Toshiro Muto: What have we learned from "unconventional" market
operations?
Speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, on the occasion of a meeting with
participants in market operations, Tokyo, 23 July 2003.
* * *
I. Monetary policy in uncharted territory
As the Japanese economy has been facing severe adjustment in recent years, the Bank of Japan has
effected various measures that are unprecedented for any central bank, including the zero interest rate
policy, quantitative easing, and a commitment to continuing the current policy until the consumer price
index stably reaches zero or above. Moreover, the Bank will be able to purchase asset-backed
securities from the end of July, thus expanding the scope of the assets it purchases. People often talk
about the so-called "unconventional monetary policy" under deflation. All of the above measures can
be considered unconventional in light of traditional central banking.
Until recently, it appears that the zero interest rate policy and quantitative easing have been
considered a special case for Japan, a country suffering from deflation. However, there are now
several countries whose policy interest rates are approaching zero. For example, the short-term policy
rate is 1 percent in the United States and zero to 0.75 percent in Switzerland. As a result, the zero
interest rate policy and quantitative easing have been increasingly attracting the attention of other
countries.
Since the Bank began to conduct monetary policy in uncharted territory, it has constantly made new
findings in the area of financial markets and money market operations. As the pioneering central bank
in this uncharted territory, the Bank is in a unique position to explain to the audience both at home and
abroad the experience under the zero interest rate policy and quantitative easing. As all of you here
are experts in market operations and other financial market transactions, I feel it may be stimulating to
focus my talk on the issues of mutual interest related to market operations and financial markets,
rather than talking about developments in the economy and monetary policy in general. It is often said
that the devil is in the details. Therefore, I believe it is useful for fruitful discussion on monetary policy
that we share a few findings from market operations under quantitative easing, even though these
findings may appear rather technical.
II. Findings in the area of market operations
There are a few important pillars in the current quantitative easing framework. Among them, the most
important is to use the outstanding balance of current account deposits at the Bank as the main
operating target and to provide ample funds through market operations.
A. Increase in demand for current account deposits
Obviously, if we provide ample funds to the market, short-term interest rates will fall to zero. If
shortterm interest rates are significantly above zero, financial institutions will limit the amount of funds in
their current account deposits, which pay no interest, roughly to the required reserves. Such behavior
has been familiar to many central banks for many years. But what would happen if short-term interest
rates were to decline to zero? A little more than two years ago when the target for market operations
was changed from the overnight call rate to the outstanding balance of current account deposits, both
market participants and the Bank doubted whether it was really possible for the Bank to provide the
current account deposits with funds far in excess of around 4 trillion yen, the required reserves at the
time. In fact, in the month of May 2001, only two months after a new target of 5 trillion yen for the
current account deposits was introduced, we frequently observed undersubscription in market
operations where bids fell short of the Bank's offers. You may recall that undersubscription occurred
repeatedly also in subsequent market operations.
However, since autumn 2002 when the target for the current account deposits was raised from
"around 10 to 15 trillion yen" to "around 15 to 20 trillion yen," undersubscription has rarely occurred.
The target has been raised since then, and now stands at "around 27 to 30 trillion yen." Indeed, this
high level of the target was unthinkable when quantitative easing was first introduced. With the caveat
that there is probably a limit to increasing the target since it is inconceivable that all financial
institutions hold their assets in the current account deposits at the Bank, the first of the findings from
our experience of more than two years of quantitative easing is that a central bank can provide a fairly
large amount of funds even under zero interest rates.
Among the factors that enabled the provision of a large amount of funds, initially considered almost
impossible, the following two factors stand out in significantly increasing the financial institutions'
demand for current account deposits at the Bank.
One factor is the growing conviction of many financial institutions that they would not have a problem
holding current account deposits substantially exceeding the required reserves, as a result of the
virtual disappearance of the opportunity cost for holding the current account deposits. At present, not
only major banks but also regional banks and foreign banks' branches in Japan hold sizable current
account deposits at the Bank. The interest income earned in the money market is so small that
financial institutions keep their daily excess funds in the current account deposits at the Bank rather
than invest them in the money market in view of administrative costs and possible losses, however
unlikely, due to the defaults of counterparties.
