Ben S Bernanke: Some thoughts on monetary policy in Japan
Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, before the Japan Society of Monetary Economics, Tokyo, 31 May 2003.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
I am delighted to address this meeting of the Japan Society of Monetary Economics. I would
particularly like to thank Professor Shimizu both for inviting me and for helping to arrange a series of
meetings with officials at the Bank of Japan, the Ministry of Finance, and the Financial Services
Agency. Those meetings have given me a first-hand look at the difficult challenges that the current
economic situation poses for Japan's leaders and for the Japanese people.
The economic situation here is indeed enormously complex. It involves not only structural, monetary,
and fiscal problems but also underlying political and social forces, which have at times limited the
flexibility of policy. The sometimes frustratingly slow pace of change in Japan is all the more reason,
however, for this nation's economists to speak out and present clear, persuasive arguments that will
help guide the policy debate and urge leaders to effective action. At stake is not only the economic
health of your country but also, to a significant degree, the prosperity of the rest of the world. From my
side of the ocean, it seems that many people are looking to the United States to take the responsibility
for leading the world into economic recovery. Clearly, however, faster growth in Japan and other major
industrial countries would support a stronger, more balanced, and more durable recovery than one
driven by U.S. growth alone.
Although changes in macroeconomic policy in Japan during the past decade have generally been slow
and deliberate, there has also been some willingness to experiment, not least by the Bank of Japan
(BOJ). For this reason, the recent appointment of a new leadership team at the BOJ has stimulated
considerable interest and expectation around the world. Although Governor Fukui and his colleagues
have so far not made radical breaks with previous BOJ policies, there is reason to hope that they will
be open to fresh ideas and approaches.
In that spirit, my remarks today will be focused on opportunities for monetary policy innovation in
Japan, including specifically the possibility of more-active monetary-fiscal cooperation to end deflation.
In focusing primarily on macroeconomic policies and the deflation problem, however, I do not wish to
imply that more microeconomic measures - such as bank restructuring and recapitalization,
development of more liquid capital markets, revitalization of the distressed corporate sector, and
broader structural reform - are not essential and urgent. Indeed, all these elements are crucial if
Japan's economy is to return to a more satisfactory rate of growth. However, I do think that ending
deflation and carrying out banking, financial, corporate, and structural reforms can and should be
pursued on parallel tracks, with progress being made wherever possible. Indeed, a definitive end to
the deflation in consumer prices - by restoring confidence and stimulating spending - would do much
to help moderate the unemployment and financial distress that might otherwise arise as the results of
aggressive programs of reform and restructuring.
I preface the body of my remarks with two important caveats. First, the opinions I give today are strictly
my own and should not be attributed to my colleagues on the Board of Governors of the Federal
Reserve or on the Federal Open Market Committee; nor do they reflect any official position of the
United States government. Second, the remarks that follow were prepared before my visit to Japan
and therefore do not reflect the discussions that I held this week with Japanese officials. Obviously,
then, no inference should be made about those meetings from the comments to follow.1
Today I would like to consider three related issues that bear on contemporary monetary policy in
Japan. First, I will discuss the option of asking the Bank of Japan to announce a quantitative objective
for prices, as well as how such an objective might best be structured. Rather than proposing the more
familiar inflation target, I will suggest that the BOJ consider adopting a price-level target, which would
imply a period of reflation to offset the effects on prices of the recent period of deflation. Second, I
would like to consider an important institutional issue, which is the relationship between the condition
of the Bank of Japan's balance sheet and its ability to undertake more aggressive monetary policies.
Although, in principle, balance-sheet considerations should not seriously constrain central bank
policies, in practice they do. However, as I will discuss, relatively simple measures that would
eliminate this constraint are available. Finally, and most important, I will consider one possible strategy
for ending the deflation in Japan: explicit, though temporary, cooperation between the monetary and
the fiscal authorities.
What objective for Japanese monetary policy?
Before setting off on a trip, one should know one's destination. In that spirit, a discussion of Japanese
monetary policy should begin with some discussion of the policy objective. I leave until later how the
objective can be achieved.
