to envisage future manufacturing costs and selling
prices, firms will not be able to even prepare their production plans. The economy will tumble
into turmoil.
Therefore, what the Bank is aiming at is that stable and moderate inflation continues, and not
by any means generating hyperinflation (Chart 4).
C. Advantages of inflation targeting policy
In order to achieve stable and moderate inflation, what kind of policy will be desirable?
One answer is a policy framework called inflation targeting. The Bank has been pursuing
monetary easing under the price stability target of 2 percent in terms of the year-on-year rate
of change in the CPI. That can be understood as a typical example of inflation targeting
policy (Chart 5).
Enhancing policy credibility and predictability
Inflation targeting policy has a number of advantages.
To begin with, as the policy contains a specific numerical target for the future inflation rate, it
can be judged objectively whether the target has been met. Through enhanced transparency,
a central bank's obligation to be accountable with regard to policy judgment and the status of
achieving the target will become crucial. That will create a situation in which credibility in
monetary policy is likely to be enhanced.
As it becomes easier to forecast price levels, various economic entities can conduct
economic activity on the basis of such forecasts. The predictability of future prices will be
further reinforced as credibility in monetary policy becomes enhanced (Chart 5).
Preventing hyperinflation
About the Bank's policy, some demonstrate concern that when the time comes for the Bank
to stop monetary easing, it might be difficult to do so due to pressure from financial markets
or the government, and that eventually leads to inducing hyperinflation. The adoption of
inflation targeting also is effective against such concern.
The reason for that is that the inflation targeting policy is a device to hold a specific numerical
target for the future inflation rate and make a commitment to achieving a situation that
generates neither inflation above the target rate nor deflation.
Though the inflation targeting policy has often been discussed in Japan as a measure to
overcome deflation, it was originally adopted in countries like New Zealand in the 1980s that
suffered high inflation.
I would like you to understand that, in case the economy should overheat and the inflation
rate should rise well above the 2 percent price stability target, the Bank has already made a
commitment to taking appropriate measures in line with the framework of inflation targeting
policy.
I should stress that, in line with the mission stipulated in the Bank of Japan Act, the Bank will
conduct monetary policy based on its judgment and responsibility while facilitating
communication with the government (Chart 5).
II. Aim of the QQE and the current situation of Japan's economy
So far, I have explained the price stability target of 2 percent in terms of the year-on-year rate
of change in the CPI; namely, the so-called inflation targeting policy and the thinking behind
that.
Now, I will talk about the contents and effects of the QQE, which was introduced as a policy
to achieve the 2 percent price stability target, by also taking into account the current state of
Japan's economy.
A. What is the QQE?
The QQE consists of two pillars (Chart 6).
The first pillar is the commitment under which the Bank will achieve the price stability target
of 2 percent as soon as possible. The Bank has made a clear commitment that it "will
achieve the price stability target of 2 percent at the earliest possible time, with a time horizon
of about two years".
The second pillar is to engage in actions that embody the commitment specified in the first
pillar. As exemplified by the phrase "quantitative and qualitative monetary easing", those
actions are to increase the "quantity" of the Bank's balance sheet and change the "quality" of
its asset purchases.
An increase in quantity requires massively increasing the amount of money the Bank directly
supplies to the financial system - this is called "the monetary base" - at an annual pace of
about 60-70 trillion yen.
Measures to increase the monetary base are mainly through the purchases of Japanese
government bonds (JGBs), and the Bank will purchase JGBs so that their outstanding
amount will increase at an annual pace of about 50 trillion yen.
A change in quality requires purchasing assets with a higher risk profile. Among the JGBs,
the Bank has started purchasing those with longer remaining maturities. In addition, it has
increased the amounts of purchases in exchange-traded funds (ETFs) and Japan real estate
investment trusts (J-REITs) in order to reduce risk premiums on assets.
When we decided to introduce the QQE last April, we used the expression "a new phase of
monetary easing both in terms of quantity and quality". The Bank has been pursuing
monetary easing in exactly that manner, at an unprecedented scale.
B. Working on expected real interest rates
While the QQE consists of those two pillars, as far as its transmission channels are
concerned, the most important factor of all in terms of having an effect on the economy is
lowering expected real interest rates. The following explanations will become somewhat
complicated, but please bear with me (Chart 7).
Expected real interest rates are obtained by subtracting the expected rates of inflation from
the nominal interest rates actually observed in financial markets or over the counter.
While nominal rates - that is, objective interest rates - are visible, expected real interest
rates are those that people forecast subjectively, based on their respective price projections,
and thus various rates exist on a person-by-person basis.
Viewed from the borrowers' side, real interest rates are equivalent to borrowers' subjective
expectations regarding their real costs of borrowing, taking into account price changes, when
they borrow money at a certain nominal interest rate. Consequently, the lower the expected
real interest rates of an economic entity, the more subdued the entity expects its real cost of
borrowing to be.
The QQE has the effect of reducing nominal interest rates and the effect of lifting each
economic entity's inflation expectations, and both will exert downward pressure on expected
real interest rates, which are derived from subtracting the expected rates of inflation from the
nominal rates (Chart 8).
