Hiroshi Nakaso: The potential impact of large-scale monetary
accommodation
Remarks by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, at the Paris
Europlace Financial Forum, Tokyo, 25 November 2014.
* * *
Introduction
It is a great honor to have this opportunity to speak today before the Paris Europlace
Financial Forum.
In my remarks, after touching on the latest action taken by the Bank of Japan to expand
quantitative and qualitative monetary easing, dubbed the QQE, I would like to share my
views on the potential impact of large-scale monetary accommodation on the functioning of
financial markets, with a special focus on Japan.
Monetary policy in major economies
Let me begin with our monetary policy.
In April last year, the Bank of Japan introduced the QQE to achieve the price stability target
of 2 percent at the earliest possible time, with a time horizon of about two years. The main
objectives of the QQE have been to dispel a view that took root among people over a long
period of deflation that prices would not rise - in other words, a deflationary mindset - and to
create a situation in which households and firms behave on the assumption that prices would
moderately increase. Specifically, in terms of the policy transmission mechanism, we intend
to raise inflation expectations through a strong and clear commitment to achieve the price
stability target of 2 percent, and at the same time to exert downward pressure across the
entire yield curve through massive purchases of government bonds. As a result, real interest
rates will decline, thereby stimulating such private demand components as business fixed
investment, private consumption, and housing investment. The upward pressure on prices
will grow stronger as demand increases and the output gap narrows accordingly. Rises in
actual inflation rates will be translated into higher expected rates of inflation and thus lower
real interest rates. This will reinforce the virtuous cycle as the economy is provided with
additional stimulus.
Since its inception, the QQE has been producing the intended effects, and Japan's economy
has steadily followed a path towards the achievement of the price stability target of 2 percent.
In fact, the year-on-year rate of change in the consumer price index (CPI) excluding fresh
food, which stood at minus 0.5 percent in March 2013 immediately before introducing the
QQE, subsequently turned positive and moved up to reach above 1 percent by the end of
last year.
In recent months, however, a couple of developments on the price front have attracted our
attention. First, the decline in demand following the consumption tax hike has been
somewhat protracted in durable consumer goods including automobiles, as well as in
housing investment. Second, crude oil prices have declined substantially after the summer.
These factors have contributed to slowing the CPI inflation rates, which had hovered in the
range of 1.0-1.5 percent since the end of the last year, down to 1.0 percent in September.
Of the two factors, the temporary weakness in demand associated with the consumption tax
hike has already started to wane. Meanwhile, the decline in crude oil prices will have positive
effects on economic activity and push up prices over the longer-run. Nevertheless, given the
fact that Japan's economy is currently in a transition process of converting the deflationary
mindset, prolongation of the current downward pressure on prices, albeit temporarily, was
judged to run the risk of delaying the process. To prevent such risk from materializing and to
maintain the improving momentum of expectation formation, we decided to take preemptive
actions to expand the QQE at the Monetary Policy Meeting held on October 31 (Chart 1).
Specifically, we decided to accelerate the pace of buildup in the monetary base by about
10-20 trillion yen to "an annual increase of about 80 trillion yen." In order to carry this out,
we will increase the amount outstanding of the holdings of Japanese government bonds
(JGBs) by about 30 trillion yen to "an annual increase of about 80 trillion yen." At the same
time, we decided to extend the average remaining maturity of the JGB purchases by about
three years at maximum to "about 7-10 years." The purpose of the measures is to leave
operational flexibility to buy JGBs from across the maturity zones and thus effectively
compress the entire yield curve in line with market conditions, whereas the downward
pressure on the yield curve has been rather uneven thus far, with substantial declines in
rates on the shorter end while rates on the longer end remain relatively high. In addition, as
for exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs), the
increases in the amounts outstanding of the Bank's holdings will be tripled in both cases. The
latest decision to expand the QQE will further strengthen the policy transmission mechanism
that I mentioned at the outset. The decision is also intended to demonstrate and confirm our
strong and unequivocal commitment to achieve the price stability target.
