Mr Hayami discusses the Bank of Japan's thinking behind the current zero interest rate
policy
Speech by the Governor of the Bank of Japan, Mr Masaru Hayami, at the Japan National Press
Club in Tokyo on 22 June 1999.
I. Introduction
Four months have passed since February when the Bank of Japan launched its so-called zero
interest rate policy, and my speech today explains our thinking behind this historically
unprecedented policy.
At the outset, it should be pointed out that all decisions regarding the Bank's policies,
including the present zero interest rate policy, are made after deep and wide-ranging
discussions by the Policy Board. For example, as can be seen in the recent minutes of
Monetary Policy Meetings, when the Policy Board decided upon a zero interest rate policy, it
gave serious consideration to such policy alternatives as quantitative monetary easing and
inflation targeting. For details of these discussions, the minutes of Monetary Policy Meetings
are available.
II. Zero Interest Rate Policy
A. Elements of the Zero Interest Rate Policy
The so-called zero interest rate policy comprises three elements. First, to encourage the
unsecured overnight call rate to move as low as possible by providing ample funds. Second, to
pay due consideration to maintaining the proper functioning of the market so as to avoid
disturbance in the short-term money market. And third, to continue with the current policy
until deflationary concerns subside.
Of these three, the first element is a specific directive to guide the interest rate down to around
zero. Like the central bank in the US and elsewhere, daily monetary control in Japan is
conducted through guiding the shortest inter-bank rate, namely the unsecured overnight call
rate. Up to last February when the Bank decided on the zero interest rate policy, the target for
guiding the unsecured overnight call rate had already been as low as 0.25 percent, which had
left hardly any room for further reduction. Under such circumstances, a view was expressed at
the Monetary Policy Meeting on February 12 that for further monetary easing quantitative
targeting might be more effective. The majority view, however, was that the demand for
monetary base fluctuated widely depending on money market developments and that its
relationship with the real economy was not stable. After thorough discussion, it was decided
to make the maximum use of the remaining room for the further reduction of interest rates by
eliminating the de facto floor for the call rate. Interest rates and the quantity of money are two
sides of the same coin. A reduction of interest rates to zero accompanies simultaneous
quantitative easing on a massive scale, which expressed by the phrase "provide ample
liquidity."
The second policy element is to pay due consideration to maintaining the proper functioning
of the market. This means the careful and cautious guidance of interest rates while keeping a
close watch on the behavior of market participants and the functioning of the market after the
lower limit for the call rate has been removed. Since the call market is an important market
where all transactions in Japan are finally settled, the central bank should at all cost avoid any
disruption. In guiding interest rates down to zero the Bank was navigating uncharted waters
and hence in the process had to pay particular attention to the effects of the policy change.
Since the decision on February 12, the Bank gradually and cautiously encouraged the fall in
the call rate while carefully monitoring market developments. By April the unsecured
overnight call rate had declined to 0.03 percent and has remained stable since then. This call
rate of 0.03 percent can be regarded as the de facto zero interest rate taking into consideration
transaction fees.
A conspicuous change in the market structure during this period was the downsizing of the
call market from 35 trillion yen to 20 trillion yen, or a decline of approximately 40 percent.
The downsizing itself is a result of the large decline in the need for fund-raising in the call
market and, in a sense, is a natural reaction of the market mechanism to the ample provision
of funds. The question is whether such downsizing has made transactions in the market less
smooth. So far we have not observed any problems, but we will maintain a close watch on the
impact of our zero interest rate policy on the market function.
With respect to the third policy element that the Bank will continue with the current policy
until deflationary concerns subside, this is not in the February 12 decision, but is an
expression of the current stance of the Bank's monetary policy based on the majority opinion
of the Policy Board. Needless to say, the objective of monetary policy is to contribute to the
sound development of the national economy through the pursuit of price stability. In other
words, the Bank aims at achieving a situation which is neither deflationary nor inflationary.
Therefore, as long as deflationary concerns linger, the Bank should continue with its current
monetary easing to achieve price stability and economic recovery. In making clear its stance,
the Bank sought to explain to the market, as well as to the public, the objective of its monetary
policy in the context of current economic conditions so as to maintain the credibility of
monetary policy. Particularly in view of the instability in the financial market that we have
experienced from time to time since last year, we thought it necessary to restate the objective
of monetary policy to secure market stability. In fact, since I referred to this objective in April,
the downward trend has permeated from shorter to longer term interest rates.
