Hiroshi Nakaso: Japan's economy and monetary policy
Speech by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, at a meeting with
business leaders, Okinawa, 3 March 2016.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
It is my pleasure to have the opportunity today to exchange views with administrative,
financial, and business leaders in Okinawa Prefecture. I would like to take this opportunity to
express my sincerest gratitude for your cooperation with the activities of the Bank of Japan's
Naha Branch.
At the Monetary Policy Meeting held at the end of January 2016, the Bank decided to
introduce "Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest
Rate." Today, before exchanging views with you, I would first like to explain the Bank's view
on the recent developments in and outlook for economic activity and prices. I will then move
on to its recent conduct of monetary policy while elaborating on "QQE with a Negative
Interest Rate" that the Bank has decided to introduce.
I. Recent developments in and outlook for economic activity and prices at home
and abroad
Current situation of Japan's economic activity and the bank's projection in the
January 2016 outlook report
To start with, let me talk about economic developments in Japan. Although global financial
markets have been volatile since the turn of the year, I believe there is no need to be too
pessimistic as the fundamentals of Japan's economy have been firm.
With regard to Japan's recent economic activity, domestic demand has followed an uptrend,
with a virtuous cycle from income to spending being maintained in both the household and
corporate sectors. In the corporate sector, profits clearly have continued to improve, reaching
a record high, with support from an improvement in the real economy as well as the low
crude oil prices and the correction of the yen's appreciation (Chart 1). Against this
background, business fixed investment has been on a moderate increasing trend. In the
household sector, labor market conditions have continued to tighten. The active job
openings-to-applicants ratio and the diffusion index for employment conditions in the
December 2015 Short-Term Economic Survey of Enterprises in Japan (Tankan) have
improved to almost the same levels as around the first half of 1992. Moreover, the
unemployment rate has been declining and in the range of 3.0-3.5 percent for the first time
since 1997. The labor market is in a situation close to "full employment," where
unemployment is due solely to mismatches between job openings and job applicants
(Chart 2). Reflecting the tightening of labor market conditions, employee income has been
increasing moderately. Under such steady improvement in the employment and income
situation, private consumption has been resilient.
Looking ahead, domestic demand is likely to follow an uptrend, with a virtuous cycle from
income to spending being maintained in both the household and corporate sectors. Exports
are expected to increase moderately on the back of emerging economies moving out of their
deceleration phase. Against this backdrop, Japan's economy is likely to be on a moderate
expanding trend. As in the January 2016 Outlook for Economic Activity and Prices (Outlook
Report), it is estimated that the economy will continue growing at a pace above its potential
through fiscal 2016. In fiscal 2017, it is projected to maintain positive growth, although with a
slowing in its pace to around a level somewhat below the potential growth rate, reflecting the
effects of a front-loaded increase and subsequent decline in demand prior to and after the
consumption tax hike, as well as the cyclical developments in the economy. The medians of
the Policy Board members' forecasts for the real GDP growth rates are also indicated in the
January Outlook Report, and those for fiscal 2015, 2016, and 2017 are 1.1 percent,
1.5 percent, and 0.3 percent, respectively (Chart 3).
Price developments in Japan and the outlook
Let me now turn to price developments in Japan. Asignificant change in price developments
has been observed after the introduction of QQE. The year-on-year rate of change in the
consumer price index (CPI, all items less fresh food), which had been minus 0.5 percent
before the introduction of QQE, improved to as high as 1.5 percent in April 2014, excluding
the effects of the consumption tax hike (Chart 4). Thereafter, the year-on-year rate of change
in the CPI has declined, marking about 0 percent recently, but this was largely attributable to
a substantial fall in crude oil prices since summer 2014. As for the underlying trend in
inflation, the year-on-year rate of change in the CPI excluding fresh food and energy - both
of which are with large fluctuations - had been negative before the introduction of QQE, but
turned positive in October 2013. Since then, it has remained positive for 28 consecutive
months and increased to 1.1 percent recently. The share of price-increasing items minus the
share of price-decreasing items in the CPI has been increasing clearly, suggesting that price
rises have been observed in a wide range of goods and services (Chart 5).