As we just heard from Governor Noyer, the European Central Bank has stepped up its
monetary easing. And in the United States, the Federal Reserve concluded its asset
purchase program but has maintained the view that the policy rate is likely to be kept at a
near-zero level for a considerable time.
The unconventional monetary easing measures, taken by the central banks to address
unprecedented challenges facing the economies, are often said to have had unintended, and
even unfavorable, impacts on the functioning of financial markets. My quick response is that I
do not fully agree. Although I do share the views that massive monetary easing would indeed
have a considerable impact on the market and that central banks should be vigilant against
market developments, thus far serious impairment of the market function has not been
observed. In the rest of my remarks, I would like to elaborate on why I think this is the case
by focusing on three topics: "search for yield" activities, negative interest rates, and market
liquidity.
"Search for yield" activities
First I would like to address a frequently cited remark that unconventional monetary stimulus
could destabilize financial markets and the economy at large by encouraging "search for
yield" activities among investors and thus creating financial imbalances. As one of their
transmission channels, unconventional monetary policy measures including the QQE aim to
promote portfolio rebalancing by investors and thus push down the risk premium in prices of
various asset classes. In this regard, one can say that a rise in asset prices and a decline in
volatility are intended effects of the QQE.
In this context, I would stress instead that we should be mindful of the risk that "search for
yield" activities enter into a self-fulfilling cycle and destabilize the markets and the economy.
The combination of higher prices and the lower volatility of an asset induces investors to
overvalue liquidity of the asset and drive up prices. This could in turn invite another round of
investment, raising asset prices in a self-fulfilling manner. In addition, if a rise in asset prices
creates overly bullish expectations among non-financial entities such as the corporate and
household sectors, it could trigger excessive risk-taking behavior in these sectors as well.
Thus far, we have not observed signs of self-fulfilling, overheated price movements in
Japan's financial markets. This is evidenced by occasional price adjustments reflecting
factors such as geopolitical events, changes in the outlook on global economies, and policy
changes in major economies. We also regularly check, in the Financial System Report, a
"heat map" of financial activity indexes that helps us to gauge the macro conditions of
financial activity by combining a host of indicators in both the financial and non-financial
sectors (Chart 2). The indexes, with few parts in red, suggest that currently no signs of
financial imbalances are observed. Having said this, we will of course continue looking
carefully for any signs of overheating in the financial markets.
Negative interest rates
Another development attracting attention in Japan's financial markets is seen in the negative
interest rates of some financial products. The rates for treasury discount bills (T-Bills)
declined to negative territory in September and remained there for most of the time since
then (Chart 3). The payment of negative interest on securities sounds counter-intuitive and
thus may prompt concern that Japan's financial markets are suffering a serious malfunction.
If we look into the details of each transaction, however, we can see plausible reasons why
investors have accepted negative interest rates.
Let me briefly mention a few cases where investors would buy T-Bills at negative interest
rates. Commercial banks have an incentive to hold a certain amount of liquid short-term
assets for the purpose of liquidity and duration risk management. Among various types of
these assets, investors often prefer T-Bills because they are not only eligible collateral for
borrowing from the Bank of Japan but also most suitable as collateral pledged against other
money market and derivative transactions. Under the QQE, yields of liquid short-term assets
have already approached zero across the board, and therefore even a small premium added
to T-Bills could easily push their rates below zero.