Another factor relates to the periodic rise of concern over financial system stability triggered by such
events as the fall in stock prices. When the availability of funds tends to be tight as at the end of the
financial year, including the mid-year book closing, or the calendar-year end, financial institutions try to
smooth out their funding. This will increase the demand for holding current account deposits at the
Bank. In fact, during the financial crisis of 1997-98, the money market shrank, and the liquidity
shortage forced a number of financial institutions with rapidly deteriorating creditworthiness into
bankruptcy. It may be quite natural that renewed memories of this period prompted extremely strong
demand for current account deposits at the Bank.
B. Factors leading to undersubscription
Such an increase in the demand for current account deposits by market participants must somehow
be met by supply. Otherwise, interest rates will rise. As you all know, supply is being made in the form
of the Bank's funds-supplying operations, where market participants place bids against the Bank's
offers. Thus, the second finding under quantitative easing is that the Bank needs to devise a variety of
measures to provide ample funds. For example, even when some market operations resulted in
undersubscription, others were successful. Also, the extent of undersubscription varied depending on
the time of year. It is not easy to deduce these situations from the theoretical analysis of aggregate
supply of and demand for the current account deposits.
Having said this, one of the main reasons for undersubscription was the growing sense of a surfeit of
funds in the market. This was the case in May 2001, soon after the target for current account deposits
was introduced, when sentiment that the additional supply of funds was redundant seemed to be
growing stronger day by day. The undersubscription in February and March 2002 and the summer of
2002 was caused in part by such sentiment, but other factors were also at work.
Undersubscription is likely to occur when there is an increase in market participants' demand for the
financial assets the Bank offers to purchase in its market operations. Funds-supplying operations are
the transaction where a central bank provides funds to the current account deposits of financial
institutions against its purchase of a specific financial asset. For example, during February and March
2002, uncertainty about financial system stability was heightening as full protection of time deposits
was about to be lifted from April. Moreover, the demand for such risk-free assets as treasury bills
(TBs) and financing bills (FBs) by all economic agents, including financial institutions, increased
significantly in the market. In such circumstances, the Bank's offers to purchase TBs and FBs failed to
attract a sufficient number of bids, and undersubscription ensued.
A change in the long-standing skewed distribution of funds across financial institutions also
contributed to undersubscription. In the past, major banks had a balance-sheet structure in which the
deposits they received fell short of their loans. At present, the deposits at these major banks are in
excess of their loans reflecting an inflow of deposits. As a result, their funding needs in the market
have been reduced.
It is not certain whether undersubscription will recur in the future. But what is certain is that the
success of the central bank in providing a massive amount of funds under zero interest rates will
depend on micro-level factors, including the funding position of individual financial institutions and the
demand for specific assets used in the Bank's market operations, in addition to the overall supply of
and demand for current account deposits at the central bank. In this regard, by closely monitoring the
changes in each financial market, the Bank has been carefully selecting the means by which it carries
out market operations for the smooth provision of funds. For example, the Bank has recently
expanded the scope of acceptable bills by lengthening the maturity period up to 12 months as well as
the range of eligible counterparties for its bill purchasing operations. It has also conducted a
combination of longer-term funds-providing operations and shorter-term funds-absorbing operations.
III. Challenges under quantitative easing
A. Criteria for assessing financial market stability
The first challenge under quantitative easing is to select the criteria by which the Bank should assess
the state of financial markets when conducting market operations. Some economists may argue that
the quantitative easing framework requires the Bank to do no more than mechanically maintain the
target balance for current account deposits every day. Unfortunately, this is not necessarily the case.
Even when the Bank maintains the target balance, there are cases in which financial markets remain
unstable. In these cases, ensuring financial market stability becomes most important.
Then, the question is how to assess subtle changes in financial markets in light of maintaining their
stability. In the money market, a tightening of the market will not necessarily be translated into a
change in overnight interest rates, as these rates have been at around zero. For example, even when
concern about financial system stability intensified in autumn 2002, the unsecured overnight call rate
stayed at 0.001 percent. However, the repo rate on forward transactions, the yield on TBs with longer
maturity, and the offer rate of the Bank's funds-supplying operations all increased. Thus, when
conducting market operations under such circumstances, it becomes important to judge how and to
what extent the target balance for current account deposits should be achieved and various interest
rates should be stabilized to ensure financial market stability. Moreover, the criteria for such judgment
differ depending on the economic and financial conditions. Therefore, it has become very challenging
to judge whether financial market stability is being maintained.