The Bank of Japan Law, passed in 1998, sets price stability as a primary objective for the central
bank. As with our own Federal Reserve Act, price stability is not, however, precisely defined in the
Law. Currently, the BOJ has promised that the zero-interest-rate policy will be maintained until
deflation is brought to an end, a policy that might be deemed consistent with the price stability
objective.
Two objections to this conclusion might be raised, however. First, the BOJ's statement seems to imply
that the current level of policy stimulus might start to be withdrawn as soon as measured inflation
returns to zero; in particular, no explicit commitment has been made to maintain inflation at zero, much
less at some positive rate, in the longer run. But the presence of measurement bias in Japanese price
indexes suggest that a measured inflation rate of at least one percent is likely required in order to
achieve true price stability in the long run. Moreover, inflation above zero will be needed if real interest
rates in Japan are to be negative for a period, as many observers think is necessary for full recovery.
In short, it would be helpful if the zero-interest-rate policy were more explicit about what happens after
the deflationary period ends.
Second, over the past five years, since the onset of the current deflationary episode - and, incidentally,
since the passage of the new Bank of Japan Law - the price level has trended down, registering a
cumulative decline (depending on the price index) of between 4 and 9 percent. For example, over this
period the GDP deflator has dropped nearly 9 percent, the private consumption deflator has fallen
51/2 percent, and wages and salaries are down 4-1/2 percent. One might argue that the legal objective
of price stability should require not only a commitment to stabilize prices in the future but also a policy
of actively reflating the economy, in order to restore the price level that prevailed prior to the prolonged
period of deflation.
As you may know, I have advocated explicit inflation targets, or at least a quantitative definition of
price stability, for other leading central banks, including the Federal Reserve. A quantitative inflation
target or range has been shown in many countries to be a valuable tool for communication. By
clarifying the objectives of the central bank, an explicit inflation target can help to focus and anchor
inflation expectations, reduce uncertainty in financial markets, and add structure to the policy
framework. For Japan, given the recent history of costly deflation, however, an inflation target may not
go far enough. A better strategy for Japanese monetary policy might be a publicly announced,
gradually rising price-level target.
What I have in mind is that the Bank of Japan would announce its intention to restore the price level
(as measured by some standard index of prices, such as the consumer price index excluding fresh
food) to the value it would have reached if, instead of the deflation of the past five years, a moderate
inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement
bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of
future episodes of sustained deflation.) Note that the proposed price-level target is a moving target,
equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and
rising 1 percent per year thereafter.2 Because deflation implies falling prices while the target price-level
rises, the failure to end deflation in a given year has the effect of increasing what I have called the
price-level gap (Bernanke, 2000). The price-level gap is the difference between the actual price level
and the price level that would have obtained if deflation had been avoided and the price stability
objective achieved in the first place.
A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the
first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap
was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy.
Second, once the price-level target was reached, or nearly so, the objective for policy would become a
conventional inflation target or a price-level target that increases over time at the average desired rate
of inflation.3
Although restoration of the pre-deflation price level by means of a price-level target might be a
reasonable interpretation of the BOJ's price stability objective, I would not want to push the purely
legal argument too far. For example, based on a mandate for price stability, I would not ask either the
BOJ or the Federal Reserve to restore the price level prevailing in their respective nations in 1950!
Rather, I think the BOJ should consider a policy of reflation before re-stabilizing at a low inflation rate
primarily because of the economic benefits of such a policy. One benefit of reflation would be to ease
some of the intense pressure on debtors and on the financial system more generally. Since the early
1990s, borrowers in Japan have repeatedly found themselves squeezed by disinflation or deflation,
which has required them to pay their debts in yen of greater value than they had expected. Borrower
distress has affected the functioning of the whole economy, for example by weakening the banking
system and depressing investment spending. Of course, declining asset values and the structural
problems of Japanese firms have contributed greatly to debtors' problems as well, but reflation would,
nevertheless, provide some relief. A period of reflation would also likely provide a boost to profits and
help to break the deflationary psychology among the public, which would be positive factors for asset
prices as well. Reflation - that is, a period of inflation above the long-run preferred rate in order to
restore the earlier price level - proved highly beneficial following the deflations of the 1930s in both
Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the
Great Depression through reflationary policies in the early 1930s, while President Franklin D.
Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and
subsequent years. In both cases, the turnaround was amazingly rapid. In the United States, for
example, prices fell at a 10.3 percent rate in 1932 but rose 0.8 percent in 1933 and more briskly
thereafter. Moreover, during the year that followed Roosevelt's inauguration in March 1933, the U.S.
stock market rallied by 77 percent.
Eggertsson and Woodford (2003) have advanced a second argument for a price-level target for Japan
in an important recent paper on monetary policy at the zero bound. These authors point out (as have
many others) that, when nominal interest rates are at or near zero, the central bank can lower the real
rate of interest only by creating expectations of inflation on the part of the public. Eggertsson and
Woodford argue that a publicly announced price-level target of the type just described is more
conducive to raising near-term inflation expectations than is an inflation target.4
One way to understand their argument is to imagine that the public expects the leaders of the central
bank to take more aggressive actions, the further they are from their announced objective. Now
suppose that, in an economy experiencing a stable deflation, the central bank leadership announces a
fixed inflation target but then makes no progress toward that target during a given period. Then in the
next period, the central bank is in the same position as previously, in terms of its distance from its
objective; hence, by hypothesis, the central bank has no incentive to increase its effort to meet the
announced target, and the public has no reason to expect it to do so. In this respect the inflation target
is too "forgiving" an objective; failure is not penalized, nor is greater effort demanded. In contrast,
under a price-level-targeting scheme, continuing deflation combined with an upward-sloping path for
the price-level target causes the size of the price-level gap to increase over time.
Thus, failure by the central bank to meet its target in a given period leads to expectations of (and
public demands for) increased effort in subsequent periods - greater quantities of assets purchased on
the open market, for example. So even if the central bank is reluctant to provide a time frame for
meeting its objective, the structure of the price-level objective provides a means for the bank to commit
to increasing its anti-deflationary efforts when its earlier efforts prove unsuccessful. As Eggertsson and
Woodford show, the expectation that an increasing price level gap will give rise to intensified effort by
the central bank should lead the public to believe that ultimately inflation will replace deflation, a belief
that supports the central bank's own objectives by lowering the current real rate of interest.
A concern that one might have about price-level targeting, as opposed to more conventional inflation
targeting, is that it requires a short-term inflation rate that is higher than the long-term inflation
objective. Is there not some danger of inflation overshooting, so that a deflation problem is replaced
with an inflation problem? No doubt this concern has some basis, and ultimately one has to make a
judgment. However, on the other side of the scale, I would put the following points: first, the benefits to
the real economy of a more rapid restoration of the pre-deflation price level and second, the fact that
the publicly announced price-level targets would help the Bank of Japan manage public expectations
and to draw the distinction between a one-time price-level correction and the BOJ's longer-run inflation
objective. If this distinction can be made, the effect of the reflation program on inflation expectations
and long-term nominal interest rates should be smaller than if all reflation is interpreted as a
permanent increase in inflation.
A barrier to more aggressive policies: the BOJ's balance sheet
Discussing the optimal objectives for Japanese monetary policy is all very well, but what of the
argument, advanced by some officials, that the Bank of Japan lacks the tools to achieve these
objectives? Without denying the many difficulties inherent in making monetary policy in the current
environment in Japan, I believe that not all the possible methods for easing monetary policy in Japan
have been fully exploited. One possible approach to ending deflation in Japan would be greater
cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank
of Japan should consider increasing still further its purchases of government debt, preferably in explicit
conjunction with a program of tax cuts or other fiscal stimulus.
Before going into more detail about this possibility, however, I want to discuss a specific institutional
factor that currently constrains - somewhat artificially, I would argue - the ability of the Bank of Japan
to pursue more aggressive policies, including both so-called non-conventional and more-orthodox
policies. This institutional constraint, often cited by BOJ officials, is the condition of the BOJ's balance
sheet, and the fear, in particular, that a successful program of reflation might inflict capital losses on
the BOJ and thereby weaken its institutional position.
