Toshihiko Fukui: Challenges for monetary policy in Japan
Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Spring Meeting of the Japan
Society of Monetary Economics, on the occasion of its 60th anniversary, Tokyo, 1 June 2003.
* * *
Introduction
I am honored to have this opportunity today to address such a distinguished audience. Members of
this esteemed society are generous enough to provide us at the Bank with their opinions and the fruits
of their researches, which we in our turn take into consideration when we examine our policy
measures from all angles. I should like, therefore, at the outset of this speech, to express my sincere
gratitude to all of you for continuing to stimulate the intellectual debate in this way.
The society and the Bank have a long history of good communication, as indeed is recorded in our
Archive, and the first example of this was a speech given by Keizo Shibusawa, then Deputy Governor
of the Bank, at the inaugural meeting of the society in June 1943. The meeting was held incidentally a
year after the Bank of Japan Law of 1942, modeled on the law governing the Reichsbank, the then
central bank of Germany, became effective under wartime legislation. In his speech, Deputy Governor
Shibusawa emphasized the principle of maintaining the value of the currency when formulating
monetary policy, stating that, although the demands on policy of a given time or situation may exert
some influence, the fundamentals of this principle do not change. While I can only guess what was
actually in Deputy Governor Shibusawa's mind at the time he made this statement, my own
understanding is that, at a time when the war was producing upheaval in both the economic and the
financial environment, he wished to remind his listeners of the importance of orthodox central banking.
At the same time, I believe he wished to convey his sincere hope that the society's members would
continue to analyze the fundamentals of the currency system, making full use of their expertise.
Another example may be found in a speech given at the 40th anniversary meeting of the society in
1983, when the Japanese economy was at the peak of its postwar prosperity. Discussing the mandate
of the Bank of Japan, Governor Haruo Mayekawa stated that, in conducting monetary policy, the
highest priority should naturally be placed upon the stability of prices. He concluded his speech by
observing that the formulation and execution of successful policy could only be achieved if the policy
measures employed had a solid theoretical foundation.
Ten years ago in June, I was, as an Executive Director of the Bank, invited to the 50th anniversary
meeting of the society and presented a speech titled "Missions and Responsibilities of a Central Bank
in a Contemporary Context." At that time, the economy was deteriorating following the bursting of the
asset price bubble, and looking back, as I prepared my speech for today's occasion, at the path
trodden by Japan's economy over the last decade, I was impressed by the fact that the surrounding
environment has become much more severe, although the basic mandate of the central bank, to
maintain the stability of prices, has not changed in the least.
Even if we restrict our attention to the area of monetary policy, there have undoubtedly been a number
of changes worthy of note.
The first and most important of these is the change that has taken place in the financial environment,
and here the substantial decline in interest rates is most notable.
In fact, the level of interest rates was already low a decade ago, as the economy continued to
deteriorate following the bursting of the asset price bubble, and weak balance sheets in both the
corporate and financial sectors suggested that deep adjustments were inevitable. In these
circumstances, the Bank took a series of monetary easing measures, and the official discount rate had
declined to the then unprecedented level of 1.75 percent by the end of 1993. The same period saw a
moderate decline in the overnight call rate to the range of 2.0-2.5 percent from 3.5-4.0 percent.
At that time an official discount rate of 1.75 percent was considered extremely low and was indeed the
lowest level of this rate since the Bank began operation in 1882, a period that included the financial
crisis of 1927 and the fiscal expansion policy adopted by Finance Minister Korekiyo Takahashi in the
1930s. In retrospect, however, there was an enviable amount of room left for interest rate reductions,
and hence interest rates were useful as policy tools.
Recently, in contrast, not only the overnight call rate but almost all money market rates have declined
to a level close to zero percent. Moreover, since spring 2001, the Bank has moved into territory
unexplored by any central bank in history by implementing quantitative easing with interest rates
already at the zero bound.
I stated at my inaugural press conference that a central bank conducting monetary policy with very
little room left for interest rate reductions is like a boxer fighting with his hands tied behind his back.
Even with our hands tied, we at the Bank have not given up fighting and are indeed doing the best we
can. It was, however, beyond anyone's imagination in 1993 that the Bank would be fighting against
deflation under such a constraint.
