J u l y 2 2 , 2 0 1 9
Bank of Japan
Overcoming Deflation: Japan's Experience and
Challenges Ahead
Speech at the 2019 Michel Camdessus Central Banking Lecture,
International Monetary Fund
Haruhiko Kuroda
Governor of the Bank of Japan
Introduction
It is my great pleasure to have the opportunity today to give a speech in honor of Michel
Camdessus.
In my speech today, I would like to share some thoughts on Japan's deflation that started
from the late 1990s, when Mr. Camdessus served as the Managing Director of the
International Monetary Fund (IMF). The inflation rate in Japan started to decline after the
burst of the asset bubble in the early 1990s. The economy fell into deflation in the late
1990s, in the sense of a sustained decline in prices, and this deflation persisted for about 15
years.
Such chronic deflation used to be regarded as a phenomenon unique to Japan. However,
most advanced economies have been experiencing low inflation and low interest rates since
the global financial crisis. Many central banks now face a common challenge of how to
raise inflation rates. I believe that Japan's experience of a long battle against deflation would
provide a case study for other central banks in conducting monetary policy going forward.
Keeping this in mind, I would like to discuss two topics today. The first is the reasons
behind chronic deflation in Japan and the effects of quantitative and qualitative monetary
easing (QQE) that the Bank of Japan introduced in 2013 as a measure to overcome deflation.
As I will explain later, Japan's economy is finally no longer in deflation owing to the
powerful monetary easing, and it is reconfirmed that monetary policy is effective even in
overcoming chronic deflation. However, it is taking time to achieve the Bank's price
stability target of 2 percent. After explaining the reasons behind this, I will move on to the
second topic of the Bank's initiatives to overcome the current persistent low inflation. The
Bank introduced the new policy framework, "QQE with Yield Curve Control," in 2016 and
strengthened it in 2018. I will elaborate on the Bank's thinking behind the new initiatives
and its experience.
I. Chronic Deflation and QQE
A. Decline in the Natural Rate of Interest and Chronic Deflation
Now, let me start with Japan's experience of deflation. In Japan, after the burst of a
large-scale asset bubble in the early 1990s, the economy decelerated significantly and the
inflation rate declined gradually. The economy fell into deflation amid the successive
collapse of major financial institutions in the late 1990s. Thereafter, except for some periods
when commodity prices surged, the CPI inflation rate remained in negative territory for
about 15 years (Chart 1).
Why did Japan's economy fall into deflation and face difficulty in getting out of it for a long
time? In my view, this is basically because the natural rate of interest declined rapidly, due
to the stagnant potential growth rate, the bubble burst, and the subsequent financial crisis
(Chart 2).1 The Bank had been searching for measures to strengthen monetary easing from
an early stage. It adopted the zero interest rate policy in 1999 and introduced quantitative
easing (QE) in 2001 ahead of other central banks. However, it could not create sufficiently
accommodative financial conditions in a situation where the nominal policy interest rate
had already reached the zero lower bound, and QE at that time simply exchanged nearly
zero interest rate short-term assets for zero interest rate deposits at the Bank of Japan. In
addition, amid a situation of stagnant economic activity and prices, it was perceived by the
public and markets that the Bank did not commit strongly enough to achieving price
stability. This also gradually pushed down inflation expectations and made it more difficult
to overcome deflation.
B. Developments in Economic Activity and Prices since the Introduction of QQE
In order to break through this situation, the Bank introduced QQE in April 2013. This
framework of powerful monetary easing consists of two pillars: (1) a strong and clear
commitment to achieving the price stability target of 2 percent at the earliest possible time
and (2) large-scale purchases of short- to long-term government bonds to reduce long-term
interest rates.
QQE exerted significant effects, supported by the favorable economic conditions at the time.
Nominal interest rates declined largely across the entire yield curve. In particular, long-term
interest rates were influenced strongly, since they had room for a further decline even under
the zero lower bound on short-term interest rates. With concern about the persistent
deflation being dispelled, inflation expectations rose, and short- and long-term real interest
rates fell to a level far below the natural rate of interest. As a consequence, the economy
improved significantly and the inflation rate went up. For the first time in about 15 years,
Japan's economy is no longer in deflation. Since the global financial crisis, the inflation rate
in Japan alone has increased, while the rates in many advanced economies have declined.