Like other central banks, the Bank of Japan has a balance sheet, with assets, liabilities, and capital.
Also like other central banks, the BOJ purchases interest-bearing assets with money that it creates
and thus typically earns significant profits, or seignorage. Some of these profits are used to cover the
expenses of the BOJ itself, subject to review by the Ministry of Finance (MOF). The BOJ also has
reserves for possible losses on securities and foreign exchange transactions and is permitted by the
Article 53 of the Bank of Japan Law to retain 5 percent of the surplus from the settlement of profits and
losses as a reserve fund. The portion of the surplus not retained by the Bank is paid to the national
treasury.
From the point of view of conventional private-sector accounting - which, as I will discuss, is not
necessarily the correct standard in this case - the BOJ's balance sheet has become noticeably riskier
in recent years. For example, the BOJ's most recent financial statement showed that of the 68 percent
of its assets held in the form of government securities, about two-thirds are long-term Japanese
government bonds (JGBs). This represents a very substantial increase over customary levels in the
BOJ's holdings of long-term government debt. Because yields on government bonds are currently so
low, these holdings expose the BOJ's balance sheet to considerable interest-rate risk (although any
losses would be partly offset by unrealized capital gains on earlier acquisitions of bonds). Indeed,
ironically, if the Bank of Japan were to succeed in replacing deflation with a low but positive rate of
inflation, its reward would likely be substantial capital losses in the value of its government bond
holdings arising from the resulting increase in long-term nominal interest rates.
With such concerns in mind, BOJ officials have said that a strengthening of the Bank's capital base is
needed to allow it to pursue more aggressive monetary policy easing. In fact, the BOJ recently
requested that it be allowed to retain 15 percent (rather than 5 percent) of the surplus for the 2002
fiscal year that just ended to increase its capital, and the Ministry of Finance has indicated that it will
approve the request. Even with this additional cushion, however, concerns on the part of the BOJ
about its balance sheet are likely to remain.
The public debate over the BOJ's capital should not distract us from the underlying economics of the
situation. In particular, the private shareholders notwithstanding, the Bank of Japan is not a private
commercial bank. It cannot go bankrupt in the sense that a private firm can, and the usual reasons
that a commercial bank holds capital - to reduce incentives for excessive risk-taking, for example - do
not directly apply to the BOJ.5 Indeed, putting aside psychological and symbolic reasons, important as
these may be in some circumstances, there appear to be only two conceivable effects of the BOJ's
balance sheet position on its ability to conduct normal operations. First, if the BOJ's income were too
low to support its current expenditure budget, the Bank might be forced to ask the MOF for
supplemental funds, which the BOJ might fear would put its independence at risk. This consideration
by itself should not necessarily make the BOJ less willing to undertake more aggressive monetary
policies, however, because purchasing additional assets with non-zero yields, even if these assets are
risky or illiquid, normally increases the Bank's current income. Second, an imaginable, though quite
unlikely, possibility is that the Bank could suffer sufficient capital losses on its assets to make it unable
to conduct open-market sales of securities on a scale large enough to meet its monetary policy
objectives.
In short, one could make an economic case that the balance sheet of the central bank should be of
marginal relevance at best to the determination of monetary policy. Rather than engage in what would
probably be a heated and unproductive debate over the issue, however, I would propose instead that
the Japanese government just fix the problem, thereby eliminating this concern from the BOJ's list of
worries. There are many essentially costless ways to fix it. I am intrigued by a simple proposal that I
understand has been suggested by the Japanese Business Federation, the Nippon Keidanren. Under
this proposal the Ministry of Finance would convert the fixed interest rates of the Japanese
government bonds held by the Bank of Japan into floating interest rates. This "bond conversion" -
actually, a fixed-floating interest rate swap - would protect the capital position of the Bank of Japan
from increases in long-term interest rates and remove much of the balance sheet risk associated with
open-market operations in government securities. Moreover, the budgetary implications of this
proposal would be essentially zero, since any increase in interest payments to the BOJ by the MOF
arising from the bond conversion would be offset by an almost equal increase in the BOJ's payouts to
the national treasury.6 The budgetary neutrality of the proposal is of course a consequence of the fact
that, as a matter of arithmetic, any capital gains or losses in the value of government securities held by
the BOJ are precisely offset by opposite changes in the net worth of the issuer of those securities, the
government treasury.