The second major change concerns the revision of the Bank of Japan Law.
A sense that the previous Bank of Japan Law was not quite in tune with the current of change
characterizing the world's central banking systems and financial markets would no doubt have already
existed in 1993, but this had not yet advanced to the stage of making specific proposals for revisions
to the Law. The situation changed rapidly, and four years later, in 1997, the revised Bank of Japan
Law was enacted, and has been in effect since April 1998.
The focus of the revision has been greater independence for the Bank in conducting its monetary
policy and calls for improved transparency. This in its turn has led to a significant reorganization of the
Policy Board, through which the Bank makes monetary policy decisions independently, and the Bank
marked a new start with a completely new governing structure.
The transparency of the Bank's policy conduct was also improved by the publication of the minutes of
every Monetary Policy Meeting (MPM) of the Bank's Policy Board. Any visitor to the Bank's Web site
can see that, in addition to the minutes, a significant amount of information is being released including
reports of the Governor's press conferences, texts of speeches given by senior officials, and an
abundance of research materials detailing the background to policy decisions.
The third and the most recent change concerns the increasing global interest in monetary policy within
economies suffering from deflationary trends.
In 1993, in spite of the similar background situation, that is, strong downside risks to the world
economy and consistently falling inflation rates, there seemed to be no particular concern anywhere in
the world about the decline in inflation rates per se. A quick check of the keywords appearing in
articles in major newspapers at that time reveals that people's attention was overwhelmingly focused
on inflation rather than deflation.
Recently, however, as disinflation has progressed, interest rates have fallen across the world. An
international comparison of the levels of money market rates reveals several countries whose current
rates lie within the 0-1.0 percent bracket, in particular Switzerland at 0.2 percent and Singapore at
0.5-0.6 percent. In the United States, the policy interest rate currently stands at 1.25 percent, which, if
we make a direct comparison, is the level seen in Japan at the beginning of 1995. An increasing
number of people are now interested in deflation.
Looking back at developments over the last decade, I have been struck anew by how immensely
important it is for the central bank to gain reliable insights into the outlook for the economy. At the
same time, we clearly cannot be too surprised at the fact that, with the passage of time, changes have
taken place in the debate surrounding monetary policy.
We at the central bank must continue to make efforts to gain new insights and learn from new ideas,
while not allowing ourselves to fall captive to whatever mindset is dominant at a particular point in
time. I feel acutely the importance of further interaction with the academic world, because cutting-edge
research on financial and economic theory is fundamental to our efforts.
Since I assumed the office of Governor in March this year, and indeed before, I have had the
opportunity to listen to a wide range of advice, and have learnt much from opinions voiced about the
Bank and forwarded to me not only from members of the society but also from other academics both
at home and abroad. At the same time, I am afraid that I must admit to feeling a certain degree of
frustration, in the light of my long years of experience as a central banker, as I listen to some of the
opinions. I cannot help but feel that there is still significant progress to be made in establishing a
creative process whereby the Bank first provides academics with sufficient information about the
issues it is facing, and then works together with them based on the same information in its search for
fresh policy solutions.
We are fortunate to have among the current nine members of the Policy Board three members who
have spent a number of years in senior academic positions. In addition, there are an increasing
number of former Bank staff currently working at academic institutions and devoting their efforts to
bridging the gap between theory and practical policy. With their help, we expect to be able to extend
our links with the academic world, thus not only gaining the benefit of academics' advice but also
contributing to their research by sharing our practical experiences.
This has been a somewhat protracted introduction. My aim today, however, is to share with you, as
frankly as possible, my own current thinking with regard to the conduct of monetary policy, which I
hope will be of interest to you. I hope also that my remarks will play a part in further strengthening the
constructive relationship that already exists between academics and the central bank.
I. Functions of the quantitative easing framework
First, I would like to briefly explain the basic framework underlying current monetary policy and to
describe how monetary policy measures have been implemented within this framework.
The current framework we are adopting is called quantitative easing and was introduced on March 19,
2001. It has three main features. I will explain the implications of each point in as contemporary a
context as possible.