This indicates the significant effects of QQE (Chart 3).
That said, the inflation rate is still below 1 percent and the low inflation environment
remains. As I just mentioned, in Japan, powerful monetary easing has boosted demand
through a decline in real interest rates. This transmission mechanism has worked firmly as
initially intended. However, the problem is that, even though demand shortage was met, it is
still taking time to overcome low inflation.
C. Reasons Why It Takes Time for Inflation to Rise
In our understanding, the combination of a vulnerability of inflation expectations to adverse
shocks and structural factors explains why a rise in inflation is taking time.
Inflation expectations started to rise following the introduction of QQE in 2013, but leveled
off around the next summer and started to decline thereafter. Such a decline was largely due
to a drop in the inflation rate that mainly reflected a significant fall in crude oil prices. In
2014, Japan's economy was halfway through the re-anchoring process from a deflationary
equilibrium to a new equilibrium. Unfortunately, the economy faced large adverse price
shocks at such a critical point, and inflation expectations stopped rising as they are
vulnerable to such shocks before they are well anchored.2
However, inflation remained sluggish even after 2016, when crude oil prices started to
increase. So, it is not possible to attribute the reason only to past price shocks. Let me
introduce some hypotheses that focus on structural factors to explain the current sluggish
inflation.
The first is that the hysteresis effects of inflation expectations are stronger than expected.
The introduction of QQE dispelled an extremely pessimistic view that deflation would
continue. However, the experience of prolonged low growth and low inflation has become
deeply embedded in people's mindset and behavior, and the assumption that prices will not
increase easily has been entrenched. Recently, many analyses show that households'
inflation expectations are significantly affected by their experience for a long time. For
example, compared to the age group who experienced relatively high inflation, inflation
expectations are lower for younger generations in Japan. They only have the experience of
low inflation and deflation.3
The second hypothesis is that the past experience of deflation and recent technological
innovation have constrained the unit labor cost and this mechanism has worked strongly.
Even though the unemployment rate has declined to about 2.5 percent and the tightening of
labor market conditions has been evident, wage growth for regular employees has remained
moderate. Because of the long experience of a severe employment situation under deflation,
both labor and management may have come to prioritize the stability of long-term
employment over immediate wage increases.4 In fact, wages of part-time workers, whose
employment can be adjusted more flexibly, have been increasing by more than 2 percent,
while those of regular workers increasing by less than 1 percent. In addition, the unit labor
3
With regard to the characteristics of households' inflation expectations by generation in Japan, see
Jess Diamond, Kota Watanabe, and Tsutomu Watanabe, "The Formation of Consumer Inflation
Expectations: New Evidence from Japan's Deflation Experience," CARF Working Paper,
CARF-F-388, 2017.
4
Regarding the effects of the past employment situation on the present wage-setting stance, see
Yuto Iwasaki, Ichiro Muto, and Mototsugu Shintani, "Missing Wage Inflation?: Estimating the
Natural Rate of Unemployment in a Nonlinear DSGE Model," IMES Discussion Paper Series,
no.2018-E-8, 2018.
cost is constrained by offsetting a rise in labor cost with an improvement in productivity.
Since the IT investment using the recent digital technology is highly substitutable to labor, it
may constrain a rise in real wages (Chart 4).
In addition to the two factors that I explained, there are many others, including the progress
in globalization. Various factors are interacting with each other and working on prices. For
example, when households strongly believe that prices will not increase easily, firms may
become cautious about raising their prices for fear of losing their customers, and thereby try
to constrain the unit labor cost or markup.
Reflecting these various factors, the Phillips curve in Japan has flattened, and it has taken
time for the curve to shift upward due to the delay in a rise in inflation expectations. I think
Japan's experience may be a clue to explaining the "missing inflation" in advanced
economies. The United States and Europe suffered severe economic downturns after the
global financial crisis as well as the prolonged low growth and low inflation environment
since then. As with Japan's experience of deflation, such severe situations may have affected
the mindset and behavior of households and firms in those countries. The progress in
digitalization and globalization is also common among advanced economies.