Although the MOF could insulate, without budgetary cost, the BOJ's balance sheet from interest-rate
risk on its holdings of government bonds, a similar program offered by the MOF to private-sector
holders of bonds, such as commercial banks, would not be costless from the MOF's point of view, if
inflation and interest rates were subsequently to rise.7 However, if the MOF entered into the proposed
swap agreement with the BOJ, new purchases of government bonds from the private sector by the
Bank of Japan would be costless to the national treasury. Thus, conditional on the swap arrangement
being in force, open-market purchases of government bonds by the BOJ would combine an
expansionary monetary policy with a reduction of interest-rate risk in the banking system at no
budgetary cost.8 The simple step of immunizing the BOJ's balance sheet thus opens a number of
interesting policy options.
5
There does not appear to be any provision in the Bank of Japan Law that addresses whether the Bank can or cannot have
negative net worth, or what would happen if it were to report negative net worth.
6
An alternative approach would be for the MOF to offer the fixed-floating swap to the BOJ only for its holdings of government
bonds above some specified level. An advantage of this approach is that it would provide more current income to meet BOJ
expenditure needs.
7
However, these losses would be offset to some degree if nominal GDP were to grow with inflation, raising tax revenues. As
an historical note, the U.S. Treasury initiated a bond conversion program at the time of the Treasury-Federal Reserve
Accord in 1951, which allowed some private holders of long-term bonds as well as the Federal Reserve to avoid capital
losses implied by the un-pegging of long-term nominal rates at that time. Because some private bondholders were assisted
as well as the central bank, the budgetary cost to the government was not zero; most of the costs of protecting private
long-term bondholders were absorbed by the Treasury. See, for example, Eichengreen and Garber (1991) for a discussion.
8
I assume here that the BOJ does not sterilize the effects of its purchases of bonds, that is, it allows current account
balances to rise by the amount of its purchases.
BIS Review 25/2003
The bond conversion (or interest-rate swap) just described is all that would be needed to protect the
BOJ's balance sheet against any side effects from operations in government bonds. Incidentally, the
approach could be extended to insulate the BOJ's balance sheet against potentially adverse effects of
other types of asset purchases that the government might want to encourage. For example, to
facilitate expanded purchases of asset-backed commercial paper, the government might agree, on
request of the BOJ, to exchange government debt of the same maturity for the commercial paper. The
net effect would be that the fiscal authority would assume the credit risk flowing from the nonstandard
monetary policy action, as seems appropriate.
What should the Bank of Japan give up in exchange for the Ministry of Finance's removing a
significant amount of risk from the BOJ's balance sheet? One option would be for the Bank to use its
increased ability to bear risk to undertake new policy actions that would entail accepting other types of
risk onto its balance sheet. Today I will argue for a different approach and suggest that the Bank of
Japan cooperate temporarily with the government to create an environment of combined monetary
and fiscal ease to end deflation and help restart economic growth in Japan. To do this, the BOJ might
have to scrap rules that it has set for itself - for example, its informal rule that the quantity of long-term
government bonds on its balance sheet must be kept below the outstanding balance of banknotes
issued.
Monetary and fiscal cooperation
There is no unique solution to the problem of continuing declines in Japanese prices; a variety of
policies are worth trying, alone or in combination. However, one fairly direct and practical approach is
explicit (though temporary) cooperation between the monetary and the fiscal authorities. Let me try to
explain why I think this direction is promising and may succeed where monetary and fiscal policies
applied separately have not.
