Masaaki Shirakawa: The Bank of Japan's efforts toward overcoming
deflation
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Japan National Press Club, Tokyo,
17 February 2012.
* * *
Introduction
It is a great honor for me to have the opportunity to speak to you today at the prestigious
Japan National Press Club. This is my third time speaking here, having initially done so in
May 2008 - my first public speech after becoming Governor of the Bank of Japan - and then
again in May 2010, around the time when the European debt problem triggered by the crisis
in Greece started to overshadow the global financial markets. Given that today happens to
be just a few days after the Bank implemented measures to further enhance monetary
easing, this is my first opportunity to provide a thorough explanation of this latest policy
decision. The previous two speaking events before the Club were valuable opportunities for
me, because they resulted in my being presented with many thought-provoking opinions and
questions and provided the chance to put my own thoughts in order. With that in mind, I
really look forward to exchanging views with you after delivering my speech.
As I have just mentioned, the Bank decided the following three measures this week, at the
Monetary Policy Meeting on the 14th, with a view toward clarifying its monetary policy stance
and to further enhance monetary easing in order to overcome deflation and achieve
sustainable growth with price stability (Chart 1). First, the Bank introduced a numerical
expression of price stability in the form of "the price stability goal in the medium to long term."
Second, as for its conduct of monetary policy for the time being, the Bank stated that it will
"continue pursuing powerful monetary easing with the aim of achieving the goal of 1 percent
in terms of the year-on-year rate of increase in the consumer price index (CPI) until it judges
that the 1 percent goal is in sight." And third, the Bank increased the total size of the Asset
Purchase Program introduced in the fall of 2010, from about 55 trillion yen to about 65 trillion
yen, by adding another 10 trillion yen earmarked for the purchase of Japanese government
bonds (JGBs).
Today, I will first explain the aim of and thinking behind these decisions. In the second half of
my speech, I will focus on the challenge of overcoming deflation, which is the goal of the
aforementioned measures, and discuss the causes of deflation as well as our thinking on
necessary policy actions. After short-term interest rates in major economies including Japan
declined to virtually zero, the scope of the operational tools of monetary policy has expanded
from a traditional way of "raising and cutting interest rates" to the area of unconventional
policy tools such as the purchase of various financial assets. Therefore, please forgive me if
some parts of my speech inevitably become somewhat technical.
I. "The Price Stability Goal in the Medium to Long Term"
Numerical Expression of Price Stability
I will begin with "the price stability goal in the medium to long term." This is the inflation rate
that the Bank judges to be consistent with price stability sustainable in the medium to long
term. The Bank judges it to be "in a positive range of 2 percent or lower in terms of the
year-on-year rate of change in the CPI" and, more specifically, has set "a goal at 1 percent
for the time being."
The Bank conducts monetary policy based on the Principle of Currency and Monetary
Control as clearly stipulated in the Bank of Japan Act; namely, that the policy shall be aimed
at "achieving price stability, thereby contributing to the sound development of the national
economy." In doing so, the price stability must be of the sort that is sustainable in the
medium to long term. Then, what kind of state does this "price stability" refer to?
Conceptually, we can express it as "a state where economic agents such as households and
firms may make decisions regarding economic activities without being concerned about the
fluctuations in the general price level." In the conduct of monetary policy, price stability needs
to be expressed in numerical terms. Individual central banks express price stability in
numerical terms within the context of each country's situation and name the expression
differently. Examples of such numerical expressions include the Bank of England's "target,"
"definition of price stability" adopted by the European Central Bank and the Swiss National
Bank, and the U.S. Federal Reserve's previously adopted "longer-run projection," as well as
the "longer-run goal" it introduced recently.
"Understanding," "Goal," and "Target"
Six years ago, in March 2006, the Bank introduced its own framework under which it
expressed price stability in numerical terms, named "an understanding of medium- to
long-term price stability." After undergoing a series of changes in expression, the Bank's
recent "understanding" was "a positive range of 2 percent or lower, centering around
1 percent" on the basis of a year-on-year rate of change in the CPI.