B. How to evaluate the functioning of financial markets
The second challenge is to maintain the functioning of financial markets. The word "call" in the money
market derives from the phrase "money at call," referring to the money available on demand. The
amount outstanding of the call market decreased substantially after financial institutions felt that it
would not be a problem to hold reserves far in excess of required reserves. Since the call market is the
market in which participants lend and borrow short-term funds, the shrinking of the market implies a
possibility that financial institutions may not be able to appropriately perform their banking activity.
Therefore, the Bank inevitably has a serious concern about maintaining the functioning of the market.
Lenders in the money market are reluctant to lend when market rates fall to virtually zero. Some
regional banks have closed down their Tokyo branches. It has also been pointed out that, with liquidity
in the call market declining as a result of less market participation, the market may not function
effectively in funds procurement in times of emergency.
Let me elaborate by illustrating these points with examples.
The amount outstanding of the call market stood at 26.5 trillion yen at the end of February 2001 just
before the introduction of quantitative easing. This amount fell by roughly 10 trillion yen in two years to
16.5 trillion yen at the end of February 2003. In addition to the introduction of quantitative easing, two
factors among others are considered to have contributed to this reduction: one is the progress in
consolidation among large financial institutions, and the other is the shift of deposits to large banks,
which are usually on the funding side in the call market, as a result of the partial removal of blanket
deposit insurance.
Let us look at the contrast between call transactions involving overnight instruments and those
involving term instruments. The amount outstanding of overnight transactions fell by some 20 percent,
from 15.3 trillion yen at the end of February 2001 to 12.3 trillion yen at the end of February 2003.
During the same period, the amount outstanding of transactions involving term instruments decreased
from 11.2 trillion yen to 4.2 trillion yen, about one-third the level at the end of February 2001. Looking
at the money market in terms of secured transactions, the total amount of bond gensaki and repo
transactions hardly changed, remaining at around 18 trillion yen per business day during the same
period. In fact, the amount outstanding of the secured call market now is even larger than before the
introduction of quantitative easing. These facts suggest that the deterioration in the functioning of the
money market is a phenomenon related not only to zero interest rates, but also to the extremely
cautious attitude of market participants in taking on credit risks.
I have just mentioned that in Japan, with short-term market rates declining virtually to zero, lenders
become reluctant to lend, and that some regional banks have closed down their Tokyo branches.
Similarly, in the United States, with the decline in the federal funds rates, there is heated discussion as
to how far the interest rate on money management funds could decline relative to the returns on trust
funds, and whether the decline in interest rates would interfere with the effective functioning of this
major channel of funds intermediation. In essence, the discussions in the United States and Japan
have something in common. The transaction and settlement of funds and securities as well as the
assessment of credit risks always entail some fixed costs. And when short-term market rates approach
zero, interest revenues may fall short of these costs. This tends to hinder the smooth implementation
of various financial transactions.
The relationship between the zero interest rate policy or quantitative easing and the market functioning
requires a multifaceted examination. Thus, we would like to examine this issue from a broader
perspective, not focusing narrowly just on the decline in the amount outstanding of the call market.
IV. Outright purchase of long-term Japanese government bonds (JGBs)
I commented earlier that one of the findings under quantitative easing was the need for the Bank to
devise a variety of measures to provide ample funds. I have also just mentioned financial market
stability and the deterioration of market functioning in the context of concern and challenges under
quantitative easing. As an application of these discussions, I would now like to turn to the outright
purchase of long-term JGBs by the Bank.
Many central banks in major industrialized countries conduct monetary policy mainly through money
market operations. It is only those in the United States and Japan that also conduct the outright
purchase of long-term government bonds on a large scale. Even before the Bank began quantitative
easing, it was effecting the outright purchase of long-term JGBs to provide liquidity for sustainable
growth in line with the long-term trend increase in banknotes. When introducing quantitative easing,
the Bank adopted a new framework for market operations according to which it would increase the
amount of its outright purchase of long-term JGBs when it considered such an increase necessary for
the smooth provision of liquidity, subject to the limitation that the outstanding amount of long-term
JGBs effectively held by the Bank should be kept below the outstanding balance of banknotes issued.