A. Adoption of quantitative indicators in money market operations
The first feature of the quantitative easing framework is the change in the operating target for money
market operations from the uncollateralized overnight call rate to the outstanding balance of current
account deposits at the Bank. Whether it is possible to enhance monetary easing effects even after
short-term interest rates reach the zero bound is a major issue that continues to attract debate. Still, it
was quite natural for a central bank to pay attention to the amount of liquidity provision and expect
effects from a further increase in liquidity provision even when short-term interest rates had fallen to
zero percent, or rather for the very reason that they had reached this zero bound.
When the quantitative easing framework was introduced in March 2001, the target for the outstanding
balance of current account deposits at the Bank was 5 trillion yen, which exceeded the total reserve
requirement at the time by slightly less than 1 trillion yen. When I took office as Governor, the target
range for the outstanding balance had already been set at "around 17 to 22 trillion yen," and the Bank
has since steadily raised it. At the MPM on April 30, the Bank raised the range by 5 trillion yen to
"around 22 to 27 trillion yen," and then again to "around 27 to 30 trillion yen" at the MPM on May 20.
As a result, the outstanding balance has increased sixfold over the course of the last two years. The
Bank's repeated raising of the target for the outstanding balance was decided in view of the economic
outlook and the financial market situation. As mentioned in the Bank's "Outlook and Risk Assessment
of the Economy and Prices," released in April, monetary easing measures have effectively blocked the
channels through which various shocks induce liquidity concerns, and have thereby secured financial
market stability, helping to prevent the economy from falling into a deflationary spiral.
On the other hand, it should also be pointed out that, even though the outstanding balance of current
account deposits has increased considerably since the introduction of the quantitative easing
framework, the Bank's drastic quantitative easing has not been quite strong enough by itself to boost
the economy and prices. Why is this so?
It may have been because the adjustment pressure on the economy was, and is, still quite strong.
However, one of the effects expected from the introduction of quantitative easing was the so-called
"portfolio rebalancing effect." The Bank thought that, even when the marginal value of liquidity services
became zero, people would start to rebalance their portfolios by investing in assets with higher
marginal values whether these were real or financial assets, if the Bank increased further its provision
of liquidity. The aim of this process was thus to generate positive economic momentum, acting, for
example, to push up asset prices. So far, however, the effect has not been widely observed.
It might also be fair to touch upon the issue of the decline in the functioning of financial markets,
especially the money market, since the introduction of the quantitative easing framework. With zero
interest rates, money market participants have been less willing to invest their funds in the market,
because returns from such transactions have not been sufficient to cover their trading costs. Due to
the Bank's ample provision of liquidity, there has been a sharp decrease in trading volume among
market participants, with the exception of trading carried out with the Bank. As a result, more market
participants have become concerned about whether they will be able to raise funds in the market
smoothly in the future even if they offer higher interest rates.
Ironically, the decline in the functioning of the money market has increased the precautionary demand
of financial institutions for increased current account deposits at the Bank. At the time of the
introduction of the quantitative easing framework, there were doubts about whether the Bank would be
able to provide sufficient liquidity to achieve its target for the outstanding balance. In fact there were
frequent cases of undersubscription, where bids fall short of the Bank's offers, in the Bank's
fundssupplying operations. However, such undersubscription has not occurred recently, and the Bank has
been able to push through substantial increases in its target for the outstanding balance of current
account deposits. The more the Bank proceeds with monetary easing to secure financial market
stability, the more demand for current account deposits increases due to the impaired functioning of
the market. As a result, the Bank will have to meet this increased liquidity demand in order to secure
market stability. This is the dilemma the Bank currently faces.
All drastic policy measures have negative side effects. The fundamental issue, therefore, is not
whether such side effects exist; rather, it is how to make effective use of the stimulative effects of
quantitative easing measures on the economy and prices, while giving due consideration to the
possible emergence of excessive side effects. Before we move on to deal with this point in more
depth, I would like to comment on the remaining two features of the quantitative easing framework.
B. Increasing the Bank's outright purchases of Japanese government bonds (JGBs)
The second feature of the quantitative easing framework is the decision to increase the Bank's outright
purchases of JGBs when this is deemed necessary for the smooth provision of funds to meet the
target balance of current account deposits at the Bank. At the same time, there is a ceiling on the
Bank's outright purchases of JGBs which prevents the amount of JGBs held by the Bank from
exceeding the outstanding amount of banknotes issued.
