Yutaka Yamaguchi: The economic situation and monetary policy in Japan1
Speech by Mr Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, at the Economic Seminar of
the Japan Research Institute, Tokyo, 26 November 2001.
* * *
I am honored to have been given the opportunity to talk before this distinguished audience. My topic
today is the economic situation and monetary policy in Japan. There are many issues I would like to
talk about related to this topic, but as my time is limited, I would like to focus on the current issue in the
economy, the continuous decline in prices. The phenomenon had long been forgotten, as it last
emerged just after the war, but it has caught the attention of many and has been actively discussed in
recent years. I would therefore like to share my thoughts with you on policy actions that might be taken
to stop the decline in prices, which naturally include monetary policy.
I. The Economy: The Present Situation and the Outlook
I would first like to explain the Bank's assessment of the current economic situation based on the
Bank's semi-annual report, Outlook and Risk Assessment of the Economy and Prices, "the outlook
report" for short, published on October 29.
The Bank started publishing outlook reports last year, and the report is released twice a year in April
and October. The aim of publication is to promote public understanding by enhancing the
transparency of the conduct of monetary policy by comprehensive disclosure of the views of the
Bank's Policy Board members on the outlook for the economy. The October 2001 report covered fiscal
years 2001 and 2002, the period from April 2001 through March 2003, and assessed the most likely
scenario, or a baseline scenario, for economic and price developments during the period, and the
upside and downside risk factors involved.
There is only time today to give a brief summary of the conclusions of the outlook report. It concluded
that, as a baseline scenario, Japan's economy would go through a severe adjustment in fiscal years
2001 and 2002. At the same time, however, the report asserted that the economy would stop
deteriorating in fiscal 2002 if overseas economies started to recover in fiscal 2002. Even in that case,
more time will be needed before clear signs of recovery can be confirmed and prices are expected to
continue declining gradually in fiscal years 2001 and 2002.
This outlook clearly involves a high degree of uncertainty and there exist both upside and downside
risks to the baseline scenario. Among the risk factors that need to be watched closely are
1) developments in overseas economies, especially those in the U.S., and in IT-related industries;
2) developments in the financial markets at home and abroad, especially stock prices; and 3) the
impact of structural reform of the economy, fiscal consolidation, and the NPL disposal.
II. Problems of the Price Decline
If the consumer price index falls, albeit modestly, in fiscal years 2001 and 2002, this will be a post-war
record of a continuous decline for three years. To consider the relation between prices and monetary
policy, we need to examine the factors behind the price decline.
The projected continuous decline in prices is caused by two factors. The first is the downward
pressures on prices brought about by weak demand. Given the baseline scenario that I mentioned
earlier, the output gap in the economy will be likely to widen into fiscal 2002. The second is the
downward pressures from the supply side, for example, imports of low-priced goods, deregulation, and
streamlining of distribution channels.
These two kinds of pressures are both important as factors behind the price decline. But in relation to
the short-term economic outlook, it is more of a concern that the downward pressures generated by
weak demand will gradually intensify.
This analysis of the price decline does not mean that the Bank is worried only about the pressures due
to weak demand and not about those from the supply side. The Bank is well aware of the necessity of
stopping the continuous price decline in view of the severe economic situation, and is taking strong
monetary easing measures unprecedented in the history of central banking.
Then, what are the problems with the current continuous price decline?
A loss of price stability, regardless of whether this is due to deflation or inflation, could cause the
following problems. Firstly, when prices are not stable, the signaling function of prices does not work
properly and efficient resource allocation is hampered; and secondly, uncertainty heightens which
makes it difficult for economic agents to take decisions for the future. In other words, fluctuations in
prices interfere with the most important function of a market mechanism: resource allocation.
We should examine whether the ongoing gradual price decline could cause these problems. However,
the Bank's recent concern is more about the danger that a vicious circle might be generated by the
price decline: a deflationary spiral emerges when a price decline leads to a recession and this in turn
triggers a further fall in prices. A deflationary spiral can develop for various reasons but the
background common to all is that various contracts for economic transactions are mostly agreed at a
fixed nominal value which cannot be adjusted flexibly for price declines. I will explain this focusing on
three economic variables: interest rates, debts, and wages.