II. Lessons Learned from Japan's Experience and Challenges Ahead
So far, I have talked about the first topic of Japan's experience of deflation and the Bank's
powerful monetary easing to overcome it. I also explained the reasons behind the persistent
low inflation. Now, I would like to move on to the second topic of the Bank's challenges
under the low inflation environment.
Regarding the monetary policy conduct, I think that the Bank learned two lessons from the
past experience.
First, even in the face of a substantial decline in the natural rate of interest, it is possible to
realize accommodative financial conditions and stimulate economic activity and prices by
strengthening monetary easing. We have not yet fully understood the effects and side effects
of unconventional monetary policy, but there is no need to be too pessimistic about them.
Second, we need to bear in mind that it may take time to overcome entrenched low inflation,
even with the powerful monetary easing. Of course, this does not mean that the inflation
rate will never rise again. In Japan, firms' moves to raise wages and prices have been
spreading gradually, while the economy has continued on an improving trend. The Bank
considers it important to persistently support such moves through monetary policy. We need
to maintain upward pressure on the inflation rate for as long as possible and encourage
people to change their mindset and behavior.
Based on this understanding, the Bank has pursued powerful monetary easing since the
introduction of QQE that is called a "new phase of monetary easing." However, it is not
easy to continue with such powerful measures for a long time. Next, I would like to talk
about three points regarding the challenges in maintaining accommodative financial
conditions and the Bank's initiatives to overcome them.
A. Communication and Expectation Management
The first challenge is how to communicate with the public in order to manage people's
expectations effectively. Expectation management is one of the most fundamental elements
of monetary policy conduct, and in particular, forward guidance regarding the future policy
stance plays an important role under the low interest rate environment.
In a standard economic model, even when short-term interest rates reach the effective lower
bound, if a central bank announces that it will maintain accommodative financial conditions
for a long time, the behavior of each economic entity could change, thereby producing
significant monetary easing effects. In reality, however, people's behavior does not seem to
change as much as the theory suggests, especially when the forward guidance horizon
becomes longer. One of the reasons behind this "forward guidance puzzle" is the difficulty
in assuring people's understanding of the central bank's guidance for the distant future. The
central bank's guidance cannot gain confidence unless people perceive it as realistic and
time consistent. However, if the central bank focuses too much on such consistency and
makes the guidance complicated, it becomes more difficult to convey its thinking to the
public. As suggested by recent studies on the "rational inattention," households and firms do
not always pay close attention to monetary policy or price developments. So, the central
bank needs to clearly explain its thinking in plain language in order to manage their
expectations.
On this basis, the Bank of Japan has adopted two types of forward guidance. The first is an
"inflation-overshooting commitment" introduced in September 2016. This is a commitment
that the Bank will continue expanding the monetary base until the observed inflation rate
exceeds 2 percent and stays above that level in a stable manner. By linking to the price
stability target, the Bank clearly shows its determination to maintain accommodative
financial conditions for longer than assumed in a standard economic model. The second is
"forward guidance for policy rates" introduced in July 2018. This shows the Bank's
intention to maintain the current extremely low levels of short- and long-term interest rates
for an extended period of time, at least through around spring 2020, taking into account
uncertainties regarding economic activity and prices. Through this forward guidance, the
Bank has made clear that it considers it appropriate to maintain the current low levels of
interest rates for such a long time. It also has clarified the time frame to make its intention
easy to understand. Since the introduction of forward guidance for policy rates, the survey
results show that an increasing number of market participants consider that interest rates
will remain low (Chart 5). This indicates the effectiveness of such guidance.
B. Securing Effective Policy Measures
The second challenge in maintaining accommodative financial conditions for a long time is
to secure highly sustainable policy measures.
In order to address this challenge, in September 2016, the Bank decided to place yield curve
control at the core of the monetary policy framework. Under yield curve control, the Bank
aims to control both short- and long-term interest rates, setting the target level of 10-year
Japanese government bond (JGB) yields at around zero percent. The previous policy
framework that set the amount of JGB purchases as the operating target was simple to
operate in practice. However, there was a problem that the degree of downward pressure on
the yields could change to a large extent, depending on economic and market conditions at
the time. In contrast, under yield curve control, the Bank sets the specific target level of
interest rates and conducts JGB purchases so as to achieve this target. In exerting monetary
easing effects stably for a long time, the Bank judges that yield curve control is a better
framework in terms of both controllability and sustainability.
