Yutaka Yamaguchi: Monetary policy in a changing economic environment
Speech by Mr Yutaka Yamaguchi1, Deputy Governor of the Bank of Japan, at a symposium sponsored
by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 30 August 2002.
* * *
1. Three years ago at this same conference, I was given an opportunity to talk about Japan's
monetary policy in the years when asset price bubbles expanded.2 Today, I would like mainly
to review monetary policy in the following phase when the bubbles burst, for asset price
swing is the "changing economic environment" most relevant to us. Incidentally we are now
in the third phase when the economy is in "liquidity trap", which I will leave for a future topic
of discussion.
2. I have to start with a bit old story. The Tokyo stock market peaked at end-1989. The bubble
in the property market -and in Japan the real estate had far greater market capitalization
relative to the stocks- persisted about a year longer. Growth slowdown followed. The trend
growth rate in the 1990s is just one percent a year on average, a marked shift downward
from 4% in the 1980s (Chart 1).
Chart 1. Economic Growth and Inflation
Note: Figures for the CPI are adjusted for the impacts of consumption tax which was
introduced at the rate of 3 percent in April 1989, and increased to 5 percent in
April 1997.
Sources: Ministry of Public Management, Home Affairs, Posts and Telecommunications,
Consumer Price Index; Cabinet Office, Annual Report on National Accounts.
3. There is little doubt that the burst of asset price bubbles contributed significantly to the
decline in the trend growth rate. But it was not the sole reason. Against the backdrop of a
changing environment such as a rapidly aging society and limit to export-led growth,
prospective shift to a more moderate growth was already broadly envisioned in the early
1980s. The economic system, which had been built on the premise of high growth, needed
to be modified and in fact was already in the middle of significant structural adjustment in the
mid-1980s.
4. The asset price bubbles not merely interrupted this process but turned the clock backward.
The excessive optimism, the main feature of a major asset bubble, induced the businesses
to build up capital stock, payrolls and debts that would have made sense only under
sustained acceleration of growth. When the bubbles burst, the ensuing adjustment and
workout had to be all the more painful and prolonged.
This aspect of Japan's asset market bubble, with its consequences on the structural
adjustment in the 1990s, is important because it illustrates the specific environment in which
the Bank of Japan had to conduct monetary policy. In other words, monetary policy
conducted in different context should be assessed in the light of each unique historical
setting and its effects should be different where, for instance, a need is less evident for a
structural shift to lower growth.
5. The Bank of Japan started to cut the ODR, then at 6%, in July 1991. Those were the days
when production and CPI showed signs of acceleration and substantial uncertainty existed if
the business cycle had peaked. Reemergence of a land price bubble was a more convincing
scenario than a sustained asset deflation. Therefore the ODR cut in mid-1991 received
harsh criticism in and outside the country as a premature relaxation.
In retrospect, it turned out to be the first of a series of reductions, and by September 1995
the ODR was as low as 0.5% - the level some economists regard a possible threshold to a
liquidity trap. In about four years span, the sizable room for interest rate reduction had
essentially been used up.
6. The Bank of Japan has often been criticized for an alleged delay in monetary easing. A
number of research has been conducted, including among others those by the BOJ staff as
well as by the Federal Reserve Board staff, to assess the easing path by applying a standard
backward-looking 'Taylor rule' as criteria.3 Chart 2 shows one such example. They conclude
that monetary easing after the bubble burst, particularly in the crucial early stage of
relaxation, could be considered to have been generally appropriate as a standard
stabilization policy based on real-time financial and economic indicators as well as market
forecasts. And yet, even with a policy response which could be considered appropriate in
normal times, there emerged a substantial decline in the trend growth rate as well as rapid
and continuous fall in asset prices that weakened the financial system and destabilized the
economy.
7. Against the background of the post-bubble economic performance of Japan, the views have
been expressed that the Bank should have gone beyond standard stabilization policy and
tried more aggressive easing before monetary policy became constrained by the zero
nominal bound.