With interest rates on financing bills (FBs) and treasury bills (TBs) close to zero, there emerged a
situation for holders of FBs and TBs similar to holding the equivalent amount of current account
deposits at the Bank. For this reason, it is likely that the demand for holding current account deposits
by selling FBs and TBs will become saturated. Realizing this, the Bank decided to secure smooth
provision of liquidity by purchasing JGBs. The effect of these increased purchases of JGBs has been
to raise total purchases by the Bank to 1.2 trillion yen per month, up from 400 billion yen until March
2001. As a result, the outstanding amount of JGBs purchased by the Bank is at present equivalent to
roughly 60 percent of the monetary base.
The Bank's purchases of JGBs have indeed contributed to the smooth implementation of quantitative
easing. However, as long-term interest rates have been declining, even JGBs have almost become
substitutes for current account deposits at the Bank. At present, ten-year JGBs have fallen to slightly
above 0.5 percent and even 30-year JGBs are below 1.0 percent. The average maturity of newly
issued JGBs in Japan is currently about five years. The fact that yields on five-year JGBs are in the
range of 0.1 to 0.2 percent indicates that the government has already been raising funds at an interest
rate of virtually zero percent. Thus, the Bank's execution of a market operation that involves
exchanging JGBs for current account deposits at the Bank is becoming equivalent to exchanging ten
1,000 yen notes for one 10,000 yen note.
In opposition to this view, there is an argument that, as long as long-term interest rates are not in fact
zero percent, there is still a difference between current account deposits at the Bank and JGBs. The
corollary is that market operations involving the exchange of JGBs for current account deposits are
indeed meaningful, and a massive large-scale purchase of JGBs by the Bank would be effective.
There is also an argument that it is inappropriate to allow long-term interest rates to decline any closer
to zero percent. According to this view, the Bank should enhance the effects of quantitative easing not
merely by increasing quantity but also by introducing qualitative improvement of quantitative easing
measures through the purchase of other types of assets.
C. Policy commitment based on the consumer price index (CPI)
The third feature of the quantitative easing framework is the Bank's explicit commitment based on the
year-on-year growth rate of the CPI: namely that the Bank will maintain the current framework for
money market operations until the CPI (excluding fresh food, on a nationwide basis) records a
yearon-year increase of zero percent or more on a sustainable basis.
The idea of the first feature, as I have already explained, is to achieve further increases in the Bank's
provision of liquidity even after short-term interest rates have reached the zero bound. The idea of the
third feature is to achieve an easing effect by the Bank's commitment to keep short-term rates at low
levels well into the future. In this way, even if short-term rates come up against the lower bound, the
Bank can still "borrow" from the effect of the future low rates. Thus, the fundamental aim of the third
feature is to lower longer-term interest rates across the board by "borrowing" future monetary easing
through the commitment.
This policy commitment shows the Bank's determination to put a stop to price declines by binding
future monetary policy to the actual inflation rate. However, this should not be misunderstood as
inflation targeting. I am fully aware of views that the Bank should adopt inflation targeting instead of
the current commitment. However, it should be noted that, in a sense, this commitment has significant
implications that go beyond those of standard inflation targeting.
In a standard inflation targeting regime, a central bank raises the policy interest rate when the
expected inflation rate rises above the target inflation rate, even if the actual inflation rate is
considerably below the target inflation rate. Given that people's expectations regarding the inflation
rate vary greatly, it may be inevitable that even a slight change in prices triggers speculations at a very
early stage about future monetary policy.
In contrast, the Bank's policy commitment states that the Bank will continue to implement drastic
quantitative easing until the year-on-year change in the CPI, that is, the change in actual prices,
becomes positive. In other words, this policy commitment means that, unless year-on-year changes in
the CPI become positive on a sustainable basis, the Bank will continue to implement drastic monetary
easing measures even after the economy has started to improve and inflationary expectations are
emerging. This is thus an extremely strong policy commitment through which the Bank is implicitly
"borrowing" from the effects of future monetary easing.
