Toshihiko Fukui: Central banking under globalization
Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at MAS Lecture 2007,
Monetary Authority of Singapore, Singapore, 15 November 2007.
* * *
I am very privileged to have been invited by the Monetary Authority of Singapore to deliver its
2007 lecture. I have seen the list of prominent speakers in past lectures, and I am much
honored to follow them. My topic today is the role of central banks in the context of
increasing economic globalization.
I. Progress in economic globalization
As globalization proceeds, cross-border trading of goods and services as well as funds and
financial products has been increasing. Although this trend had been underway for at least
half a century, the pace of increase seems to have accelerated in recent years.
According to research done by the International Monetary Fund (IMF), world real GDP
increased by around 50 percent over the last decade (from 1996 to 2006), indicating a high
growth rate. Over the same period, the volume of world trade almost doubled, representing a
growth rate around 30 percent faster than that of world GDP. This means that international
trade in goods and services has outperformed the expansion in the world economy. Also,
from 1994 to 2004, the growth in the global sum of overseas assets and liabilities outpaced
that of world GDP by around 50 percent, and this can be considered an indication of the
progress in financial globalization.
The rapid pace of globalization is closely related to advances in information and
communications technology (ICT) and strong growth in Asia and other emerging economies.
The progress in ICT has further eased geographical limitations on cross-border transactions
of goods, services, and financial products. Against the background of these technological
innovations, emerging economies, with their abundant supply of skilled labor, have
established their position as global production bases. In addition, emerging economies are
now regarded not only as production sites for manufacturers but also as locations for
software development centers or call centers for non-manufacturers. These economies are
now being brought into the business process of supply-chain management by many firms.
With the accumulation of purchasing power through this process, emerging economies have
also increased their presence as markets with huge potential. In the meantime, their wealth,
coupled with abundant funds accumulated in oil-producing countries, has caused a
significant increase in the international flow of funds. This has in turn promoted financial
innovation such as the introduction of sophisticated financial products and the expansion of
financial players such as managed funds.
Development of the international division of labor and progress in financial innovation have
fostered efficient allocation of resources, thereby contributing to world growth. World GDP
growth is likely to register around 5 percent this year, close to what we have been observing
since 2003.
Another feature of current world economic growth is a reduction in the amplitude of
fluctuations in the rate of growth and inflation. This is the so-called "Great Moderation," often
cited by academics and economists. The stability in the world economy and prices became
noticeable after the Second Oil Crisis. The inflation rate, in particular, has decreased
substantially since the year 2000 in terms of its average in both industrialized countries and
emerging economies, and has also been less volatile.
The current situation of the world economy, where low inflation coexists with high economic
growth, seems favorable for central banks, which aim to achieve stability in prices and in
economic activity. However, it is a regrettable truth that the job of central banks never gets
easier, only more challenging. Let me now discuss some phenomena that have brought new
challenges into being.
II. Changes in the relationship between output and prices
The first phenomenon is that the conventional wisdom regarding the relationship between
output and prices is becoming increasingly inapplicable. In technical economic terms, this
phenomenon could be described as a "flattening of the Phillips curve," and there is
uncertainty about how flat the curve has actually become, how long this situation will
continue, and whether the relationship will eventually return to its previous state.
This phenomenon has been observed in many industrialized countries, and I would like to
outline the situation in Japan as an example.
After hitting bottom in 2002, the Japanese economy entered the phase of recovery,
supported by strong external demand due to the expansion of overseas economies. In recent
years, the annual growth rate has been around 2 percent, slightly higher than the economy's
potential growth rate, and resource utilization, namely in labor and production capacity, has
been increasing. However, upward pressure on prices has yet to rise markedly. The
year-onyear rate of change in the consumer price index (CPI, excluding fresh food) was negative
from fiscal 1998 through fiscal 2004, and has since been around 0 percent.
I think this situation, where prices do not rise despite the steady growth of the economy, is in
part due to changes in the environment surrounding prices and wages amid the progress of
globalization. Products made in Japan have been facing fierce competition from products
imported from emerging economies. In the meantime, Japanese workers have been
experiencing increased competition from their counterparts in emerging economies through
growth in imports and direct investment. In the face of greater exposure to global competition
and capital market discipline, Japanese firms have continued to restrain labor costs to
increase corporate value, even under tighter labor market conditions. Meanwhile, employees
in most cases still prefer stable employment over wage increases because of their past
experience of a severe employment situation. To put it simply, prices are becoming more
susceptible to global factors, while the sensitivity of prices to the state of the domestic
economy has been declining.