There are several points that warrant attention in order to elicit the utmost effects of yield
curve control.
The first is to secure confidence that a central bank can actually control long-term interest
rates. Unlike the money market dominated by the central bank, the government bond market
consists of various participants, and the price mechanism is more complex. Based on our
experience, in order to control long-term interest rates, the central bank needs to gain a
strong presence in the government bond market. It also is important to develop and secure
effective operational measures to realize fine-tuned interest rate control.
More specifically, the Bank already holds more than 40 percent of JGBs on a stock basis.
Also, its share of JGB transaction volume on a flow basis has been at a high level (Chart 6).
Long-term interest rates have been controlled by changing the amount of JGB purchases
appropriately, based on the premise that the Bank has a strong presence in the JGB market
in terms of both stock and flow.5 When yield curve control was introduced in September
2016, there were skeptical views about the Bank's ability to control interest rates. In fact,
when U.S. and European long-term interest rates rose significantly from late 2016 to early
next year, there was sudden upward pressure on JGB yields as well. In this phase, the Bank
used a powerful tool called "fixed-rate purchase operations," in which it buys unlimited
amounts of JGBs at a specific interest rate level. As this new tool was used in a timely
manner, market confidence regarding the Bank's ability to control interest rates has
strengthened. Since mid-2017, long-term interest rates have shown a greater tendency to
move at around the target level.
The second point is to maintain the minimal market functioning while controlling the
long-term interest rates appropriately. Of course, there is a trade-off between strengthening
a central bank's ability to control interest rates and maintaining the market functioning.
Increasing market confidence in the central bank's ability implicitly works as a put option.
If this situation progresses further, the market functioning could be overly constrained. In
fact, from around early 2018, as confidence in the effectiveness of yield curve control
strengthened, daily fluctuations in JGB yields clearly became smaller and the JGB
transaction volume also showed a decreasing trend (Chart 7). To deal with this difficult
situation, in July 2018, the Bank clarified that long-term interest rates might move upward
and downward to some extent mainly depending on developments in economic activity and
prices, and made clear that it would conduct JGB purchases in a more flexible manner
depending on market conditions. Meanwhile, the Bank has proceeded with adjustments to
maintain and improve the market functioning, for example, by relaxing the terms and
conditions for the Securities Lending Facility (SLF). Reflecting these efforts, price
movements and the transaction volume of JGBs have recovered recently.
As I mentioned earlier, yield curve control was introduced in 2016 to enhance the
sustainability of the monetary easing policy. In addition, I believe that the Bank can
maintain accommodative financial conditions for a long time by continuously making
efforts to strike a balance between conducting yield curve control as well as maintaining
and improving the market functioning.
C. Examination of the Financial Functioning
The third challenge in continuing with powerful monetary easing is to examine its impact
on the financial functioning.
To achieve price stability, it is essential to ensure financial stability and sustain the
transmission mechanism of monetary policy. If long-term and super-long-term interest rates
decline excessively, the rates of return on insurance and pension products also will decline.
The Bank considers it necessary to pay attention to the possibility that this will give rise to a
feeling of anxiety about the sustainability of financial functioning in a broad sense. The
Bank also has examined whether the prolonged low interest rates will lead to an expansion
of leverage due to excessively bullish expectations and whether they will result in the
malfunctioning of financial intermediation through the impact on profits of financial
institutions.
Out of the two effects stemming from the prolonged low interest rates, the latter warrants
more attention at this point. Excessively low interest rates could make financial institutions
reluctant to lend, such as through capital constraints, and thereby diminish the monetary
easing effects. In addition, if financial institutions take excessive risks under the severe
profit environment in order to acquire immediate profits, the vulnerability of the financial
system could increase in the longer term. These risks are judged as not significant at this
point, mainly because financial institutions have sufficient capital bases. However, we will
continue to pay attention to whether there are any changes in financial institutions' behavior
or the functioning of financial intermediation amid continued accommodative financial
conditions.