The first point concerns interest rates, the so-called "zero interest rate constraint." Currently, not all the
market interest rates are zero, but short-term rates, which the Bank can control through its policy, are
virtually zero and cannot decline further. Once nominal interest rates decline to zero, there will be no
room left for monetary policy to affect aggregate demand or the level of prices by lowering nominal
interest rates and, consequently, real interest rates.
The second point concerns debts. Debts held by firms and households are usually fixed at a nominal
value, and cannot be adjusted for price declines. Hence, repayment of debts becomes more difficult as
prices decline and corporate sales and/or household income decrease. To make matters worse, Japan
now faces the associated problems of excessive debts in the corporate sector and the large amount of
the NPLs in the banking sector. The gravity of these debt problems aggravated by the heavier debt
burden due to price declines is hampering the recovery of our economy. In the past, there were some
cases where credit contracted substantially when the economy was in a deflationary spiral, and this
was due to a vicious circle in which an increase in debt burden interacted with a price decline.
The third point concerns wages. Nominal wages have a downward rigidity. In general, corporate profits
decrease in cases where nominal wages remain rigid while sales decrease due to a price decline. In
Japan, nominal wages have been adjusted with a certain amount of flexibility and careful analysis is
needed to examine whether or not wage rigidity is exerting downward pressures on corporate profits
and heightening the risk of falling into a deflationary spiral.
From what I have said it is clear that developments in nominal income, including corporate profits and
employee's income, are important yardsticks to judge whether or not the economy will fall into a
deflationary spiral. For example, in 2000, despite some negative inflation rates, the profits of firms
marked an increase of 34 percent, and that of employee's income was one percent. Therefore, the
probability of the economy falling into a deflationary spiral was low. After the turn of the year, the
situation changed and began to give cause for concern, as corporate profits started to decrease and
the year-on-year increase in wages has remained negative since summer 2001. Thus, although the
pace of price decline was almost the same in calendar years 2000 and 2001, the implications are
different this year.
Is there a high probability of Japan's economy falling into a deflationary spiral in the future? In the
outlook report in October, the Policy Board members' assessment was that, for fiscal 2002, economic
growth will remain negative and prices will continue to decline. However, this assessment did not
include the emergence of a deflationary spiral and we assumed that the deterioration of the economy
would stop in the second half of fiscal 2002 if overseas economies started to recover. That was our
baseline scenario and the associated downside risk factors should not be forgotten. If you recall my
earlier explanation of deflationary spirals, I do have a deep concern about developments in corporate
profits and financial system problems in a situation where nominal short-term interest rates reach zero.
In this sense, we cannot totally rule out the possibility that the economy will fall into a deflationary
spiral, and the situation warrants vigilant monitoring.
III. Effects and Limits of Current Monetary Easing Measures
A. Outline of Current Monetary Easing Measures
The Bank of Japan has taken strong monetary easing measures which no other central bank has ever
adopted before, against the background of the Bank's severe economic outlook. The framework of the
current monetary easing measures can be summarized in the following four points.
First, the main target of market operations was changed from the overnight call rate to the amount
outstanding of the current accounts at the Bank. In addition, the new target was raised from four trillion
yen to five trillion yen in March, to six trillion yen in August. Since September, in response to a surge in
liquidity demand triggered by the terrorist attacks in the U.S., the Bank has provided the market with
ample liquidity "aiming at above six trillion yen" without setting an upper limit. As a result, the amount
outstanding of the current accounts at the Bank averaged 9.2 trillion yen for the September and
8.8 trillion yen for the October reserve maintenance period.
Second, the Bank has committed itself to continuing the above mentioned framework of monetary
operations until the rate of increase of the CPI rises to and remains stably at or above zero percent.
This commitment aims to drive down interest rates of longer maturity by clearly stating that the Bank
will continue the current monetary easing measures in the future. This monetary easing effect is often
called "the commitment effect" or "the duration effect."
Third, the Bank decided that it could increase its outright purchase of long-term Japanese Government
Bonds (JGBs) when the Bank found it necessary to smoothly provide ample liquidity to the market, on
the condition that the amount outstanding of long-term JGB holdings be within the amount outstanding
of banknotes issued. In accordance with this framework, in August the Bank increased the amount and
frequency of JGB outright purchase from twice a month amounting to 400 billion yen to three times a
month amounting to 600 billion yen.