B. Effects of the Zero Interest Rate Policy
Since April, the unsecured overnight call rate, the direct target of the Bank's monetary policy
operations, has remained stable at around 0.03 percent, or virtually at zero percent. Interest
rates on longer terms have also declined sharply in the short-term money market. As a result, a
sense of relief regarding fund availability has spread among financial institutions. Also,
concern overseas about the availability of funds to Japanese banks has receded significantly,
the effect of which has manifested itself in the almost complete disappearance of the Japan
premium since March. The permeation of monetary easing seems to have induced liquidity to
flow into longer term debt and equities, having a favorable effect on long-term interest rates
and stock prices.
Against this background, tightness in corporate funding has eased considerably. Last year, the
turmoil in international financial markets and the failure of several Japanese financial
institutions impaired the proper functioning of domestic financial markets, making it difficult
for even blue-chip companies to raise funds in the market. Financial institutions were obliged
to assume a strict attitude toward lending because of not only the constraint on their capital
position but also difficulties in their fund raising. All this has changed considerably since
early spring, and we can now safely say that the financial environment as a whole has
improved significantly.
It appears that the zero interest rate policy has begun to exert a beneficial influence on
strengthening the forces for economic recovery from the monetary side. What are the reasons
for this? Simply stated, the monetary easing in February was to reduce the targeted call rate
by some 0.25 percent, which was the same as the policy change on September 9 last year in
terms of the size of reduction in the call rate. Nevertheless, the effects seem to have perhaps
been much larger than generally expected.
One of the reasons for the larger than expected effects is that the zero interest rate policy
benefited from the synergy of such favorable factors as an improvement in the international
environment surrounding Japan. Last summer, the economic crisis in Russia and the collapse
of a major hedge fund in the US triggered considerable tension in international capital
markets. The increase in the Japan premium was caused not only by domestic factors but also
by such international factors. Fortunately, the tension in international financial markets began
to lessen from around the end of last year. On the domestic front, measures to restore Japan's
financial system, such as the injection of capital using public funds and the introduction of a
special credit guarantee system for small and medium-sized firms substantially contributed to
easing tightness in the financial market and corporate funding. In addition to the favorable
turn of events, a strong resolve expressed by the Bank to avoid deflation by implementing the
zero interest rate policy was a significant contributing factor.
The zero interest rate policy not only had such an effect but also helped to revive, to some
extent, the weakened financial intermediation function in Japan as observed last year.
To elucidate the point, let me first describe a 'liquidity effect' of the zero interest rate policy.
Whatever the level may be, a reduction in interest rates requires a corresponding increase in
liquidity. Reducing the interest rate down to zero means that the central bank will provide
enough liquidity so that all the demand for short-term funds will be met in the market. Under
such circumstances, the market will reach a stage where there is hardly any liquidity risk for
market participants. As was mentioned previously, concern about liquidity increased
substantially in Japan's financial markets last year. The zero interest rate policy played a
significant role in completely turning around the situation which could be labeled 'liquidity
evaporation.'
The zero interest rate policy also had the effect of encouraging risk taking by market
participants. Whether indirect financing like bank lending or direct financing, the essence of
financial intermediation lies in taking future risks. When financial institutions become
excessively cautious, as was the case last year, they will not take even normal risks and the
financial intermediation function to support economic activity weakens considerably. As a
consequence of the latest decline in interest rates, institutional investors have gradually
become more active in investing in securities with longer maturities or those carrying some
credit risk such as CP and corporate bonds. Of course, excesses must be avoided and we
intend to carefully monitor market developments. In contrast, as regards bank lending, we
cannot yet say that a recovery has been seen. Needless to say, we also intend to closely
monitor any changes in the attitude of banks toward lending and how such changes might
affect corporate funding and investment behavior.
III. Discussions on Zero Interest Rate Policy
A. Zero Interest Rate Policy and Quantitative Easing
We recognize there are opinions that it is not enough just to continue the current policy and
that the Bank of Japan should pursue quantitative easing or inflation targeting, or increase the
purchase of government bonds to prevent a rise in long-term interest rates.
Regarding quantitative easing, it should be noted that both a reduction in interest rates and
quantitative easing are expressions of monetary easing, only from a different point of view.
One cannot increase quantity while keeping interest rates constant, and conversely, one cannot
reduce interest rates while keeping quantity constant. Interest rates and the quantity of money
should be treated as inseparable.
The zero interest rate policy is to encourage the unsecured overnight call rate to move as low
as possible by providing ample funds. In this sense, the Bank has already effected sufficient
quantitative easing because interest rates have declined to virtually zero.
For example, at present the required reserves for financial institutions amount to some 4
trillion yen per day, but the Bank has been providing more liquidity than the required amount.