Conclusion
As time is running out, I would like to conclude my speech.
In recent years, low inflation and low interest rates have been prolonged globally, and many
central banks face a common challenge of how to raise inflation rates. Based on this
recognition, I talked about Japan's experience and challenges from a somewhat long-term
perspective, as Japan faced low inflation and low interest rates at an early stage and has
continued to make various efforts to overcome this situation.
Japan's economy has improved significantly while the Bank has continued with powerful
monetary easing through "QQE with Yield Curve Control." The positive annual CPI
inflation has taken hold, and the economy is no longer in deflation in the sense of a
sustained decline in prices. That said, annual CPI inflation is in the range of 0.5-1.0 percent.
The Bank will persistently continue with powerful monetary easing in order to maintain the
momentum toward achieving 2 percent inflation.
Recently, uncertainties regarding the global economy have been heightening, and some
nervousness has been seen in global financial markets. The Bank needs to pay close
attention to the effects of these developments on Japan's economic activity and prices. We
will carefully examine various risk factors, in addition to developments in economic activity
and prices as well as financial conditions, and weigh the benefits and costs of the policy
effects. In this way, the Bank will continue to conduct its policy in an appropriate manner.
Thank you very much for your attention.
Overcoming Deflation: Japan's Experience and
Challenges Ahead
Speech at the 2019 Michel Camdessus Central Banking Lecture,
International Monetary Fund
July 22, 2019
Haruhiko Kuroda
Governor of the Bank of Japan
Introduction
I. Chronic Deflation, and Quantitative and
Qualitative Monetary Easing (QQE)
II. Lessons Learned from Japan's Experience and
Challenges Ahead
Conclusion
Consumer Prices
y/y % chg.
4
Introduction of QQE
3
2
1
0
-1
CPI (all items less fresh food)
-2
CPI (all items less fresh food and energy)
-3
CY 85 90 95 00 05 10 15
Note: Figures are adjusted for changes in the consumption tax rate.
Source: Ministry of Internal Affairs and Communications.
1
Chart 2
I. Chronic Deflation and QQE
Natural Rate of Interest
%
5
Potential growth rate
4
R* in the DSGE Model
R* estimated based on Laubach and Williams (2003)
3
R* estimated based on Imakubo et al. (2015)
2
R* estimated based on the HP Filter
1
0
-1
-2
CY 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17
Notes: 1. Figures for the potential growth rate are based on staff estimations.
Notes: 2. For details of the methodologies used in this chart, see Nao Sudo, Yosuke Okazaki, and Yasutaka Takizuka, "Determinants of the Natural Rate of Interest in Japan: Approaches
Based on a DSGE Model and OG Model," Bank of Japan Research Laboratory Series, no.18-E-1, 2018.
2
Sources: Consensus Economics Inc., "Consensus Forecasts"; Bank of Japan.
QQE and Price Developments
Japan's Consumer Prices Price Developments in G7 Countries
y/y % chg.
y/y % chg. 3.0
3
Average from 2000 through 2012
Introduction of
QQE
2.5
Average from 2013 through 2018
CPI (all items less fresh food
2
and energy)
2.0
1
1.5
0
1.0
Average from 2013/Q2
-1
through 2019/Q2
0.5
Average from 2000/Q1
+ 0.5%
through 2013/Q1
- 0.5%
-2
0.0
-0.5
-3
Japan U.S. Germany U.K. France Italy Canada
CY 00 02 04 06 08 10 12 14 16 18
Notes: 1. Figures for Japan are adjusted for changes in the consumption tax rate.
Notes: 2. In the right chart, figures for Japan, U.K., and Canada are the CPI; those for U.S. are the PCE deflator; and those for the euro area countries are the HICP.
Sources: Ministry of Internal Affairs and Communications; Haver.
3
Chart 4
I. Chronic Deflation and QQE
Mechanism of Constraint on ULC
Wages of Full-Time and Elasticity of Substitution between
Part-Time Employees Labor and Capital
elasticity
y/y % chg.