In brief, the forecasts of the CPI (all items less fresh food) are obtained by adding the
underlying trend in inflation to the contribution of energy items to the CPI. The January
Outlook Report assumes that Dubai crude oil prices will rise moderately from the recent
35 U.S. dollars per barrel to the range of 45-50 dollars per barrel toward the end of fiscal
2017, which marks the end of the projection period. The contribution of energy items to the
year-on-year rate of change in the CPI (all items less fresh food) is estimated to be slightly
more than minus 1 percentage point and is at its highest level recently. However, under the
aforementioned assumption of crude oil prices, the contribution is projected to decrease.
Meanwhile, since the underlying trend in inflation is likely to rise steadily, this is likely to be
seen clearly in the year-on-year rate of change in the CPI. Therefore, the underlying trend in
inflation has been improving steadily and the baseline scenario would be as follows: the
year-on-year rate of change in the CPI is likely to accelerate toward the price stability target
of 2 percent as the economy is likely to be on a moderate expanding trend. Taking these
factors into account, the year-on-year rate of change in the CPI (all items less fresh food) is
projected to reach around 2 percent - the price stability target - around the first half of fiscal
2017.
Global financial markets and overseas economies
On the other hand, global financial markets have been nervous since the turn of the year; the
yen has appreciated as investors sought a safe haven due to elevated risk aversion against
the backdrop of declining global stock prices resulting from the further decline in crude oil
prices and looming uncertainty such as over future developments in the Chinese economy.
Next, I would like to explain the current situation of and outlook for overseas economies that
are creating turmoil in global financial markets.
To give an overview of the recent developments, overseas economies - mainly advanced
economies - have continued to grow at a moderate pace on the whole, despite the
slowdown in emerging economies. By region, the U.S. economy has continued to steadily
recover, reflecting the firmness in household spending. Some market participants are holding
a cautious view toward developments in the U.S. economy, but no new concerns are being
observed, and therefore I suppose their view is too pessimistic. The European economy also
has continued to recover moderately (Chart 6).
It is true that the Chinese economy, which has been attracting the world's attention, has
continued to be in a state of deceleration due to downward pressure from an overhang of
production capacities and inventory adjustments in the manufacturing sector (Chart 7). Other
emerging economies and commodity-exporting economies as a whole also remain in a
situation of deceleration, as the effects of the slowdown in the Chinese economy have
spread to them and as the decline in commodity prices has been protracted. Some
economies in Asia, however, have seen a pick-up in IT-related demand. Looking ahead, the
Chinese economy is likely to broadly follow a stable growth path, albeit at a somewhat slower
pace mainly in the manufacturing sector, as authorities proactively carry out policy measures
to support economic activity. Other emerging economies and commodity-exporting
economies as a whole are expected to gradually increase their growth rates, due mainly to
the effects of the recovery in advanced economies and of economic stimulus measures,
although some commodity-exporting economies are likely to remain in a situation of
deceleration for the time being.
II. The bank's Monetary Policy Management
Basic mechanism of monetary easing
However, after the turn of the year, the global financial markets have continued to be volatile,
as I have mentioned earlier. At the Monetary Policy Meeting held at the end of January 2016,
many Policy Board members pointed out that there is an increasing risk that such volatility in
global financial markets might delay an improvement in business confidence of Japanese
firms and conversion of the deflationary mindset, and might also negatively affect the
underlying trend in inflation. To preempt the manifestation of this risk and to maintain
momentum toward achieving the price stability target of 2 percent, the Bank decided to
introduce "QQE with a Negative Interest Rate."
Now, I would like to focus on the Bank's monetary policy management. To begin with, let me
review the basic transmission mechanism of monetary easing that the Bank had pursued,
and then talk about the newly introduced "QQE with a Negative Interest Rate."
Generally speaking, the main transmission channel of monetary easing would be as follows:
it will cut the real interest rate - that is, interest rate adjusted by inflation expectations - and
stimulate economic activities such as business fixed investment and housing investment.
Inflation expectations are taken into account because, if prices are expected to rise,
corporate profits and wages also are likely to increase, and thus the real interest rate, which
means the real cost of borrowing, will become lower than the nominal interest rate.