The Bank's strong policy commitment, which has "borrowed" the effects of low future interest rates and
kept long-term interest rates stable at low levels, can be said to have succeeded in keeping real
interest rates low enough to prevent the economy, which has been suffering from deflation, from falling
into a deflationary spiral. However, the potential growth rate of the economy and the marginal
productivity of capital have declined, causing firms to revise downward their forecasts for the GDP
growth rate and remain cautious in investing. In accordance with the relationship between the natural
and market interest rates defined by Knut Wicksell, while the natural interest rate has been quite low,
the market interest rate has continued to be high relative to the natural interest rate, and thus seems to
have failed to boost economic activity.
Thus, there still remain many issues that must be resolved for the current framework of quantitative
easing to become more effective. It is also true, as I mentioned earlier, that monetary easing
measures have effectively blocked the channels through which various shocks induce liquidity
concerns, and have thereby secured financial market stability, contributing to preventing the economy
from falling into a deflationary spiral. The effects of quantitative easing measures should therefore not
be underestimated. In 1997-98, the financial crisis in Asia and the failure of a few large Japanese
financial institutions triggered concerns among financial institutions about the availability of liquidity,
and as a result, there was a sharp credit contraction and the economy deteriorated rapidly. In contrast,
although there have been factors causing uncertainty about the Japanese financial system, such as
the terrorist attacks in the United States, the military action against Iraq, and the decline in Japanese
stock prices, credit contraction stemming from liquidity concerns has not occurred since the
introduction of the quantitative easing framework. And thus, any deterioration of the economy that
such a contraction might have caused has been avoided.
As described above, even after short-term interest rates had reached the zero bound, the Bank did not
throw up its hands in defeat but rather continued to make efforts by providing ample liquidity and
"borrowing" from the effects of future monetary easing.
At present, Japanese financial institutions are still in the process of improving their soundness, and
with the globalization of the economy, progress in IT, an extremely rapidly aging society, and an
equally rapidly declining birthrate, the economy faces major structural changes. The people of the
entire country are struggling to find ways to overcome the difficulties in this unprecedented process of
transition. In such a situation, it is natural for the public to have high expectations of the country's
central bank. In order to meet these expectations, I am adamant in my determination to duck no
challenges, but to put all my knowledge and experience into overcoming these difficulties.
II. Issues on further improvements in monetary policy
In order to further improve monetary policy, I think it is important to address various issues related to
monetary policy and to discuss them thoroughly. Some of these issues may fall within the scope of
conventional economic analysis and may thus be dealt with using the appropriate analytical tools.
Other issues, such as defining the purview of the central bank and addressing its position within a
democratic society, may however fall outside the scope of conventional economic analysis.
Keeping these points in mind, I would like to elaborate in what follows on some issues which need to
be clarified with regard to the Bank's efforts to improve the current quantitative easing framework.
Currently, a variety of views are held by people outside the Bank requesting further monetary easing
measures. Some of these views are as follows. One view holds that, if the effect of the quantitative
easing on the economy and prices is not fairly strong, the Bank should increase the provision of
liquidity significantly. This view recommends that, in doing so, the Bank consider the option of
purchasing financial assets whose risk profiles differ from JGBs, and which are not, under normal
circumstances, the object of central bank purchases. Another view proposes that the Bank seek to
exert stronger pressure on public expectations by fundamentally changing the structure of its current
policy commitments.
A. Changes in the structure of policy commitments
I would like to start this section by discussing possible changes in the structure of the Bank's policy
commitments. Here, clearly, the focus of attention must be whether to adopt inflation targeting.
As I have already mentioned, by comparison with current policy commitments, one of the problems of
adopting inflation targeting is as follows. Assuming that a target has been established (for example, at
2 percent), if the expected inflation rate rises above the target and the Bank does not start tightening
at that early stage, the actual inflation rate is likely to go beyond the target. Since the Bank's current
policy commitments do not assume such a tightening at an early stage, they actually run a risk in the
direction of greater inflation than in the case of standard inflation targeting. Therefore, the following
issues become very important: whether it is truly desirable at this particular juncture to exchange the
current policy commitment for one that might require an earlier and more forceful tightening of
monetary policy by setting a target; or whether the Bank should allow a temporary overshooting of the
inflation rate; and in either situation, how the Bank would be able to restabilize the expected inflation
rate.