Fourth, the Bank has established the so-called Lombard-type lending facility. By utilizing this scheme,
financial institutions, under certain conditions, are now able to borrow funds from the Bank at the
official discount rate as long as they have eligible collateral. This measure has strengthened the
monetary easing effect in the sense that financial institutions have been ensured access to ample
liquidity and that money market interest rates have been stabilized. The official discount rate, which is
applied to this Lombard-type lending facility, has been lowered twice in 2001, in February and in
September, and is currently at 0.1 percent.
B. The Strong Monetary Easing Effects in Financial Markets
Current monetary policy has achieved extremely easy conditions in the financial markets. In the
money markets, short-term interest rates, including longer ones on term instruments, have declined to
a lower level than in the zero-interest-rate period of 1999-2000. Since the unit for transactions of the
overnight call rate was changed from 0.01 percent to 0.001 percent in early September, the rate has
declined to as low as 0.001 percent to 0.004 percent, a microscopic world indeed.
In the bond markets, the interest rates on JGBs continued to move at levels close to the historical low
although they did not decline below the level marked in March this year. Furthermore, medium-term
interest rates, such as that of JGBs with five years remaining to maturity, are moving at
0.4-0.5 percent, which is lower than the level in March.
In the CP and corporate bond markets, credit spreads have narrowed with the decline in short- to
medium-term interest rates and investors have become more willing to take risks. Therefore, the
demand for issuance of new securities in firms with relatively high credit ratings has increased and the
amount outstanding of issuance of CP and corporate bonds has maintained a high level. In Japan, the
share of corporate financing through the capital markets is still relatively small. However, it has
become important as a channel by which the monetary easing measures have permeated through the
economy because the credit intermediation function of banks is weakened.
By contrast, the effect of the current policy on asset prices such as stock prices and foreign exchange
rates has been relatively limited. Although stock prices rose somewhat after the announcement of the
monetary easing measures in March this year, they declined steadily from May onward reflecting a
deterioration in business conditions and successive downward revisions of the outlook for corporate
profits. Stock prices have not shown a positive response to the increase in the outstanding balance of
current accounts at the Bank since August. Foreign exchange rate of the yen also did not depreciate
compared to levels in March, as the U.S. economy showed a faster-than-expected slowdown.
C. Easing Effects on the Corporate and the Household Sectors
The crucial point in assessing current monetary policy is whether the ample provision of liquidity by the
Bank and consequent easing in the financial markets are affecting the economic entities outside the
financial markets such as the corporate and household sectors. Regrettably, the easing effects have
not fully permeated to the economy. The monetary base, the sum of banknotes and current accounts
at the Bank, is increasing by 14 percent on a year-on-year basis. However, the growth rate of money
supply is only 3.6 percent on the same basis, somewhat higher than at the beginning of this year,
mainly due to a shift of funds from maturing postal savings. More serious is the fact that bank lending
is contracting at 1.9 percent year-on-year and the pace of this decline has been accelerating
somewhat. GDP and price conditions also have not shown any improvement. Business capital
spending and housing construction do not seem to be stimulated by the historically low interest rates.
IV. The Monetary Policy and Prices
A. Is Deflation a Monetary Phenomenon?
I will return to the reasons behind the weak response of the economy to the strong monetary easing
policy. Instead, here, I would like to pose a question: Is it fair to say that the insufficient monetary
easing is causing continuous price declines and stagnant economic growth? For example, we often
hear the argument that "both inflation and deflation are monetary phenomena and price declines can
be stopped only by increasing money supply," a simplified form of the quantitative theory of money. Is
this kind of argument correct?
A part of the above argument that "both inflation and deflation are monetary phenomena" does hold as
a long-term economic relationship when the amount of money changes significantly. In fact, the policy
objective of many central banks including the Bank, that is to attain "price stability," is based on the
understanding of this relationship. However, this relationship holds only over a sufficiently long period
of time and can be interpreted as a sort of definitional or identical relationship. Therefore, at a practical
level, it cannot be applied to the conduct of monetary policy.