When deciding to what extent the real interest rate should be lowered, policymakers can
focus on the natural rate of interest as a reference level. Every country has its own natural
rate of interest, which is neutral to economic activity in that it will neither accelerate nor
decelerate the economy. The effects of monetary easing will be produced by reducing the
real interest rate to a lower level compared to the natural rate of interest. In general, the
natural rate of interest will be determined largely by the potential growth rate, which
represents the economy's growth potential. In Japan, the potential growth rate was in the
range of 3-4 percent during the 1980s but declined significantly after the turn of the 1990s.
Recently, it is estimated to be around 0.5 percent or lower.
Bearing these factors in mind, monetary policy since the 1990s can be summarized as
follows. With the aim of taking measures to bring about recovery following the economic
recession after the burst of the bubble, the Bank gradually cut the policy interest rates. As a
result, short-term interest rates reached approximately 0 percent at the end of the 1990s.
However, at the same time, the potential growth rate became low, and accordingly the
natural rate of interest declined. Even though the Bank had lowered the nominal short-term
interest rate to 0 percent, it was unable to reduce the real interest rate to a level significantly
below the natural rate of interest due to the widely spread deflationary sentiment among the
public.
In order to make a breakthrough in this situation, the Bank introduced QQE in April 2013.
This policy measure aimed at lowering the real interest rate by two means (Chart 8). The first
is to raise inflation expectations through the Bank's strong commitment to achieving the price
stability target of 2 percent at the earliest possible time. The second is to make use of the
room for lowering the nominal interest rate. Although short-term interest rates already had
declined to as low as 0 percent, long-term interest rates still had room to fall. Therefore, the
Bank decided to massively purchase Japanese government bonds (JGBs), thereby putting
downward pressure across the entire yield curve; i.e., not only short-term interest rates but
also long-term interest rates including 10-year JGBs, as well as super-long-term interest
rates of JGBs with maturities of 20 years or longer.
By referring to some specific data, let me briefly explain how the intended effects have been
spreading so far. Yields on 10-year JGBs already had been lowered to a record low level
before the Bank decided to introduce "QQE with a Negative Interest Rate," and thus the
entire yield curve has been pushed down to an extremely low level (Chart 9). At the same
time, inflation expectations have been rising on the whole from a somewhat longer-term
perspective. According to various survey-based indicators, inflation expectations generally
have been raised by about 0.5 percentage point under QQE (Chart 10). The decline in the
nominal interest rate and the rise in inflation expectations suggest that the real interest rate
has been largely pushed down. In fact, after the introduction of QQE, the real interest rate
has remained in negative territory. Thus, as I have mentioned, the real interest rate, having
declined to the record low level, stimulated domestic demand, resulting in a moderate
recovery in Japan's economy and an improvement in the underlying trend in inflation.
Zero lower bound of interest rates and framework for "QQE with a negative interest
rate"
The newly introduced "QQE with a Negative Interest Rate" maintains and reinforces the
basic mechanism of QQE, which has produced its intended effects. For a long period of time,
a common understanding has made us believe that the nominal interest rate cannot fall
below the zero lower bound. However, at present, some central banks in Europe, including
the European Central Bank (ECB), are in fact implementing negative interest rate policies.
The following two points were considered to be reasons why the nominal interest rate cannot
turn negative. First, financial institutions' profits would be squeezed if a negative interest rate
were applied to their current accounts at the central bank. If a negative interest rate were to
massively squeeze financial institutions' profits - which I would view as an extreme case -
functioning of financial intermediation could be hampered and, as a result, the intended
effects of monetary easing would wane. Second, a larger negative interest rate would
incentivize financial institutions to withdraw more cash from their current accounts at the
central bank in an attempt to avoid a negative interest rate being applied. Since financial
institutions, by holding a large amount of cash, have to suffer various costs including that of
delivery and storage, as well as run new risks such as theft, it is unlikely that they will largely
replace their current account balances with cash holdings as soon as the interest rate on
current accounts becomes negative. This implies, however, that there could be a certain limit
to the depth of the negative interest rate. In other words, if these two concerns were
dispelled, negative short-term interest rates could be formed by applying a negative interest
rate to current accounts at the central bank, thereby pushing down the short end of the yield
curve.