When setting an inflation target, either as a certain range or a level of the inflation rate, the Bank
would aim to achieve this target within a specified period, although there would be allowance for some
slippage. Clearly a prerequisite for such a policy to be convincing to the public is that the Bank is at
least reasonably, if not absolutely, confident that it has at its disposal the policy tools necessary to
achieve its goal. In this regard, there are those who maintain that the Bank need only boldly commit
itself to taking any unconventional policy measures necessary to achieve the inflation target. Indeed,
some economists seem to have formed a critical view that it is the Bank's own skepticism about the
effectiveness of its monetary policy which is preventing it from hammering out a more forceful
commitment and from having a more potent influence on the public's expectations.
However, having had their expectations that the economy would return to a sustainable growth path
left unfulfilled so often since the bursting of the asset price bubble, people in Japan are not so naive as
to trust unconditionally the mere announcement of an inflation targeting policy by the Bank; nor indeed
would the rest of the economy respond by taking an immediate turn for the better. Unless Japan's
economy benefits from positive external factors such as a surge in foreign demand, a policy
announcement by the Bank aimed at influencing public expectations will become effective only after
the Bank has successfully demonstrated that an effective transmission mechanism exists between the
Bank's policy and an actual stimulative effect on economic growth. Therefore, it is important for the
Bank not only to pursue further monetary easing, but also to devise and implement a variety of policy
measures which contribute directly to improving the transmission mechanism.
The Bank is fully aware that inflation targeting enjoys relatively wide support among academics, and
that many central banks have adopted inflation targets of one kind or another. It has become one of
the important policy tools for central banks to enhance transparency. In that sense, I have no intention
of flatly denying the concept behind the policy measures related to inflation targeting. I would like to
examine, in the process of reviewing how to make full use of the monetary easing policy in the future,
whether we can reorganize the policy framework of the Bank, and whether there will be any room for
introducing such a tool as inflation targeting within that framework. I cannot predict honestly what
results will be produced by this wide-ranging discussion, or when.
B. Additional measures to encourage the effects of monetary easing to permeate
through the economy
The fundamental policy issue confronting the Bank is what exactly it can and should do in order to
encourage the effects of monetary easing to permeate through the economy.
The Bank's quantitative easing policy, by providing ample liquidity in the form of the current account
balance at the Bank, aims at improving the overall financial environment for firms and households, and
thus at stimulating the economy. If the current quantitative easing does not have a strong effect on the
economy, this can be interpreted as follows. The transmission mechanism between the Bank's ample
provision of liquidity and the stimulative effect on firms and households is not functioning properly. To
put it another way, the liquidity provided by the Bank is circulating within the financial sector and not
flowing out of it, or the stimulative effect of low interest rates is not working in such a way as to
permeate through the economy.
This phenomenon of a choked or blocked channel in financing is closely related to the fact that the
financial institutions' credit intermediary function is deteriorating due to the nonperforming-loan
problem. The most important issue in making the effects of the monetary easing permeate through the
economy is to actively support financial institutions' efforts to reestablish their soundness. At the same
time, the Bank believes it is necessary also to apply itself on a second, parallel policy front, exercising
its ingenuity in devising its own measures in the area of money market operations and corporate
financing.
As you are all aware, at the MPM held in early April 2003 the Bank decided to start examining a new
scheme to promote smooth corporate financing by nurturing the asset-backed securities (ABSs)
market. The Bank's initiative in this regard is unprecedented in the sense that it will be purchasing
ABSs, which are private debts, outright and thus stepping into the realm of credit risk. ABSs possess a
number of advantageous characteristics. By pooling risks, they act to reduce the overall level of credit
risk, relative to the sum of the individual risks. In addition, by restructuring the overall risk into multiple
layers representing different degrees of risk, they can also attract investors who have a variety of
different risk preferences.
Indeed, the rationale behind the Bank's decision to examine the feasibility of ABS purchases is as
follows. Given the current situation in which financial institutions are performing their credit
intermediation function only imperfectly, if the Bank ca