Foreign investors have also played an important role in driving yen rates into negative
territory. Since the summer of 2014, U.S. dollar funding rates implied in foreign exchange
swaps have risen, as the net demand for dollars in the foreign exchange swap market has
increased (Chart 3). This means that foreign investors with dollar cash liquidity can convert
dollars into yen via a foreign exchange swap contract and borrow yen at a much cheaper
rate. Since yen money market rates are already at almost zero, the yen funding cost for
these investors would most likely turn negative. They can take advantage of the negative
funding cost by investing in T-Bills even with negative rates. This investment strategy can still
capture a reasonable margin if the yen swap costs are deeper in the negative. Market
participants attribute higher dollar premium to both demand and supply factors. On the
demand side, Japanese investors have shifted part of their portfolios into foreign
currencydenominated assets following the QQE, which has boosted demand for dollars in the foreign
exchange swap market. On the supply side, market participants point out that the lending
attitudes of dollar providers have turned less accommodative ahead of the expected initiation
of the Fed's tightening. Furthermore, not a few participants attribute this development partly
to stricter international financial regulations, but the validation of this claim requires further
exploration.
In sum, T-Bill rates have been pushed down to a negative level because they gather investor
demand for a number of technical reasons, while yen short-term interest rates have already
been as low as a near-zero level across the board. In this sense, negative interest rates
represent the very effect of powerful monetary easing under the QQE.
Market liquidity
Lastly, I would like to turn to the issue of market liquidity. As I pointed out, putting downward
pressure on the yield curve by absorbing JGBs from the market is a factor comprising the
core mechanism of the QQE. Therefore, it seems fairly natural for the QQE to have certain
impacts on price formulation and transactions in the market. Meanwhile, since the
introduction of the QQE, market participants have often raised a concern that the massive
purchase of JGBs under the QQE will impair the functioning of the JGB market. We have
been aware that such concern has mounted following the recent expansion of the QQE. In
what way should we address such concerns?
A complexity in this topic is that the term "market liquidity" could be used differently
depending on the context. Indeed, there is no established and exclusive definition of market
liquidity. However, this definition by the Bank for International Settlements appears to be
widely known and accepted: "A liquid market is a market where participants can rapidly
execute large-volume transactions with a small impact on prices."
A quick look at a few indicators along this line gives a somewhat encouraging picture of
market liquidity. Transaction volume in JGB futures has been largely unchanged since the
launch of the QQE (Chart 4). The ratio of daily price range to turnover, which approximates
the price movement per transaction during the day, has remained stable at a low level,
indicating there is just enough market liquidity (Chart 5). All in all, these indicators appear to
suggest that activity in the JGB market has not been affected significantly by the QQE.
Nonetheless, there are a number of reasons why we cannot be sanguine about the
functioning of the JGB market. For instance, our market intelligence has found episodes
suggesting signs of deterioration in the functioning of the JGB and related money markets
that were not detected from statistical data. An example is the occasional difficulty in
borrowing on-the-run JGB. Besides, not a few participants point out that the JGB market
functioning is undermined in the sense that the market has been overly focused on monetary
policy as the factor driving prices instead of the outlook for the economy and inflation, which
would otherwise be the fundamental determinant. This implies that a change in market
expectations in the future course of monetary policy could exert a stronger impact on the
markets. Although this is not an issue of market liquidity per se, it is certainly a factor that we
should take into consideration when observing market developments.
Against this background, the Bank of Japan has been engaged in intensive dialogue with a
wide range of market participants to grasp the state of market functioning. As an effort along
this line, we have just announced several initiatives to enhance this dialogue, including the
introduction of a quarterly Bond Market Survey of market participants' views on the functions
of the bond market. We intend to publish the survey results.
Concluding remarks
The pursuit of unconventional monetary actions, that are meant to be "powerful" as Governor
Noyer suggests, would inevitably boost the central bank's presence in the financial markets
and create a resulting tradeoff between the intended policy consequences and the
functioning of financial markets. To minimize the potential side effects on market functioning,
the central bank should be committed to continuous dialogue with the market, so that it can
share its views on its policy intention and its outlook for the economy and inflation, as well as
accurately grasp participants' views on market developments. The Bank of Japan has been,
and will continue to be, committed to these efforts.
Thank you very much for your kind attention.
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