The Bank came up with a solution to the challenges regarding a negative interest rate. This
is "QQE with a Negative Interest Rate," through which the outstanding balance of each
financial institution's current account at the Bank will be divided into three tiers and a
negative interest rate will only be applied to a certain tier. The three-tier system has been
adopted partly in consideration of the impact on financial institutions' profits as well
(Chart 11). The outstanding balance of current accounts is divided into three tiers, and a
positive interest rate of 0.1 percent will continue to be applied to a vast majority of an existing
balance. Practically, as the "first floor" of the three-tier system, the "Basic Balance" is defined
as the average outstanding balance of current accounts in January through December 2015.
In the "Basic Balance," the 0.1 percent positive interest rate continues to be applied to about
210 trillion yen; in other words, the amount outstanding exceeding the required reserves, to
which a zero interest rate had been applied under the old scheme.
Next, a zero interest rate will be applied to the "second floor." For the most part, the second
floor is intended to keep the amount to which a negative interest rate is applied from building
up over time. Therefore, the balance of the "second floor" will be adjusted at an appropriate
timing in the future. Some lending programs by the Bank, such as the Loan Support Program
and the funds-supplying operation to support financial institutions in disaster areas, will be
implemented at a zero lending rate from now on. A zero interest rate will be applied to the
amounts outstanding of these facilities so that a negative margin incurred between lending
rates and the interest rate applied to the corresponding balance of current accounts at the
Bank would not disincentivize financial institutions from using the facilities. In a similar vein,
the interest rates applied to the required reserves will continue to be zero.
A negative interest rate of minus 0.1 percent will be applied only to a portion of current
account balances exceeding the amounts outstanding of the "first" and "second" floors. This
is the "third floor" of the three-tier system and is called the "Policy-Rate Balance" as a
negative interest rate is applied in the course of monetary policy. Admittedly, it is true that an
interest rate of minus 0.1 percent is applied to current account balances at the Bank, but in
practice, as I just explained, a negative interest rate is applied only to the "Policy-Rate
Balance." At the start of the negative interest rate policy, the balance amounts to about
10 trillion yen, consisting of a small portion of the total current accounts outstanding of about
260 trillion yen.
Therefore, an adverse impact on financial institutions' profits will be largely mitigated while
the negative interest rate policy will powerfully produce its intended effects of pushing down
the short end of the yield curve. This is because prices of any new financial transactions
such as JGB transactions are determined based on a "marginal" cost, as economic jargon
puts it. Consequently, a negative interest rate of minus 0.1 percent applied to a marginal
increase in the current account balances at the Bank will define the short end of the yield
curve.
Besides the costs incurred by holding current account deposits at the Bank, the downward
shift of the entire yield curve itself admittedly can have a negative impact on financial
institutions' profits. It should be noted that this is always the case with monetary easing in
general and there is nothing special with a negative interest policy in this regard: the gist is
that it is a mere reflection of monetary easing effects. Looking ahead, as the negative interest
rate policy will exert its intended effects, private demand such as business fixed investment
and housing investment is expected to increase. In that sense, the negative interest rate
policy will accelerate the process of overcoming deflation. This could be a quicker way to get
out of the low interest rate quagmire as well as bring about favorable business conditions for
financial institutions. Financial institutions may want to properly consider this point, and we
do hope that they will proactively explore potential borrowing needs, thereby creating new
business opportunities.
Spillover effects of "QQE with a negative interest rate"
In addition to the transmission mechanism for QQE, which intends to push down long-term
interest rates through massive purchases of JGBs, "QQE with a Negative Interest Rate" aims
to lower the short end of the yield curve by applying a negative interest rate of minus
0.1 percent to a certain tier of current accounts at the Bank, thereby exerting further
downward pressure on interest rates across the entire yield curve. "QQE with a Negative
Interest Rate" already has brought tangible effects. The JGB yield curve has been declining
further; yields on shorter-than-around 10-year JGBs have been negative (Chart 9). Reflecting
the declines in JGB yields, financial institutions' benchmark lending rate and housing loan
interest rates also have been declining clearly. Looking ahead, I am confident that the effects
of the declines in these interest rates will steadily spread to the real economy and prices.