Let me briefly examine such views on two aspects. The first is the practical feasibility which
partly depends on predictability on real-time basis of a post-bubble economic trend. The
second is effectiveness of an aggressive monetary policy to mitigate the adverse effects
stemming from the burst of asset price bubbles.
Chart 2. Taylor Rule
Notes:
1. Taylor rule is defined as follows:
2. Target rate based on Taylor rule, shown in bold line, is adjusted for the introduction of
consumption tax (3 percent) in April 1989, and increase in its rate (to 5 percent) in
April 1997. For reference, consumption tax non-adjusted series is also plotted in
shaded line.
Sources: Kunio Okina and Shigenori Shiratsuka, "Asset Price Bubbles, Price Stability, and
Monetary Policy: Japan's Experience," IMES Discussion Paper 2001-E-16, Institute for
Monetary and Economic Studies, Bank of Japan, 2001, Chart 7.
8. Suppose a central bank adopts dramatic easing actions way beyond "standard" or
rulebased monetary policy at an early stage. The intention would be to create an accelerated
inflation preemptively to avoid the future risk of a deflation when, as in the case of Japan,
sharp falls in some but not all asset prices, still fairly robust economic growth, and mild
inflation co-exist. The accelerated inflation rate required to offset the negative shock
generated by collapsing asset bubbles should well exceed the target if the country in
question were pursuing an inflation targeting.
The central bank pursuing such a strategy would have to be fully convinced, substantiated
by quantitative analyses, and strongly concerned about the risk of deflation a few years into
the future. Without such a superb insight, it would be hardly possible for a central bank to
abandon a price target, explicit or implicit, at a stage when deflation is yet a remote potential
risk.
9. Economic predictions are inevitably clouded by uncertainties. What makes economic reading
in the post-bubble period uniquely difficult is the great uncertainties associated with the asset
market developments.
First, we cannot be sure how the asset markets will develop and where an equilibrium with
the real economy will be restored. In addition, different asset segments can show divergent
price patterns, as was the case in Japan's stock and real estate markets in 1990. Such
divergence can emerge at an early stage when bubble-day inertia of wishful thinking lingers
with the confusing effects on expectations. Thus the possible size of capital loss and its harm
on the financial health of businesses and households is extremely difficult to estimate.
10. Second, uncertainty also exists in the transmission mechanism between asset prices and
real activity and inflation. In an economy like Japan where banks dominate financial
intermediation (Chart 3), capital losses tend to gradually accumulate in the banking system.
Indeed there was a presumption that shocks would be contained within the financial sector
and would not spread to the real side of the economy. Therefore, there was a widespread
belief that the situation would turn around if business could be sustained until land prices
started to rise again. When bank capital was eroded to a critical threshold, however, an
acute credit crunch erupted. It is against such uncertain setting that economic forecasting
must incorporate the timing and magnitude of the "headwind" generated by the deteriorating
balance-sheet conditions of businesses, households and particularly banks.
Chart 3. Financial Structures
[1] Financial liabilities held by non-financial corporations (ratio to total financial liabilities)
[2] Financial assets held by households (ratio to total financial assets)
Notes: 1. Figures are those for the end of 1999.
2. Regarding financial debt for enterprises, stocks are evaluated at the market
value, and, thus, do not necessarily correspond to the accumulated funding by
enterprises. It should be noted that U. S. for equities are likely to be higher,
compared to those for other countries, because it includes net worth of sole
proprietorships as households' equities.
Source: Bank of Japan, Research and Statistics Department, "Japan's Financial Structure: In
View of the Flow of Funds Accounts," Quarterly Bulletin, 9 (1), Public Relations
Department, Bank of Japan, 2001, pp.105-142.
11. Let me turn to the second aspect namely the effectiveness of a hypothetical early easing.
Some simulation results indicate that such a policy would have elevated the inflation rate to a
level that would work as a comfortable cushion against future deflation (Chart 4).