The first problem with the argument is that, as I mentioned above, it does not make a clear distinction
between the relationship in the long term and in the short term. For example, if we look at the relation
between money and prices, a close relationship emerges when the amount of money increases or
decreases on an extremely large scale and has a dominant impact: The hyper-inflation experienced in
Germany after World War I is one example. When the amount of money increases or decreases to a
certain extent but not on an extremely large scale, a loose relationship is observed only if we look in
the sufficiently long term. However, over a period of one year to a couple of years, unless the amount
of money increases or decreases on an extremely large scale as I have just explained, the relationship
between money and prices is not stable.
The second problem is that at present the underlying mechanism in the argument will not work as
theoretically assumed: a central bank's efforts to expand liquidity, the current account balance at the
Bank or the monetary base, will increase money supply in a broader sense, that is liquidity held by the
corporate and household sectors, and, consequently, will push up prices and the level of business
activity. Needless to say, monetary policy cannot actually resort to dropping banknotes from the
sky-this kind of policy is called "helicopter money" in economics textbooks. If such a policy is implemented,
people will rush to purchase goods and services after they receive the cash, and prices can be
expected to rise immediately. However, in actual monetary policy, money in a broad sense is provided
through a series of "transactions": a central bank purchases financial assets such as government
bonds from financial institutions, in turn creating money in a narrow sense, that is the current account
balance at the central bank, and then financial institutions make lending and securities investment.
However, what is happening currently in Japan's economy is that, although funds are abundant in the
financial markets, they do not permeate outside those markets, that is, to the corporate and household
sectors and money supply has not increased sufficiently. This has been both the cause and result of
the stagnant growth in expenditures and the decline in prices. Given that the mechanism to increase
money is not working properly, I think it is not following logical steps or is ignoring reality to argue that
increasing money could solve all the problems.
As I mentioned, while various factors affect the movement of prices, the most fundamental factor
determining price developments is the balance between aggregate demand and supply for goods and
services. As the supply capacity changes only slowly, it is the movement of demand that mainly
determines the short-term supply-demand balance. In fact, in the time-series data on the Japanese
economy, prices begin to rise only after the economic growth rate recovers and the output gap
narrows. Statistical analysis of the dynamic correlation between the economic growth rate and the rate
of increase in prices shows that the correlation coefficient is the highest when the economic growth is
one to two years ahead of a consumer price increase. On the other hand, the rate of increase in prices
does not seem to lead the economic growth rate.
In the above discussion, it is clear that in order to halt the continuous decline of prices, it is most
important to promote a sustainable, not temporary, growth in aggregate demand. The implementation
of monetary policy by the Bank so far has been aimed at halting the decline in prices by providing
ample liquidity to the markets to lower interest rates thereby stimulating aggregate demand. The
current difficulty in the conduct of monetary policy is that it cannot stimulate aggregate demand even
with all the measures employed. We need to face up to this fact.
B. Inflation Targeting
Currently in Japan, we often hear the argument calling for the adoption of inflation targeting. However,
this argument is peculiar in the sense that it focuses on first raising prices using every measure. I
believe we should devise ways to stimulate economic activity first because prices in nature are the
result of economic activity. With this understanding of the environments surrounding price
developments and monetary policy, the Bank is currently reluctant to accept the recent argument for
inflation targeting.
More fundamentally, inflation targeting should be regarded not as a short-term policy tool but as a
framework for improving the transparency of the conduct of monetary policy. As a possible tool for
improving the transparency, the Bank considers that inflation targeting is worth examining as one of
the options in the future. However, currently, as the short-term interest rate has already reached zero
percent, the Bank has very few options for further monetary easing. In addition, the effect of the
current monetary easing policy is limited because of the NPL problem. In such circumstances, it is
unlikely that the adoption of a too ambitious a target will improve confidence in monetary policy.
At this point, I would expect a counter-argument that however limited the room available for additional
monetary easing, adoption of an inflation target will of itself directly affect the "expectation" of
economic agents and will produce inflation expectations. I would admit that "expectation" is one of the
important channels by which the effects of monetary policy can permeate through the economy.