C. Spillover effects on the real economy
If many economic entities lower their expected real interest rates, that will stimulate demand
in the real economy in a number of ways.
For example, when real interest rates decline, investment in cash, deposits, and
fixedincome securities (excluding inflation-indexed bonds) becomes less attractive; thus, people
will shift their portfolios from those financial assets to equities and tangible assets such as
land and housing, or to foreign currency-denominated assets with higher returns. The rise in
equity prices and the appreciation of foreign currencies will stimulate private consumption
through the wealth effect (Charts 9 and 10).
In addition to the decline in expected real interest rates, other factors - including an increase in
consumption and an improvement in export conditions due to the depreciation of the yen - will
encourage firms to be more aggressive in their business fixed investment (Charts 11 and 12).
According to the Business Outlook Survey, conducted jointly by the Cabinet Office and the
Ministry of Finance, the index of business conditions for large enterprises will decline to
minus 9.8 in the April-June quarter but is expected to rise to plus 8.3 in the July-September
quarter. That of small and medium-sized enterprises follows more or less the same pattern
with that of large enterprises (Chart 13).
While that may be partly due to statistical peculiarities, it suggests that firms anticipate a
subsequent decline in spending after the consumption tax hike in April 2014 as a result of the
front-loaded increase in spending to be relatively short-lived.
If a shortage of aggregate demand in the economy as a whole is eliminated through an
increase in demand such as private consumption and investment, price levels will naturally
rise. In fact, the recent developments in the CPI show that Japan's economy is following a
path toward overcoming deflation as expected (Chart 14).
Production increases as demand expands, and thus employment conditions will also
improve. That does not suddenly result in a rise in wages and bonuses, but tends to first lead
to an increase in the number of employees, mainly non-regular employees. Nevertheless,
due to an expansion in corporate profits and tightness in the labor market, the income each
employee receives will gradually increase (Chart 15).
If employee income as a whole increases in such a manner, that will further elevate the
consumption of households, including those that have not benefited from the wealth effect
through a rise in stock prices or the appreciation of foreign currencies. An increase in
corporate profits will increase business fixed investment. Those increases in demand will
again lead to an increase in income.
An improvement in fiscal conditions due to an increase in tax revenue and an improvement in
pension financing caused by a rise in asset prices will also alleviate people's concern about
the future as a whole, and thereby exert positive effects on the economy.
In such a manner, by overcoming deflation starting with the QQE, a virtuous cycle of the
economy is expected to continue (Chart 16).
D. Outlook up to fiscal 2015
As for the outlook, Japan's economy is expected to continue with a moderate recovery as a
trend, supported by an improvement in the employment and income situation, while it is
expected to be affected by the front-loaded increase and the subsequent decline in demand
prior to and after the consumption tax hike.
As for prices, the year-on-year rate of increase in the CPI, excluding the direct effects of the
consumption tax hike, is likely to be around 11⁄4 percent for some time. After that, it is
expected to gradually return to the rising trend and is likely to reach around the 2 percent
price stability target toward the end of fiscal 2014 through fiscal 2015 (Chart 17).
Concluding remarks
Let me conclude my remarks by touching on the economy of Kitakyushu (Chart 18).
Kitakyushu's economy was long stagnant after the Lehman shock, but it has gradually been
improving in the region's main force - the manufacturing sector - partly on the back of a
correction in the yen's appreciation. Recently, an improvement has started to spread from
large to medium- and small-sized firms, and the regional economy has been recovering
moderately on the whole.
Historically, Kitakyushu prospered since the Meiji Period, centering on the Chikuho coalfield
and Moji Port, and by utilizing this location advantage, a government-managed steelworks
started operation in Yahata in 1901. For reference, while the Kitakyushu branch of the Bank
of Japan marked its 120th anniversary last year, the precursor of that branch - namely, the
Saibu branch - was established around that time, in 1893.
Kitakyushu has represented Japan's modernization, and despite a number of difficulties, it
has thrived and subsequently has been improving and evolving. As a result of many years of
tremendous efforts, Kitakyushu has established itself as one of the prominent industrial areas
in Japan - with electrical machinery and the automobile industry, in addition to the steel
industry - as well as a base for international trade with Asian and other countries.
Other than on the industrial front, Kitakyushu City has become one of the world's
environmental cities, and recently was selected as a "model city for green growth" by the
Organisation for Economic Co-operation and Development (OECD), and as a "future city" by
the Japanese government. In addition, the government has decided to recommend "local
industrial heritage sites of the Meiji period", which include Yahata steelworks-related facilities
in Kitakyushu, to the United Nations Educational, Scientific, and Cultural Organization
(UNESCO) as candidates for World Heritage sites this fiscal year. This region has started to
grab the spotlight in industrial tourism.
As global competition intensifies in the years ahead, the path Kitakyushu follows might not be
a smooth one. However, this region has a strong industrial base, including manufacturing
technology and human resources, which has been established over many years. This region
also has well-developed traffic and distribution systems, with a 24-hour airport and the
starting point of the East Kyushu Highway that extends to Miyazaki City scheduled to be
opened in fiscal 2014. While fully utilizing those strengths, I strongly believe that Kitakyushu's
economy will further grow and develop into the future.
Thank you.



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