Based on such thinking, the Bank increased the amount of its outright purchase of long-term JGBs
four times, from an initial 400 billion yen per month to the current 1.2 trillion yen per month. As a result,
the Bank now holds more than 60 trillion yen of long-term JGBs, which accounts for about 60 percent
of the monetary base.
From the viewpoint of conducting market operations, the outright purchase of long-term JGBs, after
the adoption of quantitative easing, has greatly contributed to achieving smoothly the target
outstanding balance of current account deposits at the Bank. Undersubscription has not yet been
repeated in the Bank's market operations. However, should such cases arise again, it would be highly
reassuring from a practical standpoint that the Bank has a means of securing a fixed amount of
increase in the outstanding balance every month.
Let me share with you some observations in relation to the significant increase in the outright purchase
of long-term JGBs.
The first observation is that we regard the outright purchase of long-term JGBs as a market operation
that does not result in undersubscription. The question is why market participants take the trouble to
bid on the Bank's offers for the outright purchase of long-term JGBs when they can sell these bonds in
the market.
If asked, market participants give the following explanations to this question. First, the Bank requires
market participants to bid actively against its offers, which is one of the Bank's requirements for
participation in market operations. Second, selling a large amount of long-term JGBs through the
Bank's outright purchase has a smaller effect on market prices than selling them in the market. And
third, unlike short-term interest rates, interest rates on long-term JGBs have not yet reached zero. All
these explanations appear plausible, but cannot be conclusive. The first explanation also applies to
the Bank's market operations for providing short-term funds, and these operations have actually
experienced undersubscription. The second one may hold true to some extent. The third explanation
that interest rates on long-term JGBs have not yet reached zero seems the most convincing. Whatever
the explanations, from the viewpoint of providing ample funds and analyzing the effect on market
prices of JGBs, we should pay more attention to the motivation of market participants for bidding on
the Bank's offers.
The second observation is that the provision of funds dependent largely on the outright purchase of
long-term JGBs has created concern in the Bank's market operations. The Bank is currently
conducting the outright purchase of long-term JGBs at a high rate of 1.2 trillion yen per month. Its
balance sheets at the end of March 2003 revealed that the total of banknotes and current account
deposits increased by about 6.5 trillion yen from a year earlier on the liability side. On the asset side,
the outright purchase of long-term JGBs increased substantially, while money market operations
decreased. In fact, the amount outstanding of long-term JGBs held by the Bank at the end of March
2003 increased by roughly 9 trillion yen from a year earlier, while the amount of funds provided by
money market operations decreased by about 7 trillion yen. The difference of about 3 trillion yen
between the increase in the total of banknotes and current account deposits and the amount of funds
provided by the Bank is explained by the decrease in government excess funds, which were paid to
the private sector.
If the decrease in the volume of transactions in the money market were to cause difficulties to financial
institutions in smoothly raising short-term funds, the Bank's money market operations may provide an
alternative means of securing smooth funding. In this context, a decrease in the Bank's money market
operations could be a destabilizing factor for financial markets. Even when there is a surplus of funds
in the money market as a whole, money market rates could rise slightly due to a decrease in the
supply of short-term funds by the Bank. If money market rates were sufficiently positive and there were
no concern about financial system stability, the Bank would be free to use any assets for its
operations, because a surplus or shortage of funds would ultimately be adjusted in the market.
However, this is not currently the case in Japan.
The outright purchase of long-term JGBs is a means to smoothly increase the outstanding balance of
current account deposits, and has played a significant role in securing financial market stability. At the
same time, such a purchase has engendered some unexpected side effects, such as fewer
opportunities for the Bank to conduct money market operations, which has in some cases led to a
slight rise in money market rates.
Let me briefly touch upon the relationship between long-term interest rates and the outright purchase
of long-term JGBs. Market participants often point out that the decline in long-term interest rates up
until mid-June was partly due to the Bank's outright purchase of long-term JGBs. The outright
purchase of long-term JGBs of 1.2 trillion yen per month could facilitate the adjustment of dealers'
position in the market. And it appears easy to understand that when long-term interest rates fall for
some reason, the existence of such a purchase would make dealers more bullish than otherwise. But,
based on the observation that the yield on ten-year JGBs has been fluctuating between 0.4 percent
and 1.4 percent for the past month or so, the relationship between long-term interest rates and the
outright purchase of long-term JGBs may not be as simple as it appears.