Demand on the part of both consumers and potential purchasers of new capital equipment in Japan
remains quite depressed, and resources are not being fully utilized. Normally, the central bank would
respond to such a situation by lowering the short-term nominal interest rate, but that rate is now
effectively zero. Other strategies for the central bank acting alone exist, including buying alternative
assets to try to lower term or liquidity premiums and attempting to influence expectations of future
inflation through announcements or commitments to expand the monetary base. The Bank of Japan
has taken some steps in these directions but has generally been reluctant to go as far as it might, in
part because of the difficulty in determining the quantitative impact of such actions and in part because
of the Bank's view that problems in the banking system have "jammed" the usual channels of
monetary policy transmission. Ironically, this obvious reluctance on the part of the BOJ to sail into
uncharted waters may have had the effect of muting the psychological impact of the nonstandard
actions it has taken. Likewise the Bank of Japan has resisted calls to manage the value of the yen
(see, for example, McCallum, 2000, or Svensson, 2001), citing its lack of authority to do so as well as
the prospect of retaliation from trading partners.
The alternative approach to stimulating aggregate demand is fiscal policy - government spending
increases or tax cuts. Here again the perception is that policy has been less than successful, although
Posen (1998) - in a criticism reminiscent of those who have complained that the Bank of Japan should
just "do more" - has argued that the problem is less that fiscal policy is ineffective than that it has not
been used to the extent that one might gather from official plans and announcements. In Posen's view,
Japan's debt problem is primarily the result of slow economic growth rather than active fiscal policies.
However, besides possibly inconsistent application of fiscal stimulus, another reason for weak fiscal
effects in Japan may be the well-publicized size of the government debt. The severity of the
government debt problem may be overstated in some respects - 95 percent of the outstanding debt is
domestically held, for example, and 59 percent is held by public institutions, so that the Japanese
people truly "owe the debt to themselves" - but that the government's annual deficit is now about
8 percent of GDP is nevertheless a serious concern. Moreover, an aging Japanese population will add
to the government's budgetary burden in coming decades.
In addition to making policymakers more reluctant to use expansionary fiscal policies in the first place,
Japan's large national debt may dilute the effect of fiscal policies in those instances when they are
used. For example, people may be more inclined to save rather than spend tax cuts when they know
that the cuts increase future government interest costs and thus raise future tax payments for
themselves or their children. (It is striking that, despite low interest rates, about 20 percent of the
Japanese central government budget, or about 16.8 trillion yen this year, is devoted to servicing the
national debt.) In economics textbooks, the idea that people will save rather than spend tax cuts
because of the implied increase in future tax obligations is known as the principle of Ricardian
equivalence. In general, the evidence for Ricardian equivalence in real economies is mixed, but it
seems most likely to apply in a situation like that prevailing today in Japan, in which people have been
made highly aware of the potential burden of the national debt. The principle of Ricardian equivalence
does not apply exactly to increases in government purchases (for example, road building) but it may
apply there approximately. If, for example, people think that government spending projects are
generally wasteful and add little to national wealth or productivity, then taxpayers may view increased
government spending as simply increasing the burden of the government debt that they must bear. If,
as a result, they react to increases in government spending by reducing their own expenditure, the net
stimulative effect of fiscal actions will be reduced. In short, to strengthen the effects of fiscal policy, it
would be helpful to break the link between expansionary fiscal actions today and increases in the
taxes that people expect to pay tomorrow.
My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help
solve the problems that each policymaker faces on its own. Consider for example a tax cut for
households and businesses that is explicitly coupled with incremental BOJ purchases of government
debt - so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of
Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that
much or all of the increase in the money stock is viewed as permanent.9
Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the
government's concerns about its outstanding stock of debt are mitigated because increases in its debt
are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses
should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but
- because the BOJ purchased government debt in the amount of the tax cut - no current or future debt
service burden has been created to imply increased future taxes. Essentially, monetary and fiscal
policies together have increased the nominal wealth of the household sector, which will increase
nominal spending and hence prices. The health of the banking sector is irrelevant to this means of
transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about
"broken" channels of monetary transmission. This approach also responds to the reservation of BOJ
o