Some may have concern that financial institutions' retail deposit interest rates also might turn
negative. Admittedly, each financial institution makes its own decision on interest rates for
their depositors. In the meantime, I would like to emphasize that negative retail deposit
interest rates are hardly seen even in some European countries, where a negative interest
rate policy has already been adopted with much lower rates compared to Japan - minus
0.75 percent in Switzerland, for example. Given those European experiences, I am sure that
there are no grounds for retail deposit interest rates turning negative in Japan (Chart 12).
Under a negative interest rate policy, there is no doubt that a wide range of interest rates will
decline. However, this does not mean that deposit interest rates will turn negative owing to
the monetary policy. Rather, this policy will bring about positive effects on borrowers through
a declining cost of borrowing. In the wake of "QQE with a Negative Interest Rate," housing
loan interest rates, for example, have declined more significantly than deposit interest rates,
which already had been extremely low. The decline in housing loan interest rates will spur
housing investment and lead to economic expansion. The unquestionable fact is that, not just
a negative interest rate policy, but any kind of monetary easing reduces interest rates. The
changes in interest rates could have different effects across individual entities in the short
term; however, looking at the economy as a whole, a decline in interest rates brought about
by monetary easing would likely stimulate domestic demand and expand the economy.
The bank's determined commitment toward overcoming deflation and sustainable
economic growth
Japan has been mired in deflation for more than 15 years. For Japan to achieve sustainable
economic growth in the future, the utmost priority is to overcome deflation at the earliest
possible time. In order to indicate its unwavering will to attain this target, the Bank decided to
introduce "QQE with a Negative Interest Rate." Japan's economy has steadily progressed
toward overcoming deflation for the past three years after the introduction of QQE, but we
are only halfway to achieving the price stability target. Meanwhile, the Bank has devised the
framework of monetary policy in various ways so as to adjust to economic and financial
developments.
Related to this point, I will touch on the supplementary measures decided at the Monetary
Policy Meeting in December 2015 to facilitate smooth implementation of QQE. Specifically,
we took the measures of (1) expanding eligible collateral for the Bank's provision of credit
and (2) extending the average remaining maturity of JGB purchases. As for the expansion of
eligible collateral, as the Bank continues its massive purchases of JGBs, the amount of
eligible collateral of private financial institutions has been on the decrease. Expanding the
range of eligible collateral will contribute to smooth asset purchases in the future. As for the
extension of the average remaining maturity of JGB purchases, it aims at more flexible and
smooth asset purchases while assuring liquidity in the JGB markets. As is indicated by these
measures, not only "a negative interest rate" but additional monetary easing in terms of
"quantity" and "quality" dimensions will naturally remain a policy option. I am convinced that
this new policy framework will be a drastic measure to fulfill the Bank's responsibility to
overcome deflation.
Raising growth potential of Japan's economy and monetary policy
In order to achieve sustainable economic growth, Japan's economy inevitably should tackle
the challenges to raising medium-term growth potential, on top of overcoming deflation. As I
have noted, the potential growth rate in Japan is estimated to have declined to around
0.5 percent or lower. Taking a shrinking population as a given, an overall increase in labor
productivity will be a key to raising the potential growth rate. In this sense, looking ahead, a
structural reform needs to be promoted not only in an economic context but also in a social
context, and should focus on developing a productivity-enhancing mechanism and
environment. I strongly expect the government to continue committing to such a structural
reform without loosening the reins.
The Bank also can contribute to raising the growth potential because powerful monetary
easing will dispel people's deflationary mindset and provide a favorable environment for firms
to make investment proactively and take actions to improve productivity. Furthermore, while
the Bank has been purchasing exchange-traded funds (ETFs) at an annual pace of about
3 trillion yen under QQE, it additionally has established a new program for purchasing ETFs
at an annual pace of about 300 billion yen, composed of stocks issued by firms proactively
investing in physical and human capital. This program will be enacted next month. We
already have received various encouraging opinions and comments from market participants
in the run-up to the start-up of the new program on which we place our hope for enhancing
growth potential. With such encouragement, we are working diligently on setting eligible
criteria and the operational framework for purchases.