The word "understanding" was chosen for a definite reason. Back then, the Bank was
approaching the exit from its quantitative easing policy, which had lasted for the five years
since 2001, and the Policy Board members had a wide range of views with regard to price
stability in the coming new phase. At the same time, all the members recognized the need to
publish, as the Policy Board, the basic idea of price stability in numerical terms. As a result,
the decision was made to ask individual Policy Board members to present their own
understanding of price stability in specific inflation rates and issue numerical expressions in
the form of a range covering the presented rates, and this was published as the
"understanding."1
Over time, however, a growing number of voices began to be heard, pointing to the
difficulties in understanding the Bank's judgment from a collection of individual views held by
each member. Others expressed the view that connotations of "understanding" did not allow
for smooth interpretations of the Bank's policy stance in its efforts toward achieving price
stability, and in overcoming deflation in light of the current situation. The Bank's decision to
introduce "the price stability goal in the medium to long term" also took into account such
various views. Let me summarize the differences between the "goal" and the former
"understanding." First, the "goal" introduced represented "a judgment by the Bank" and not
"the views of individual Policy Board members." Second, while judging that the "goal" was "in
a positive range of 2 percent or lower in terms of the year-on-year rate of change in the CPI,"
the Bank clarified this by setting it at a more specific 1 percent for the time being (Chart 2).
And third, in order to strengthen the so-called "policy duration effects," the goal is more
clearly linked to the Bank's policy commitment on the duration of powerful monetary easing
including the virtually zero interest rate policy, which I will explain in more detail later.
Based on my explanation to this point, the question of why the Bank did not choose
alternatives such as "target" might arise. The basic idea of the "goal" introduced is largely in
line with the basic thinking held by some central banks abroad with regard to using the word
"a target," in that it expresses the inflation rate the Bank judges to be consistent with the
mission of a central bank and is one that the Bank aims to achieve in the medium to long
term. In Japan, however, it is still often the case that "inflation targeting" is mistakenly
considered equivalent to conducting monetary policy in an automatic manner in pursuit of a
certain inflation rate. In reality, in many countries, including those adopting inflation targeting,
monetary policy is conducted not in such an automatic manner but with an emphasis on price
and economic stability in the medium to long term, as I will explain in more detail later. The
Bank judged that the Japanese wording of "the price stability goal in the medium to long
term" would be the most appropriate name for the actual conduct of monetary policy.
In the case of Japan, while inflation rates have remained low over a protracted period, the
sustainable levels of such rates could rise gradually in the future if efforts to strengthen the
economy's growth potential bear fruit.2 In view of the high uncertainty surrounding future
developments, including possible structural changes in Japan's economy and the global
economic environment, the Bank judged it appropriate to attach the term "goal" to the
inflation rate that the Bank aims to achieve in the medium to long term, instead of the
expression of "target" that gives a rigid impression, and to review it once a year in principle.
II. Strengthening of Policy Duration Effects
Clarification of Determination to Pursue Monetary Easing
Next, I would like to explain the second step taken at the latest Monetary Policy
Meeting - the strengthening of policy duration effects. In order to generate the policy duration
effects, central banks make a commitment to the future course of monetary policy based on
certain conditions. When short-term interest rates almost hit zero, leaving little room for a
further decline, there is a need to introduce measures that influence the entire yield curve,
including the longer end, in place of the traditional operation of controlling short-term interest
rates. Long-term interest rates are formulated based on the expected future path of
short-term interest rates and risk premiums. Therefore, if market participants believe that a
central bank's commitment to monetary easing will continue for a long period of time and that
a short-term interest rate that is a policy rate will stay low for an extended period, then this
will exert a downward force on long-term interest rates.