Recently, we offered to supply funds to the market through our daily operations, but there was
not enough demand. The Bank tried to provide additional liquidity, but the market responded
"enough." This evidences, in our view, the abundance of liquidity in the market.
Another example. For the past three years, money supply has increased by 60 trillion yen,
which is more than ten times the 5 trillion yen increase in nominal GDP. As a result, the ratio
of money supply to nominal GDP, Marshallian k, which shows how much money is
circulating compared with economic activity, has rapidly risen. The pace of rise matches or
exceeds that experienced in the high inflation period of excess liquidity in the 1970s and the
bubble period of the 1980s.
As such, current monetary policy has already had a significant easing effect from the
quantitative aspect. When quantitative easing is discussed, it sometimes specifically refers to
measures which set some numerical targets for quantitative indicators such as money supply.
Since interest rates and the quantity of money are two sides of the same coin, the argument
can be rephrased as the following technical question: "For monetary easing, is it better to
focus mainly on the quantity of money or interest rates as an operational target?"
For example, in an economy where inflationary expectations fluctuate significantly due to
such external shocks as an oil crisis, nominal and real interest rates diverge. Thus, focusing
only on interest rates runs the risk of making a mistake regarding the degree of monetary
easing and tightening. Under such circumstances, it is better to conduct monetary operations
guided by quantitative targets such as money supply.
Conversely, in an economy where demand for money greatly fluctuates, setting a quantitative
target becomes rather dangerous. Until the latter half of last year, the monetary base, which is
the sum of currency in circulation and reserve deposits, had exhibited a high growth rate of
about 10 percent on a year-on-year basis. This was because, against the background of anxiety
regarding financial system instability, the financial, household, and corporate sectors held a
huge amount of liquidity either in the form of cash or deposits with the Bank of Japan. If the
Bank had adopted quantitative targeting under such a situation, it would have meant a
tightening of monetary policy which would have been contrary to its policy stance.
There are many other issues to be examined such as the relationship between quantitative
indicators and the real economy, the Bank's controllability of such indicators, and the effect of
targeting on financial system stability. These issues have been taken up for active discussion
by the Policy Board. One Board member even made a specific proposal for quantitative
targeting. However, the majority opinion of the Policy Board to date is that it is more
appropriate to effect monetary easing by using interest rates as an operational target rather
than setting quantitative targets.
B. Zero Interest Rate Policy and Inflation Targeting
The Bank of Japan Law explicitly stipulates that monetary policy aims at price stability.
Hence from the viewpoint of pursuing price stability, there would be no conflict between our
current conduct of monetary policy and inflation targeting. The difference boils down to
whether or not to set a specific numerical target such as a 1 percent increase in CPI.
Since the central bank aims at price stability over the medium to long term, it needs to make a
manifold analysis of various factors affecting price developments, such as the risk of future
price changes, to come to a judgment. It is dangerous to stick to a specific figure for a specific
price indicator as a target. For example, even if a specific target were set, it does not
necessarily follow that a policy response would not be required until the actual price index
exceeded the target. Depending on the speed of price changes and tightness of supply and
demand conditions, there might be a situation where an appropriate policy response would be
called for before the price index reached the target.
The currently prevailing argument for inflation targeting includes dissipating the current
excessive deflationary expectations of the public by raising their inflationary expectations.
Can we really raise inflationary expectations just by announcing an inflation target? Even if
we can, there is the danger that long-term interest rates may rise to the point where they have
an adverse impact on the economy.
What is the significance of setting numerical targets, be it money supply or inflation, for
monetary policy? The answer is to prevent market participants from engaging in unnecessary
speculation by clearly showing the Bank's commitment to its policy objective.
If so, without entering the tricky area of setting specific and concrete targets, the Bank can
incorporate the usefulness embodied in inflation targeting by making explicit the key elements
of monetary policy conduct. It was this line of thinking that was behind the Bank's explicit
announcement that it would "continue with the current policy until deflationary concerns
subside."
C. Underwriting and the Outright Purchase of Government Bonds by the Bank
Behind the request that the Bank underwrites government bonds, there seems to be the
intention that the Bank, through underwriting, should ensure the smooth issuance of
government bonds, thereby containing a rise in long-term interest rates. If this is the case, then
the Bank holds firm against complying with such a request.
Once a central bank engages in the automatic financing of a fiscal deficit, sooner or later the
time will come when it cannot put a brake on money expansion, thereby inducing vicious
inflation. This is one valuable lesson that we have learned from history and constitutes the
main reason why the underwriting of long-term government bonds is prohibited not only in
Japan but also in other industrialized countries.