With these changes in the environment surrounding prices, the conduct of monetary policy
has become increasingly difficult. In general, interest rate policy affects economic activity first
and then influences prices through changes in resource utilization. As the relationship
between output and prices has changed and the conventional wisdom no longer applies, it is
becoming more difficult for central banks to envisage how much change in the interest rate
will be needed to bring about a desired change in the inflation rate.
Since March last year, when the Bank of Japan terminated the quantitative easing policy and
reinstated an interest rate regime, we have raised the policy rate at a moderate pace, even
though the year-on-year rate of change in the CPI has remained stable at around 0 percent.
A factor behind this conduct of monetary policy is the changes in the relationship between
economic activity and prices I have just discussed. With these changes, the pace of growth
in Japan's economy needed to raise the inflation rate in a short period of time would have to
be quite high. In addition, significant uncertainty remains as to the exact rate of growth that
would be desirable. Monetary policy aimed at such a high level of growth in the economy
could bring about larger swings in the economy and risk the sustainability of the economic
expansion. The alternative, safer and more prudent route is to focus on securing sustained
economic growth and minimizing swings, generating a gradual rise in the inflation rate.
In the NIEs and ASEAN economies, reductions in both the rate of inflation and its amplitude
of fluctuations have also been observed. Given the relative openness of their economies and
their geographical proximity to the fast-growing Chinese economy, the NIEs and ASEAN
economies seem to have been significantly influenced by ongoing globalization. Of course,
the attainment of price stability is a major achievement of monetary policy conducted by
central banks in these economies with their main focus on prices since the Asian currency
crises, and this has greatly contributed to the growth and stability of the global economy.
If I may add, prices of international commodities such as crude oil have recently risen
substantially despite the stability in prices on a global basis. This will inevitably impair terms
of trade for oil-consuming countries, but what is important, in terms of the price situation, is
its influence on inflation expectations. There is a risk of a rise in inflation expectations in the
longer term under tight demand and supply conditions given that recent rises in commodity
prices are due in part to continued high growth in the world economy, especially in emerging
economies. This implies that the Phillips curve may shift upward. Although inflation
expectations so far seem generally contained in many countries, appropriate monetary policy
designed to achieve price stability and sustained economic growth is becoming increasingly
important.
III. The conduct of monetary policy from a medium- to long-term perspective
Next, I would like to take up the recent disruptions in global financial markets stemming from
the subprime mortgage problem in the United States. Although recent events could be
considered from various points of view, I think they were intimately related to the benign
conditions of the world economy and financial markets that continued for many years under
economic globalization, as I have just described. The crux of the problem, as I understand it,
is that risk evaluation had become too lax under those benign conditions and this has led to a
correction through market forces.
If we look back historically, we can see many cases where excessive financial and economic
activities continued for a certain period based on optimistic profit assumptions, and
eventually resulted in large fluctuations in economic activity and prices or in financial crises
through a later reaction. The Great Depression of the 1930s, Japan's asset price bubble in
the 1980s, the Asian currency crisis in the late 1990s, and the IT bubble of the early 2000s
are examples. The common feature shared by all of these was that imbalances in the
economy and prices had grown under seemingly favorable and stable conditions in the
economy and prices.
If expectations take hold that a low interest rate environment will continue indefinitely, the
rate for discounting expected future returns in the determination of asset prices will be likely
to decline, bringing about a rise in asset prices. A similar situation could also come about as
a result of optimistic assumptions about profits when an economy has enjoyed continuous
high growth for a considerable time. For example, there was the rise of influential concepts
such as "transformation to domestically led economic growth" in Japan during the 1980s and
the "Asian miracle" in the 1990s prior to the Asian currency crisis. These concepts led
economic agents to lower their awareness of risks and to overestimate their future
profitability.
Given these dangers, it has become more important for us to respond to risks that may bring
about larger swings in economic activity and prices in the longer run, since central banks
have a mission to conduct monetary policy to achieve price stability in the medium to long
term. To be more specific, it is essential to carry out careful assessment of risks that may be
relatively unlikely to materialize but, if they did, would have a large impact on the economy
and prices, such as an asset price bubble. It is also essential to assess financial conditions
and inflation expectations that may influence the economy and prices in the medium to long
term.