The Bank has made the best use of the policy duration effects while engaging in maintaining
the zero interest rate policy since 1999 and quantitative easing policy since 2001. More
recently, based on the "understanding of medium- to long-term price stability" that I
explained, the Bank made it clear that it would "continue the virtually zero interest rate policy
until it judges that price stability is in sight." Although this commitment had played a certain
role in encouraging the stable formation of long-term interest rates, the Bank made two
changes this time, with the aim of further clarifying its policy stance toward overcoming
deflation. First, the condition for policy duration is now more clearly specified based on the
1 percent inflation rate that is set as a price stability goal for the time being. Second, the
Bank judged that it was more appropriate to express the policy stance on the conduct of
monetary policy in a more active manner; that is, not only acknowledging the continuation of
the virtually zero interest rate policy but also pointing to other policy measures that have
actually been taken. For this reason, it introduced a new policy commitment, which says "For
the time being, the Bank will continue pursuing powerful monetary easing by conducting its
virtually zero interest policy and by implementing the Asset Purchase Program mainly
through the purchase of financial assets, with the aim of achieving the goal of 1 percent in
terms of the year-on-year rate of increase in the CPI until the goal is in sight." At the same
time, based on the experiences of the forming and bursting of a bubble in Japan and the
global financial crisis following bubbles in recent years, a condition to the above commitment
was set that, even when price stability is maintained, the Bank checks to see whether any
significant risk is materializing, including the accumulation of financial imbalances, from the
viewpoint of ensuring sustainable economic growth (Chart 2).3
Commitment of Timing and Commitment of Conditions
This kind of policy commitment aimed at generating policy duration effects is also adopted by
central banks abroad. One way of doing this is to refer to a specific duration or timing of an
exit, just like the U.S. Federal Reserve does. According to its statement, the U.S. Federal
Reserve currently anticipates that economic conditions are likely to warrant an exceptionally
low level of its policy rate "at least through late 2014," but holds significant reservations with
regard to such anticipation being subject to change depending on economic and price
outlooks. On the other hand, the Bank of Japan makes its commitment on a "condition"
based on the CPI inflation rate, instead of a specific "timing" of an exit from monetary easing.
The Bank judged it better to present a condition in terms of an inflation goal, rather than
specifying the timing of an exit from monetary easing to gain a greater "credibility of
commitment," and consequently more effectiveness of monetary policy, given the high
uncertainty surrounding the economic and price outlooks in Japan at this juncture. As long as
economic and price outlooks entail high uncertainty, it is impossible to specify the exact
timing of an exit from monetary easing, but there is no uncertainty with regard to the Bank's
policy stance to pursue monetary easing until it sees the exit. Given the current state of
Japan's economy, the Bank believes that this type of policy commitment is more effective in
showing its strong determination to pursue policy aiming at overcoming deflation.
Relation to Inflation Targeting
I have explained that the Bank recently introduced the combination of "the price stability goal
in the medium to long term" and "strong policy commitment based on the CPI inflation rate."
How is this related to the so-called "inflation targeting?"
I would like to note at the outset that, after going through a bubble in Japan and experiencing
the recent financial crises, the monetary authorities around the world have made efforts to
improve their frameworks for the conduct of monetary policy by learning from each other's
lessons in the wake of those crises, and consequently have converged to share the following
three elements in such frameworks.
First, they published specific inflation rates considered to be consistent with their
responsibility. As I have already explained, although the wording differs, such as between the
Bank of England's "target," "definition" used by the European Central Bank and the Swiss
National Bank, the U.S. Federal Reserve's "goal," and the Bank's "medo (in English, 'goal'),"
their characteristics are basically same.
Second, and more importantly, they have placed increasing emphasis on economic and price
stability in the medium to long term, instead of the short term, when using the numerical
expression of price stability in their conduct of monetary policy. In many cases, bubbles are
formed when the economy enjoys price stability and their bursting results in significant
fluctuations in economic activity and prices later. Even if the authorities try to control the
effect of supply shocks such as volatility in crude oil prices in the short run, economic activity
suffers a significant burden and price stability ultimately is endangered in the long run. All
these kinds of experiences in recent years underscore the importance of pursuing price
stability sustainable in the medium to long term. Even in the United Kingdom, where the
monetary policy framework is called inflation targeting, the actual conduct of monetary policy
is increasingly aimed at achieving the inflation target in the medium to long term while paying
attention to economic and financial stability, instead of achieving the target at all costs in the
short term.
Third, and related to the second element, major central banks have come to publish their
economic and price outlooks covering a longer period. Having said that, the longer the period
of forecasts, the greater their inevitable decline in terms of reliability. Therefore, these central
banks increasingly emphasize the medium- to long-term perspectives in showing their basic
thinking on the mechanism behind the outlook and assessing risks, instead of focusing too
much on highlighting the forecast numbers themselves.