However, controlling "expectation" solely by announcing a policy is unlikely to succeed. I think the
Bank can affect people's expectation only if the announcement is accompanied by effective policy
measures. The Bank is in fact already strongly affecting people's expectation by promising to continue
the current monetary easing framework until the year-on-year increase in CPI rises and remains stably
above zero percent. In fact, as I mentioned, the interest rate on the JGB with five years remaining to
maturity is currently at 0.4-0.5 percent. This interest rate level clearly indicates that market participants
are expecting the current historically low interest rates will continue for an extended period of time. In
spite of this market development, the actual and expected inflation rates do not show any signs of
upward movement.
I understand that some argue that the Bank can cause inflation by purchasing any kind of assets. I will
touch upon this issue later.
As an example of successful introduction of inflation targeting, some cite the price level targeting
adopted in Sweden in the first half of the 1930s. We at the Bank are also interested in the Swedish
experience and have studied it. What we found was a great similarity between the Swedish policy and
the Bank's current policy framework.
The most important similarity is that, while both the Swedish authorities and the Bank of Japan
declared their firm determination to prevent price declines, neither adopted a numerical target. In the
Swedish comprehensive program for price stability, it was stated that "Monetary policy should not be
tied systematically to a particular index figure. A formal and simple rule for monetary policy did not
appear feasible." More specifically, the Riksbank, the Swedish central bank, stressed the importance
of carefully monitoring various price indices while taking into account other economic variables such
as inventory figures and productivity data. It stated that implementation of the policy should not
depend on a specific price index such as the CPI. Therefore, a clear distinction should be made
between the Swedish policy and the idea of overcoming deflation by adopting a rigid price targeting
scheme using a specific price index.
When comparing Sweden in the 1930s and Japan's current situation, we should be careful because
there are critical differences between the two regarding economic and financial environments. The
significant differences are the following: (1) in the Swedish economy at the time, the level of nominal
interest rates was relatively high so that there was sufficient room for interest rate cuts, (2) the
Swedish financial system did not face a serious problem, (3) as a relatively small open economy, the
depreciation of the currency in the foreign exchange market contributed to the prevention of price falls.
In sum, there is a difficulty in applying the specific measures used in Sweden in the 1930s to the
current situation in Japan.
V. Why Japan's Economy is not able to Exit from the Deflation
Now, I would like to raise a question: What kind of economic policies are required to exit from the
ongoing deflation, and why is Japan's economy unable to do so? As I have already mentioned, three
factors in particular stand out as important: the constraints imposed by zero nominal interest rates, the
NPL problem, and the weakening sentiment.
A. Constraints of Zero Nominal Interest Rates
First let us consider the constraints imposed by zero nominal interest rates. Short-term interest rates
are already virtually zero, five-year interest rates have also declined very close to zero--the term of
debt financing by Japanese firms is in many cases five years or less. A standard mechanism of
monetary easing is: (1) inducing a decline in short-term interest rates by providing ample liquidity to
the money market, (2) thereby influencing financial variables such as the medium- to long-term
interest rates, stock prices, and foreign exchange rates, (3) consequently, expecting such changes in
financial variables will affect the behavior of financial institutions, firms and households. Now that
nominal interest rates have reached the point where no further decline is possible, monetary easing
has also reached the point where little additional effect can be expected. Moreover, real interest rates
could rise if a price decline continues in this economic setting.
By the way, facing the limits of further monetary easing with the zero interest rate constraints, what
kind of meaning does the massive amount of liquidity provision to the financial markets have? It is
premature to give a definite answer to this question. The current policy adopted by the Bank is unique
and has not been tried in other countries. The effects of such policy, especially in a situation where
serious problems exist in the financial sector, should be assessed empirically but we have not
accumulated sufficient experience and data to draw concrete conclusions. At the same time, this does
not mean that we have no clues. One example is the surge in liquidity demand in the financial markets
and the associated increase in the outstanding balance of the current accounts at the Bank after the
terrorist attacks in the US. The surge in liquidity demand itself took place not only in the U.S. but also
in other countries and major central banks including the Bank provided a huge amount of liquidity in
order to secure stability in the financial markets. While the Federal Reserve and the European Central
Bank returned to normality in terms of liquidity provision within a week, in Japan, by contrast, liquidity
demand has continued to be high. It appears that there are two factors at work here.