An increase in the outright purchase of long-term government bonds eventually leads to the
same situation as in underwriting. Over time, long-term interest rates are determined
reflecting the views of market participants on the future state of the economy and prices. If the
Bank were to prevent long-term interest rates from rising despite market pressures, it would
have no choice but to increase the purchase of government bonds. Then, inflationary
expectations would intensify, putting further pressures on long-term interest rates. Such a
vicious circle would repeat itself and the amount of government bonds that had to be
purchased would increase infinitely. This would eventually be the same as the underwriting of
government bonds.
If a limit on either the amount or the period is set for the underwriting or the outright purchase
of government bonds, can we obtain favorable results while avoiding the vicious circle?
The answer is "no" if we consider the mechanism of financial markets and the behavior of
market participants. Even if the amount or the period is limited, market participants will
always think about what is ahead when they act. It is natural for investors who want to
purchase ten-year government bonds to think about ten years ahead. Therefore, once market
participants anticipate a rise in long-term interest rates after the pre-determined underwriting
or outright purchase is completed, long-term interest rates will in fact rise immediately, not in
the distant future. Furthermore, if market participants perceive that a brake has been released
in seeing the central bank begin monetizing the fiscal deficit by even a limited amount, there
is a risk that the market would become concerned with vicious inflation and loss of fiscal
discipline. Given that globalization will continue and that investors worldwide are interested
in Japanese government bonds for portfolio management purposes, we should be very careful
about our policy operations, while keeping in mind such a market response.
The issue will come to be a matter of confidence in the yen and the Bank's conduct of
monetary policy, and eventually confidence in the Japanese economy itself. Confidence would
most likely be eroded if the Bank succumbed to the request for the underwriting or increase in
the outright purchase of government bonds, with or without a limit on the amount or the
period.
Let me turn to the difference between the outright purchase of long-term government bonds
currently conducted by the Bank and the recent request to underwrite or increase the outright
purchase of government bonds. Our current long-term government bond purchase operations
are a way to smoothly provide the long-term funds necessary for sustainable growth of the
economy. They are neither aimed at the smooth issuance of government bonds nor for
supporting their prices. The Bank makes it a rule to purchase long-term government bonds in
the amount roughly consistent with the trend growth rate of banknote issuance over the
medium term. By adopting such a rule, the Bank tries not to directly affect long-term interest
rates. The Bank will continue to hold firm to the posture that it will not purchase long-term
government bonds for smooth issuance or price maintenance purposes.
Relating to this discussion, there are suggestions that the Bank should effect quantitative
easing through the purchase of government bonds. In response to these suggestions, monetary
easing has already permeated the market and the Bank has sufficient operational tools to effect
monetary easing. The Bank does not have to resort to an increase in the purchase of
government bonds in the conduct of its current monetary policy.
Since the Bank is providing ample liquidity to the market, related anxiety has almost
disappeared in financial markets. However, many investors and financial institutions seem to
be experiencing a hard time finding good borrowers and profitable investments. For the whole
economy the savings and investment balance is tilted toward huge net savings.
Under such circumstances, if the yield on government bonds records a large increase over a
sustained period, it will most likely signal either that views on the economy are turning
favorable or that the market is warning against an increase in the budget deficit. In the case of
the former, it indicates economic recovery and we welcome this development while staying
alert to whether there is any overreaction in the market. In the case of the latter, we should use
it as an opportunity to review the costs and benefits regarding the widening of the budget
deficit in the context of future economic developments.
D. Reforming the Government Bond Market
Even if the Bank does not underwrite or increase the purchase of government bonds, it does
not mean that the government bond market is not important. In fact, the government bond
market has become increasingly important. The Bank has long been working actively on the
issue of reforming the Japanese government bond market, and it will continue to make the
utmost efforts toward that end.
For the Bank, the government bond market is an important market in which its operations,
such as repos and short-term government bond operations, are conducted. In addition, the
Bank conducts various businesses from the issuance to the redemption of government bonds
on behalf of the government, not to mention running the government bond settlement system.
From such a standpoint, we have taken a great interest and devoted much effort in improving
the functions of the government bond market. In preparation for the introduction of real time
gross settlement by the end of 2000, the Bank has been working hard on upgrading computer
systems, and, at the same time, formulating new market practices together with market
participants.
In general, financial assets with low liquidity which are traded by a small number of investors
in the market tend to show excess price volatility. Therefore, making the government bond
market more liquid and convenient for many diversified investors is essential to improve
functions of both the primary and secondary markets. The importance of reforming the
government bond market does not stop here. A highly liquid government bond market in
which the market mechanism functions efficiently forms a basis for developing other financial
markets. In this regard, we should not underwrite government bonds and contain their prices
against market pressures. Rather, we think it important, through improving the functioning of
the government bond market, to strengthen financial markets which are the basic
infrastructure of our national economy.