Given that the monetary policy frameworks of major central banks have converged as
described, I think it no longer important to play with the taxonomy of which one is inflation
targeting or not. In fact, while Chairman Bernanke made it clear that the newly introduced
longer-run goal does not mean the introduction of inflation targeting, some nevertheless do
call it inflation targeting. If the new monetary policy framework adopted by the U.S. Federal
Reserve can be called inflation targeting, a similar view could be taken in the case of the
Bank's new framework.
III. Expansion of the Asset Purchase Program
10 Trillion Yen Increase in the Purchase of JGBs
Now I would like to touch upon the third step taken at the latest Monetary Policy Meeting.
That is, the expansion of the Asset Purchase Program (Chart 3).
As part of the comprehensive monetary easing introduced in October 2010, the Bank has
purchased various types of financial assets through the Program. Using the newly
established segregated fund on its balance sheet, which is also used for the funds-supplying
operations over the longer term, the Bank has purchased JGBs - both short-term and
long-term - and, in an exceptionally unusual practice for a central bank, risk assets including
commercial paper, corporate bonds, exchange-trade funds (ETFs), and Japan real estate
investment trusts (J-REITs). The purpose of this operation is to encourage a decline in
longer-term market interest rates and a reduction in various risk premiums so that financial
conditions surrounding the ultimate borrowers of funds, such as firms and households, will
become more accommodative. In the process of enhancing monetary easing, the total size of
the Program had been increased repeatedly, from the initial 35 trillion yen in October 2010 to
55 trillion yen, and the Bank made a decision to further increase it to 65 trillion yen by
earmarking another 10 trillion yen for the purchase of JGBs at the latest Monetary Policy
Meeting. The cumulative increase in the total size of the Program is about 30 trillion yen.
In addition to this Program, the Bank regularly purchases JGBs at the pace of 1.8 trillion yen
per month, or 21.6 trillion yen per year, for the purpose of meeting the stable long-term
demand for funds. Adding up the purchases through such operation and those through the
Program, the Bank is going to purchase a large amount of JGBs until the end of this year at
the pace of 3.3 trillion yen per month, or about 40 trillion yen per year. At the end of last year,
the amount of JGBs held by the Bank was 66.1 trillion yen, representing 14.2 percent of
nominal GDP. Although you may have the impression that the U.S. Federal Reserve has
aggressively purchased government bonds, its holdings at the end of last year were
10.8 percent of nominal GDP. The holdings by the European Central Bank, which started
making such purchases in 2010, represented 2.2 percent of nominal GDP.
Such a significant scale of government bond purchases entails risk, to which more attention
needs to be paid. More specifically, once the purchase of government bonds by a central
bank is perceived as financing government debt and not conducted for the purpose of
monetary policy, this could instead invite a hike in long-term interest rates and lead to
financial market instability. The Bank has repeatedly cautioned about this risk and rigidly
maintains its policy of not conducting purchases of JGBs for the purpose of financing
government debt.
Ensuring Accommodative Financial Conditions
As a result of the comprehensive monetary easing consisting of the aggressive purchase of
financial assets and the virtually zero interest rate policy, financial conditions in Japan have
become extremely accommodative (Chart 4). More specifically, interest rates - including
longer-term ones - in short-term money markets where financial institutions lend and borrow
funds have stayed at very low levels, and credit spreads have been stable at low levels in
corporate bond and commercial paper markets. Bank lending rates have already reached
significantly low levels but continue to decline gradually. According to various surveys, firms
see their financial position and financial institutions' lending attitudes as being on a clear
improving trend.
On the other hand, in the period after the Lehman shock, an increase in quantitative
indicators such as the size of the Bank's balance sheet and the monetary base - money
provided by a central bank - has been moderate compared to that in the United States and
in Europe, sometimes inviting the misunderstanding that the Bank's monetary easing is
insufficient. When interest rates decline to extremely low levels, people tend to hang on to
money. This situation is called a "liquidity trap." Once caught in this, it is no longer possible to
measure the degree of monetary easing by simply looking at quantitative financial indicators.