V. Relationship between the Bank and its counterparties in market operations
A. Findings in the area of supply and demand for funds
The number of counterparties in the Bank's market operations is close to 150 at present. When
financial institutions become eligible as a counterparty in the Bank's market operations, they are
requested to bid actively against the Bank's offers for market operations, process transactions
accurately and swiftly, and provide the Bank with market information and analyses useful in
conducting monetary policy. In addition, the Bank recently began considering the amount of
successful bids in the previous year as a criterion for the selection of counterparties for market
operations in the following year. These requests are being made because the central bank needs to
effect monetary operations through the smooth provision of funds. Also, the eligibility criteria for
counterparties must be as transparent as possible since it is impossible to conduct transactions with
all market participants.
Having said all this, let me note that the Bank and its counterparties in market operations are important
to each other as trading parties in financial markets. In my opinion, the term "trading party" has two
significant implications.
The first implication is that both the Bank and its counterparties aim to achieve their respective goals
through the transactions in funds and JGBs. The Bank controls the amount of money in the market or
the level of interest rates, while the Bank's counterparties adjust their position in funds and JGB
holdings and improve profitability.
Let me take the example of undersubscription. Undersubscription in the Bank's funds-supplying
operations occurs in the following cases: financial institutions have already secured enough funds to
satisfy reserve requirements for the period; they have managed to raise sufficient funds in the market
to cover themselves over interim and fiscal year-end book closings; and, they can sell any TBs or FBs
or CP they hold to end-investors without difficulties. Thus, undersubscription occurs when
counterparties do not need the Bank's market operations. This implies that, in order to smoothly
conduct market operations, the Bank must understand and satisfy its counterparties' need for market
operations. It also means that the Bank must devise market operations that create such a need.
This rather obvious point was not clearly recognized under the past framework where interest rates
were the target. In that framework, the Bank was rather passive. It provided funds when interest rates
rose higher than the target, and absorbed funds when interest rates fell below the target. In contrast,
under the present framework where funds are amply provided to achieve the target balance of current
account deposits, the Bank has been under pressure to increase funds held in current account
deposits in line with the target. This has increased more than ever our awareness of the significance of
transactions in financial markets.
For example, if for some reason we observe a tightening of the conditions in a certain market in the
money markets, the Financial Markets Department of the Bank will consider providing funds to that
market. Given its responsibility to ensure market stability, the provision of funds in such a
circumstance would clearly be an appropriate decision. Looking at this differently, a tightening of
market conditions suggests that there is a demand for funds in that particular market. As the Bank is
trying to maintain the balance of current account deposits at unprecedentedly high levels, it should
take advantage of such a demand for the smooth provision of funds.
B. Exchange of information through market operations
The second implication of a trading party is that the Bank and its counterparties exchange information.
As is suggested by the term "market intelligence," we may be able to obtain a variety of information
and knowledge by carefully monitoring market movements. This is the reason why we request the
counterparties to provide us with market information and analyses useful in conducting monetary
policy.
We conduct market operations daily, and the results of these operations are a very important source of
information for us in gaining insight into the counterparties' assessment of our offers. Of course, this is
not a one-way flow of information. Presumably the results of market operations offer the counterparties
valuable information on overall market conditions, including insight into the action of other participating
players. It may perhaps seem counterintuitive, but the results of market operations have come to play
an increasingly important role, given the reduced number of transactions taking place in the money
market.
I would like to add that, as players in the same market, the Bank and its counterparties in market
operations should exchange information and ideas on how to improve the market infrastructure and
make the market function more smoothly.
Concluding remarks
My talk today has focused on technical aspects of market operations conducted under quantitative
easing. It includes a number of issues that are of fundamental importance when thinking about the
conduct of monetary policy. Market functioning, which I touched upon, is one of these important
issues. We at the Bank will continue to exert every effort to enhance the transmission mechanism of
monetary policy, while ensuring the smooth provision of funds within the framework of quantitative
easing.
We are closely monitoring the market for even the slightest change through various channels,
including daily market operations. However, we believe it is major market players like yourselves who
possess the most reliable information and insight into market conditions through direct dealing with a
variety of customers. As we are now in uncharted territory for monetary policy, we appreciate your
sharing with us your insight so that we can together navigate these waters safely.