The first factor is waning incentive to invest or lend funds in the markets with the decline in the
uncollateralized overnight call rate to 0.001 percent. Thus, financial institutions that hold excess funds
would prefer to deposit them in their current accounts at the Bank even if it does not bear interest.
Once such behavior spreads to other market participants, borrowers feel worried that they might not
be able to borrow funds in the markets, and subsequently, an increasing number of financial
institutions will start to defensively accumulate funds in their current accounts at the Bank.
The second factor is the fact that the cost of yen funding through yen-U.S. dollar swaps has become
negative for foreign banks. Foreign banks capable of funding yen at negative interest rates can earn
an interest margin without worrying about credit risk by depositing the funds in their current accounts
at the Bank. In this case, the negative yen funding rate works as a "sweetener" giving an incentive to
foreign banks providing Japanese banks with dollar funds.
These two factors, a disincentive to invest in the money markets and negative yen funding costs, give
us an interesting insight into the meaning of current market operations in which ample liquidity is
provided with the current account balance as an operating target. That is to say, the disincentive to
lend funds in the market was largely caused by the ample liquidity provision by the Bank. At the same
time, the major reason why the Bank can provide ample liquidity without facing under-subscription in
open market operations is that there is demand from foreign banks for excess reserves, and this itself
is not expected to lead to a revitalization of economic activity. Of course, we still cannot deny the
possibility that the demand for excess reserves will lead to a change in the portfolio of economic
entities and ultimately stimulate economic activity in the long run. The Bank is now closely examining
this possibility while continuing the current massive provision of liquidity.
B. The NPL Problem
The second reason why Japan's economy is unable to exit from the ongoing deflation is the NPL
problem. It is not the case that once the NPLs are disposed of, the deflation will end, and the economy
will recover right away. I think that it is now widely understood that the disposal of the NPLs will rather
be associated with short-term pain. It is also true, however, that once the economy recovers, the NPLs
will decrease. Sustainable economic growth cannot be expected in a situation where a large amount
of the NPLs remain and credit intermediation does not function fully, for the following reasons.
First of all, in such a case, financial institutions are facing the risk of their capital being impaired by
external factors such as a decline in stock prices and emergence of new NPLs following a downturn in
the economy. Capital is the last line of defense against unexpected risks and losses. It is difficult for
the management of the financial institutions to take risks when they are concerned about their capital
position. From a macroeconomic point of view, sustainable economic growth may only be achieved
with continuously favorable external conditions which will require delicate policy management.
Secondly, until the NPL disposal is completed, it is difficult to adjust lending rates to levels adequately
reflecting risk and return. Currently Japanese banks are competing with one another to lend to
blue-chip companies and credit spreads have become extremely narrow. On the other hand, the
Japanese banks are cautious about extending new loans to firms with low credit ratings and the banks
have not increased credit spreads adequately on their lending to existing less creditworthy borrowers.
In the current situation, if the banks drastically increase credit spreads, their borrowers are likely to go
bankrupt and the banks will have to pay the price in the end. However, from the long-term perspective,
unless the lending rates are set in an economically rational manner, the lending attitude of financial
institutions cannot be aggressive and consequently it is hard to achieve a sustainable economic
growth.
C. Weakening Sentiment
The third reason for the deflationary trend in Japan is weakening sentiment. Looking at households,
their expenditure has been restrained reflecting their anxieties about the future including the viability of
social security systems and employment concerns. In the corporate sector, investment appetite has
receded partly because the economic stagnation itself has lowered the expected rate of growth. I
understand that listing weakening sentiment as part of the background of deflation sounds like talking
about the two sides of the same coin. But I think that the current weak demand cannot be fully
explained by the zero interest rate constraint and the NPL problem and there remain some kind of
residual factors which should be explained as weakening sentiment. Such a decline in demand
caused by weakening sentiment can hardly be solved unless people become confident that the
economy has returned to a clear recovery path. At the same time, considering the state of typical
households and firms, I think it is difficult to deny that, together with the stagna