As I have noted so far, I believe that monetary policy to overcome deflation and the structural
reform to raise the potential growth rate must be pursued in tandem to bring Japan's
economy back on track toward sustained growth. Now that the Bank of Japan has taken
monetary easing one step further by introducing "QQE with a Negative Interest Rate," I
expect the original third arrow of Abenomics, the growth strategy, to fly higher and faster.
Moreover, I hope that households and firms will take bold steps towards economic
prosperity, making full use of the current financial environment, which is more
accommodative than ever.
Conclusion
In concluding, let me touch on the economy of Okinawa Prefecture.
The economy has continued to expand on the whole. This is attributable to a high level of
public investment and to an increase in tourism demand mainly supported by the weaker
yen, an increase in the volume of international flights, and the easing of visa requirements.
The buoyant construction and tourism sectors have been leading the expansion of corporate
activity, which has steadily improved the employment and income situation. In terms of
private consumption recently, more consumers are inclined to purchase high-end products.
These developments point to a virtuous cycle from income to spending being in operation.
This is evidenced in the Naha Branch's September and December Tankan last year, in which
business sentiment registered a new record high for two consecutive quarters.
Let me focus on buoyant tourism demand. Led by a significant increase in tourists from
China and other foreign regions, the number of tourists to Okinawa Prefecture in 2015
increased by 0.7 million from a year earlier and registered a new record high, marking
7.76 million in total. Even after the turn of the year, its increasing trend has continued, and
the effects of the slowdown in the Chinese economy have not been observed thus far. As
tourism demand increases, hotel occupancy rates and spending per tourist have been rising.
I have heard that, due to an increase in tourists from overseas, many domestic tourists even
had to give up visiting the prefecture during the high season last year. This uptrend in
tourism demand is likely to continue on the back of the overseas travel boom seen in
neighboring economies and an expansion of the runways at the Naha Airport. Okinawa
Prefecture has been assigned as the National Strategic Special Zone for international
tourism, leading to an increase in domestic fixed investment, such as construction of hotels.
Increasing demand for duty free goods and souvenirs is reflected in favorable corporate
profits in the retail and wholesale sectors.
With regard to the outlook for the tourism industry, the major industry in Okinawa Prefecture,
the prefecture aims at achieving 1 trillion yen in tourism revenue and 10 million tourist
arrivals. With the aim of attaining these targets, it plans to develop the world's highest quality
resort area in an attempt to attract high-end inbound tourists. To realize this goal, it is vital to
make the best use of its nature-rich environment as well as historical and cultural properties
that have been inherited from the Ryukyu Kingdom dating back to the 15th century, while
further upgrading the tourism industry.
In terms of efforts to make use of its geographical characteristics, on the logistics front, the
setting up of the Okinawa international logistics hub that aims to enable high-speed
transportation to major Asian cities has been progressing steadily. The decision has been
made to build a new international convention facility, with an expectation that this will
encourage demand for MICE (i.e., meeting, incentive, convention, and exhibition/event) and
promote business matching. The creation and improvement of infrastructures are likely to
largely contribute to further development of Okinawa Prefecture in line with economic growth
in neighboring economies.
There is an old phrase in Okinawa Prefecture: bankoku shinryo (i.e., bridge between
nations). I heard that the origin of this phrase goes back to the 15th century, when the
Ryukyu Kingdom - which was in close proximity to Japan, China, Korea, and Southeast
Asian regions - prospered as a transit trade country. Bankoku shinryo expresses that the
Ryukyu Kingdom will serve as a bridge that connects the entire world through its trading
vessels, making use of geographical advantages. This phrase fits today's Okinawa
Prefecture even better, since it provides bridges between countries all over the world in
terms of not only a gateway of international logistics but also a tourism site.
The Bank, centering on its Naha Branch, hopes to contribute as much as possible to further
development that takes full advantage of the economic features of the prefecture.
In closing, I wish all the best for the further development of the economy of Okinawa
Prefecture.
Thank you.
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