1.2
4
Scheduled cash earnings
(full-time employees)
1.0
3
Hourly scheduled cash earnings
All capital
(part-time employees)
0.8 IT investment
2
0.6
1
0.4
0
0.2
-1
-2 0.0
CY 09 10 11 12 13 14 15 16 17 18 All industries Manufacturing Nonmanufacturing
Notes: 1. In the left chart, Q1 = March-May, Q2 = June-August, Q3 = September-November, Q4 = December-February. Figures from 2013/Q1 are based on corrected figures adjusted
for establishments in Tokyo with 500 or more employees. Figures from 2016/Q1 are based on continuing observations following the sample revisions of the "Monthly Labour
Survey."
Notes: 2. In the right chart, the impacts of changes in the ratio of capital cost to real wages on the capital-labor ratio are estimated by the data classified by type of industries.
The estimation period is 1995-2017. Industry fixed effects are considered. The error bands indicate ±1 standard deviation.
4
Sources: Ministry of Health, Labour and Welfare; Ministry of Finance; Cabinet Office; Bloomberg; Bank of Japan.
Forward Guidance for Policy Rates
Forecasts for the Target Level of
BOJ's Forward Guidance
the Long-Term Interest Rate at End-2019
July 2018
number of respondents
40
"The Bank intends to maintain the current
extremely low levels of short- and long-term July 2018 survey
(before the introduction of forward guidance)
35
interest rates for an extended period of time, taking
October 2018 survey
into account uncertainties regarding economic
30
activity and prices including the effects of the May 2019 survey
consumption tax hike scheduled to take place in
October 2019." 25
20
15
April 2019
"The Bank intends to maintain the current extremely
10
low levels of short- and long-term interest rates for
an extended period of time, at least through around
5
spring 2020, taking into account uncertainties
regarding economic activity and prices including
0
developments in overseas economies and the effects
-0.1~ 0.0~ 0.1~ 0.2~ 0.3~ 0.5~ 0.75~
of the scheduled consumption tax hike."
0.0 0.1 0.2 0.3 0.5 0.75 1.0
%
Source: JCER, "ESP Forecast."
5
Chart 6
II. Lessons Learned from Japan's Experience and Challenges Ahead
Structure of the JGB Market
Amount of Holdings by Sector Transaction Volume by Sector
(Stock Basis) (Flow Basis)
tril. yen tril. yen
600
500
BOJ
BOJ
450
Banks
Insurance 500
Domestic banks and investors
400
Pensions
Overseas investors
Overseas
350
400
300
250 300
200
200
150
100
100
50
0 0
CY 11 12 13 14 15 16 17 18 19 CY 11 12 13 14 15 16 17 18
Notes: 1. JGBs exclude T-Bills.
Notes: 2. In the right chart, figures basically indicate the amount of JGBs sold by dealers, excluding inter-dealer transactions. Note that figures for "BOJ" indicate the total amount of JGBs
purchased by the BOJ, including those from entities other than dealers.
6
Sources: JSDA; Bank of Japan.
Functioning of the JGB Market
Developments in the
JGB Yield Elasticity to
JGB Transaction Volume
U.S. Long-Term Interest Rates
tril. yen
90
elasticity to a rise in U.S. long-term interest rates by 1bp, bps
Strengthening the Framework
0.20
for Continuous Powerful
Monetary Easing (July 2018)
Strengthening the Framework
for Continuous Powerful Monetary Easing
(July 2018)
80
0.15
Average from
70
CY 2016 through 2017
0.10
60
0.05
Transaction volume
50
0.00
in the JGB market
6-month backward
moving average
-0.05 40
Jan. Jul. Jan. Jul. Jan. Jul. CY 13 14 15 16 17 18 19
2018
2017 2019
Notes: 1. In the left chart, figures are slopes in a simple regression model (90-day backward rolling regression) in which the dependent variable is daily changes of 10-year JGB yields and
the explanatory variable is daily changes of 10-year U.S. Treasury yields (one-period lag). Shaded areas indicate ±1 standard error bands.
Note: 2. In the right chart, the transaction volume is the gross amount purchased by banks, investors, and bond dealers. JGBs exclude T-Bills.
7
Sources: Bloomberg; JSDA.