We expect that the issues regarding fiscal management and the government bond market will
continue to be discussed in various fora, including the Diet. The Bank stands ready to make a
contribution by, for example, stating its views.
IV. Current Situation and Prospects for the Japanese Economy
A. Current Situation
While the Japanese economy has stopped deteriorating, there are not yet clear signs of a
recovery. There are four reasons behind the halt in deterioration and which can be
summarized as follows:
First, an increase in policy-driven demand such as public investment and housing investment
has been observed.
Second, under the continued expansion of the US economy, the economic environment
overseas has been improving as a whole as illustrated by the gradual recovery of Asian
economies and the rebound of international commodity prices.
Third, as a result of such developments in final demand together with the cautious attitude of
firms toward production, inventory adjustment has progressed. Judging from current
inventories, it appears that conditions are being laid for production to increase once final
demand picks up.
Fourth, against the background of our zero interest rate policy and the injection of capital into
major banks using public funds, the financial environment has turned favorable.
B. Prospects
Though the Japanese economy has stopped deteriorating, we cannot yet foresee an
autonomous recovery. There are three reasons for this.
The first is that the present halt in the deterioration of the economy is basically supported by
policy-driven demand like public investment, and private demand, which is the engine for an
autonomous recovery, still remains weak. Considering that future demand prospects are
uncertain and that balance sheet adjustment is needed to improve soundness and efficiency,
particularly among large firms, business fixed investment will very likely further decline in
fiscal 1999. In view of the increasing severity of the employment and income environment
reflecting aggressive corporate restructuring, it seems difficult to expect any rapid recovery of
private consumption from the current situation.
The second reason is that we still need time to carefully monitor how an improvement in the
financial environment affects the real economy. It is true that the attitude of financial
institutions toward lending has become less strict compared with a while ago, but their
balance sheet adjustments and strengthening of risk management systems have not yet reached
a stage where they will actively seek loans that carry larger credit risk. Stock prices have been
partly supported by such outside factors as rising US stock prices. To ensure the continued
improvement of the financial environment and subsequently of the real economy which leads
to a virtuous circle between finance and the economy, it is necessary for firms to restructure
themselves in a forward-looking manner and to consolidate their business in such a way that
will gain the confidence of the market.
The third reason, which relates to the weakness of private demand pointed out earlier, is the
persisting pressure of structural adjustment. Needless to say, changes in industrial structure
are inevitable for the Japanese economy to become more efficient. Among these changes,
employment is one of the most serious problems during the transitional period. In this regard,
we welcome the government's initiative to create an employment policy framework which is
consistent with the direction of structural reform. Nevertheless, it should be noted that, at least
for a short period, there is a possibility of increased downward pressure on the economy from
the employment side.
Bearing these reasons in mind, the present situation does not warrant an autonomous recovery
of the economy led by private demand in the latter half of this fiscal year when public
investment is expected to taper off. Thus, potential downward pressure on prices appears to
remain, and it is our judgment that the economy has not yet reached the stage where
deflationary concerns have been dispelled.
V. Conclusion
At the present moment, with prolonged worries regarding financial system stability at last
subsiding, the Japanese economy stands at an important crossroads. If it can overcome such
problems as the changes in industrial structure and unemployment, then an autonomous
recovery can be realized. In this regard, we are well aware that monetary policy plays an
important role. Based on such recognition, the Bank has committed itself to maintaining its
monetary easing policy until deflationary worries subside.
Needless to say, monetary policy alone cannot solve all problems. We should thoroughly
recognize that the current zero interest rate policy is an unusual and emergency measure for a
central bank and also that we should not indefinitely pursue an expansionary fiscal policy
centering on public investment. To truly revitalize the Japanese economy we must forcefully
promote structural reform to strengthen the supply side, while sustaining the economy through
an aggregate demand policy.
There are various aspects to structural reform, the main purpose of which is to garner the
intrinsic potential power of the economy and to raise the medium-term expected growth rate.
To these ends, competitive dynamism should be fully utilized. It is thus necessary to create a
competitive market environment which encourages firms to boldly pursue technological
innovation and explore new business areas. In addition, to take advantage of new investment
opportunities, it is essential to have efficient and well-functioning financial markets which
enable savings to be smoothly channeled to investment through various financial instruments.
If the changes in industrial structure and reform of the financial system progress and public
expectations for growth become more optimistic, our monetary easing policy to date will
become even more effective.