I think such awareness is shared by most central banks, but policy frameworks differ on how
to incorporate this in the actual conduct of monetary policy.
In the case of the Bank of Japan, the current monetary policy framework was introduced
when the quantitative easing policy framework was terminated last year. Under the new
framework, (1) we examine the most likely outlook for economic activity and prices for one to
two years ahead, and (2) we assess risks considered most relevant to the conduct of
monetary policy from a longer-term perspective.
The recent disruptions in global financial markets seem to show that under the continuing
favorable conditions of healthy world growth and low inflation, financial imbalances can
accumulate, which will be followed by corrections, posing a risk to economic stability. In more
general terms, recent events could be regarded as a reminder of the importance of progress
in which financial and economic activities remain in harmony. Recent events have
strengthened my belief that it is important for a central bank to assess various factors that
may have negative consequences for the situation of the economy and prices in the medium
to long term.
IV. Market stabilization and central bank activities
Central banks can also learn a lesson from the recent market disruptions from a rather
different standpoint. It is a central bank's role to stabilize the market when it is under
pressure. The recent market disruptions occurred when there were growing uncertainties
about the location of risks due to the complexity of the international flow of funds under
economic globalization. Risks have been dispersed and re-accumulated in various markets
through the medium of advanced financial products whose risks are not easy to evaluate. At
the same time, given the wide range of financial players, including hedge funds and private
equity funds, the identity of risk-taking parties and the scale of risks have become blurred,
masking the nature of the risks the financial system is exposed to.
The problem stemming from the rise in housing mortgage loan delinquencies has crossed
the Atlantic to the European markets through a decline in the credit ratings of securitized
products such as asset-backed commercial paper (ABCP) with mortgage loans as collateral.
With uncertainty regarding the location and the scale of risks, the functioning of credit
markets including securitized markets has deteriorated overall. Conditions in money markets
in the United States and European countries turned volatile because of increased
counterparty risks among financial institutions, and central banks have aggressively supplied
funds to these markets.
The Japanese money market, however, has been generally calm, with our policy interest
rate, the overnight call rate, remaining close to our target level. The most significant factor
that kept the Japanese money market stable was the limited exposure of Japanese financial
institutions to subprime mortgage-related products. The stability could also be attributed to
the ability of the Bank to accurately grasp financial market situations and perform money
market operations, developed through a variety of past experiences including financial crisis.
To be more specific, the following seem to have contributed: (1) an accurate grasp of the
money market conditions through daily monitoring of transactions by market participants; (2)
disclosure of information concerning money market operations through, for example, daily
release of shortage and surplus of funds in the money market, both projections and actual
results; and (3) flexible use of money market operation tools covering maturities from
overnight to three months, depending on market conditions.
These are part of our normal modalities of money market operations and nothing special. It is
necessary for a central bank to accurately grasp the daily liquidity needs of market
participants as well as overall market conditions because monetary policy works through
influencing money market conditions and the behavior of market participants. In addition,
understanding each financial institution's soundness, thereby contributing to the soundness
of the financial system, is an important element of central banking.
The ability to closely monitor the liquidity condition of financial institutions should be finely
honed in normal times. After all, a central bank is a "bank." Recent actions by central banks
to calm market turbulence seem to have highlighted the simple fact that it is through its
banking business that a central bank plays a principal role. Faced with increasing complexity
in the international flow of funds, which may bring about sudden stress in the working of
financial markets, it is becoming ever more important for a central bank to accumulate further
knowledge about financial conditions through its daily activities.
V. Concluding remarks
I sometimes describe central banking in terms of the role of the goalkeeper in a football
team. It is rare for goalkeepers to score a goal themselves, but what they do is support their
teammates in their efforts to score by defending their goal from the enemy's attacks. In
defense, it is vital to read the enemy's offensive strategy; in the conduct of monetary policy, it
is essential to accurately assess the risk profiles of economic activity and financial market
conditions. When on the offensive, good teamwork is important; in monetary policy terms, it
is important to facilitate the efficient allocation of resources and stimulate innovation. The
dynamic progress of economic globalization brings with it challenges for central banks such
as I have discussed today, but we intend to grapple with them and bring victory to the team
by supporting players in the globalized economy.
Thank you.