In fact, when we ask business managers about confronting challenges, few complain about a
shortage of on-hand liquidity and many point to a lack of demand or business. In any case, in
such a situation, what is more important is the easiness of financial conditions in a broad
sense, such as developments in short-term and long-term funding rates for firms and risk
premiums as well as funding conditions of firms and households. In the case of the United
States and Europe, a significant expansion of the central bank balance sheet was
indispensable to restoring stability in financial markets that had suffered significant damage
to their functioning after the Lehman shock. Once provided to financial markets, the funds
remained piled up in deposits with central banks because of negligible opportunity costs
amid extremely low interest rate levels. On the other hand, in the case of Japan, damage to
the functioning of financial markets was relatively limited and financial system stability was
maintained even at the time of the Lehman shock. Therefore, without having quantitative
expansion on the scale seen in the United States and Europe, the Bank could realize more
accommodative financial conditions. Although tensions in global financial markets
heightened again last year due to the European debt problem, the Bank has managed to
firmly maintain accommodative financial conditions in Japan. It is expected that the recent
determined increase in the Asset Purchase Program earmarked for JGBs will further
strengthen the easing effects by affecting the entire yield curve, including the longer end.
IV. Our Thinking on Deflation and Needed Actions
Cause of Deflation
So far, I have explained the Bank's new policy steps, which aim at overcoming deflation and
bringing the economy back to a sustainable growth path with price stability. Conducting
monetary policy in this way, how significant of an effect can be expected in terms of
achieving the goal of overcoming deflation? Put differently, what kinds of measures are
needed for Japan's economy as a whole to ensure that this goal will be achieved? Using the
time left for today's remarks, I would like to share with you our thinking on deflation. A good
starting point is to have an accurate understanding of the fundamental cause of deflation in
Japan.
The various causes of deflation in Japan have been provided and discussed for years. For
example, for some time, downward pressures on prices came from deregulation and the
streamlining of distribution systems, which were pursued under the policy initiatives to reduce
international price differentials. In Japan, both employers and employees tend to make wage
adjustments for the sake of securing employment. As a result, even under the severe
economic conditions, the unemployment rate in Japan did not rise compared to that in the
United States and in Europe, while the declining trend for wages became more evident. Such
a declining trend of wages is one of the factors explaining deflation in Japan.
In the meantime, there is an argument that deflation has continued because of an insufficient
amount of money - in other words, insufficient monetary easing by the Bank. However, such
an argument needs to be properly fact-checked (Chart 5). Let's take the typical example of
money stocks, which are cash and deposits held by firms and households. The Marshallian
k is the ratio of money stocks to nominal GDP that is used to measure the size of money
stocks in relation to economic activity. In Japan, the ratio had been about 1.1 until the
mid-1990s, which means that money stocks and nominal GDP were almost same size. Since
then, the ratio has continued to rise against the background of prolonged monetary easing
and is now about 1.7 - in other words, the amount of money stocks is about 805 trillion yen
while nominal GDP is about 467 trillion yen. This ratio of 1.7 is the highest among major
economies. Conducting a similar exercise with the monetary base and the size of the central
bank balance sheets results in the same conclusion that the ratio of Japan is the highest
among major economies.
As I have stated, the Bank has managed to maintain accommodative financial conditions
despite the rising tensions in global financial markets against the background of the
European debt problem. Viewed in this way, it appears that the problem of Japan's economy
is not a lack of money but rather a lack of business chances and growth opportunities to
make the best use of money.
Ultimately, deflation is a decline in the general price level, and therefore must be caused by a
deterioration in the supply and demand balance of the macro economy - i.e., a shortage of
demand against supply. An output gap - an indicator for supply and demand balance
estimated on the basis of certain assumptions - has continued to indicate a shortage of
demand since 2000 with the exception of a very short time period.
Looking back at real GDP growth rates in Japan from a relatively long viewpoint, the rates
have gradually declined from 4.4 percent in the 1980s, to 1.5 percent in the 1990s, and to
0.6 percent in the 2000s (Chart 6). There are several reasons for this decline. First, the
negative legacy of the bubble bursting had continued to weigh on the economy since the
beginning of the 1990s. To be more specific, while firms and financial institutions were
tackling the challenge of balance-sheet repair, Japan's economy as a whole failed to adjust
to a changing environment, such as increasing globalization and a rapid aging of the
population. In particular, the effects of the population aging at a much greater speed in Japan
than in the rest of the world have become more evident since entering the 2000s. The
aforementioned widening of an output gap certainly means a shortage of demand against
supply capacity, but in the current conjuncture it is specifically a shortage of demand against
the supply capacity of existing goods and services. Rather, it might be interpreted as a
widening mismatch of demand and supply in a sense that the supply side fails to sufficiently
meet new demand in the new environment, such as demand from seniors.