Chart 4. Simulation of Hypothetical Early Monetary Easing
Sources: Alan Aherne, et al. "Preventing Deflation: Lessons from Japan's Experience in the
1990s," International Discussion Paper No. 729, Board of Governors of the Federal
Reserve System, 2002, Exhibit IV.2.
An important point here is what lies at the root of the predicament of Japan's economy and
financial system. Admittedly, under the non-negativity constraint of nominal interest rates,
real rates will be pushed up by the extent of deflation, even though deflation itself is rather
limited at less than 1 percent a year in Japan now. However, as suggested by Chart 5, asset
price deflation, which has been continuous for ten years at an annual rate of close to 10
percent, has likely exerted far greater pressure on activity than slightly positive real interest
rates.
Chart 5. Asset Price Deflation
Sources: Bank of Japan, Financial and Economic Statistics
Monthly; Ministry of Public Management, Home
Affairs, Posts and Telecommunications, Consumer
Price Index; Japan Real Estate Institute, Urban Land
Price Index.
12. The question from my perspective is: could an aggressive easing have significantly
moderated the fall of real estate price and therefore the balance sheet problem? Generally
speaking, significantly lower interest rates should be conducive to tighter output gap, higher
inflation and, when asset market is falling, moderation of asset price decline. Would such
results be achieved by aggressive easing in the aftermath of an asset bubble? I am
skeptical.
We have witnessed time and again that, after an asset inflation has developed into a major
bubble, it is impossible to "soft land" the market. If that is the case, and if the asset market in
question has traditionally served as a sort of anchor for financial stability, like the case with
the real estate in Japan, the capacity of monetary policy to stimulate demand and inflation is
bound to be severely impaired. Even if such strategy had proved to be successful, it would
only have delayed the inevitable adjustment between the asset prices and economic
fundamentals.
13. If central bank's predicting ability of post-bubble developments has to remain less than
perfect, would it better once again to consider aggressive tightening when a bubble is
perceived to be growing? This is the question I talked about three years ago here. I remain
skeptical as I was. However given the fact it is always the preceding massive flows of credit
that become worthless once the tide is reversed, leaving severe damages on the balance
sheets of parties concerned, it might be worth considering possible ways to focus on
restraining "excessive" credit flows during asset market upswings (See Chart 6 for the
development of credit and asset prices in Japan).
Chart 6. Credits and Asset Prices in Japan
Notes: Real aggregate asset price indices are a weighted average of equity and
residential and commercial estate price indices deflated by consumer prices.
The weights are based on the composition of private sector wealth.
Sources: Bank for International Settlements, Quarterly Review, International Banking
and Financial Market Developments, August 1999
14. Let me conclude by adding a few observations in somewhat broader context. It is ironic that,
as the track record shows (Chart 1, Chart 2), the Bank of Japan followed a path in the 1980s
and early 1990s that could be regarded as fully consistent with some policy rule such as
Taylor rule, and yet suffered from the wildest swings of asset markets. Suggestions have
been made that the Bank should have deviated from such implicit rule-based path both in
times of upswing as well as downswing. From my perspective, for discussions on policy rules
to be more relevant and robust, they should at least take into account major swings of asset
prices. Our experience shows that price stability, by making low interest rate possible, can
pave a way to a major asset price bubble when it is coupled with excessive optimism for the
future.
15. Finally, what matters most in the post-bubble development is the magnitude of the lost
capital and its distribution ie who in the system has to absorb the loss. In Japan, that
magnitude has been overwhelming and has concentrated in the banking sector.
When an economy is faced with the size of lost capital as Japan was, well-functioning
financial infrastructure is crucially important for its prompt resolution. Infrastructure in this
context includes proper accounting, disclosure, disciplined governance, incentive
mechanism and supervision. Japan was slow developing and putting in place such
framework.
I emphasize this aspect because, if expeditious and forceful progress had been made to deal
with the capital loss in general and that of banking system in particular, monetary policy in
Japan might have found different environment to operate. Amid a major shock such as the
collapse of key asset prices, a need to address the nexus of monetary and prudential
policies can't be overemphasized.