In any case, when growth rates trend down in this way, households increasingly grow
concerned about future income; this results in stagnant consumption and the corporate
sector restrains investment in future business. If these events occur, this will lead to a vicious
cycle in which contraction of expenditure by firms and households drags down actual growth
rates and growth expectations.
The relationship between economic activity and prices could be compared to that between
fundamental physical strength and body temperature. In order to raise the body temperature
to a normal level, it is necessary to improve the fundamental physical strength. Likewise, we
need to face the reality that, in order to raise prices appropriately, it is indispensable to
strengthen Japan's growth potential and growth expectations, and deflation cannot be
overcome without such efforts. Of course, there are some cases where only an increase in
prices takes place without changes in growth. The two oil shocks in the 1970s and the 1980s
are typical examples. However, it also should be noted that a temporary increase in prices
will not improve the performance of firms or quality of people's lives, as you can easily see in
the case where crude oil price hikes are transmitted to general prices, and we certainly do
not wish to see such a situation materialize. The bottom line is that it is important to realize
desirable inflation rates in proper sequencing so that improvement in economic activity leads
to a rise in prices in a natural manner.
Efforts toward Strengthening Growth Potential
Strengthening growth potential is an extremely difficult challenge for Japan, especially given
the constraint it faces - namely, the rapid aging of the population. Let me provide you with a
rough calculation. The economic growth rate consists of two components: the rate of growth
in the number of workers and the GDP per worker - or the rate of growth in productivity
(Chart 6).4 Of these two components, the rate of growth in the number of workers started to
decline in the 2000s and decreased at an annual rate of 0.3 percent on average during that
decade. Based on long-term projections of demographic trends recently released by the
National Institute of Population and Social Security Research, the rate of decline in the
number of workers will increase further to 0.7 percent in the 2010s, 0.8 percent in the 2020s,
and 1.2 percent in the 2030s. Meanwhile, although the rate of growth in productivity has
fluctuated due to the effects of the Lehman shock, the recent trend is 1 percent on average in
the past twenty years and about 1.5 percent on average for the period in the 2000s before
the Lehman shock. The rate of growth in productivity in Japan itself is comparable to those of
other G-7 economies and was highest in the period in the 2000s before the Lehman shock.
However, adding this rate of growth in productivity to the rate of decline in the number of
workers leaves us with a grim outlook; that is, not only will the annual rate of economic
growth in the 2010s remain around 0.5 percent, but it may decline further in the longer run.
How can we strengthen the economy's growth potential? First, while it is difficult to induce a
dramatic increase in the number of workers, it is still possible to slow the pace of decline in
the number by making it easier for elderly people and women to participate in the workforce.
Nevertheless, the key to strengthening growth potential lies in efforts to raise productivity
growth. In doing so, firms' efforts to capture global demand and cultivate new diversifying
domestic demand become necessary. On the policy front, it is important to take measures
such as deregulation in order to create an environment that encourages firms to take on
these challenges. Financial institutions' expertise in identifying good business opportunities
and providing risk money also become important with regard to providing financial support to
firms in the course of making such efforts. Above all, it will be vital for society as a whole to
realize the harsh reality and critical issues facing Japan's economy and share a sense of
values, which should include acceptance of change as well as the need to improve the
economic metabolism.
The most significant contribution that a central bank could make in terms of strengthening
growth potential is to maintain accommodative financial conditions and support firms from the
financial side by creating an environment that makes it easier for them to explore new growth
strategies. The Bank will continue to pursue powerful monetary easing, taking full account of
"the price stability goal in the medium to long term" I have discussed today. It is also an
essential role of the Bank to make efforts to minimize the effects on the financial market and
the financial system in Japan, and do its utmost to ensure stability even in the event that
some kind of destabilizing factor arises overseas amid high uncertainty surrounding global
financial developments, including the European debt problem. Furthermore, in an
extraordinary measure for a central bank, the Bank has been proceeding with a new
fund-provisioning measure to provide support for strengthening the foundations for economic
growth. This is aimed at encouraging firms to explore new growth strategies by taking
advantage of financial institutions' expertise in iden