Hiroshi Nakaso: Toward a "Comprehensive Assessment" of the
monetary easing
Speech by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, at a meeting hosted by
the American Chamber of Commerce in Japan (ACCJ), Tokyo, 8 September 2016.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
It is my great pleasure to have the opportunity today to speak at a business luncheon hosted
by the American Chamber of Commerce in Japan.
All eyes seem to be on a comprehensive assessment to be conducted at the Bank of Japan's
September 2016 Monetary Policy Meeting (MPM). This is, of course, the main topic of my
speech today. Before addressing that issue, however, I would like to touch on responses taken
by central banks after the United Kingdom's vote to leave the European Union (EU) -the
socalled Brexit - and decisions made at the Bank's MPM held in July 2016. For me, these topics
are not appetizers served before the main dishes. I believe that they are important policies on
their own.
Responses to Brexit
On June 23, 2016, contrary to general consensus, a majority of voters in the United Kingdom
supported leaving the EU, and this led to global financial markets destabilizing, manifested in
such developments as the rapid depreciation of the pound sterling.
As Japan's markets were the first to be exposed to the unfolding results of the referendum,
they reacted violently. The yen's exchange rate appreciated rapidly and the stock prices fell
sharply. The authorities around the world, including those in the G7 countries, responded
quickly and effectively. The G7 central banks expressed their intention to ensure adequate
liquidity and support the functioning of markets. In the Japanese context, we judged it
necessary to ensure accessibility of globally operating Japanese firms and financial institutions
to funding liquidity in foreign currencies, in particular to U.S. dollar funding liquidity, and to that
end, to reinforce the backstop facilities that had been installed during the Global Financial
Crisis.
Enhancement of monetary easing in July
In light of heightened uncertainties surrounding overseas economies, such as those stemming
from the United Kingdom's vote to leave the EU, the Bank decided at the July 2016 MPM to
enhance monetary easing. Specifically, measures taken by the Bank are threefold (Chart 1).
The first is an increase in the Bank's purchases of exchange-traded funds (ETFs). Specifically,
the amount of purchases will be almost doubled from an annual pace of about 3.3 trillion yen
to an annual pace of about 6 trillion yen. This measure aims at preventing the deterioration in
business confidence and consumer sentiment and promoting proactive risk-taking. I think that
this amount is significantly large given the fact that foreign investors' cumulative net purchases
of stocks amounted to about 16 trillion yen for the first three years of Abenomics (Chart 2).
The second is a doubling of the size of the Bank's lending program in U.S. dollars to support
economic growth (the Special Rules for the U.S. Dollar Lending Arrangement to Enhance the
Fund-Provisioning Measure to Support Strengthening the Foundations for Economic Growth
Conducted through the Loan Support Program). Under this lending program, the Bank will
provide back-to-back financing in U.S. dollars to financial institutions by using its own U.S.
dollar reserve funds in cases where these financial institutions make foreign currency-
denominated investments and loans to firms, which contributes to the strengthening of the
foundations for economic growth. The duration of the Bank's lending can be up to 4 years
through rollovers. The loans under the program enable firms to receive stable funding in U.S.
dollars over the long term, and the program has been actively used for funding of firms,
including local ones through regional banks. The size of the program was doubled and raised
to 24 billion U.S. dollars.
The third is an expansion in the amount of collateral that can be pledged under the Bank's U.S.
dollar funds-supplying operations. The Bank has been conducting U.S. dollar funds-supplying
operations regularly with U.S. dollar funds raised through a network of bilateral swap lines
among central banks. With this operation, financial institutions can raise U.S. dollar funds on
a full allotment basis. Nevertheless, there is a condition that the amount of funds to be provided
is up to that of eligible collateral pledged by each institution because in principle, transactions
with the Bank should be backed by collateral. Under the current monetary policy, many
financial institutions have sold Japanese government securities (JGSs) to the Bank while
holding a substantial amount of current account balances with it. Under these circumstances,
the Bank decided to establish a new securities lending facility in which it lends JGSs to
counterparties of these operations against their current account balances with the Bank. This
enables the financial institutions to raise U.S. dollar funds against JGSs borrowed from the
Bank. The new facility is designed to provide for a rainy day by precluding concern about the
lack of collateral they hold. In this way, it is expected to further enhance effectiveness of the
U.S. dollar funds-supplying operations as a backstop.
These measures, despite their technical nature, can contribute meaningfully to ensuring
access to funding liquidity in foreign currencies and thus to economic stability. I want to
reiterate that such a technocratic endeavor is no less important than such big policy moves as
the negative interest rate or the massive purchases of Japanese government bonds (JGBs),
which tend to attract more attention.
I. Background of comprehensive assessment
I would now like to turn to the broad framework of monetary policy. Against the backdrop of
heightened uncertainty over the outlook for prices, with a view to achieving the price stability
target of 2 percent at the earliest possible time, the Bank decided to conduct at the next MPM,
to be held in late September, a comprehensive assessment of the developments in economic
activity and prices, as well as of the policy effects, over the past three years since the
introduction of quantitative and qualitative monetary easing (QQE).
The background is twofold. First, since the introduction of QQE, Japan's economic activity and
prices have improved substantially, and Japan's economy is no longer in deflation. However,
the price stability target of 2 percent has not been achieved yet, despite the unprecedented
large-scale monetary easing. The Bank will analyze how monetary policy has functioned during
these years and what factors have possibly hampered achievement of the 2 percent target.
Second, under "QQE with a Negative Interest Rate," which was introduced more than half a
year ago, various interest rates, including JGB yields as well as rates for lending and corporate
bonds, have declined substantially; thus, the policy already has exerted remarkable effects. At
the same time, however, it has had an impact on financial markets' liquidity and financial
institutions' profits. The Bank will also assess the effects and impact of this policy.
II. Mechanism of QQE
Natural rate of interest and real interest rate
Regarding the first point, I would like to start with the basics of the monetary policy transmission
mechanism. In fact, the main transmission mechanism of monetary policy, be it conventional
or unconventional, is the same. That is, real interest rate effects; in other words, driving the
real interest rate higher or lower than the "natural rate of interest," which is the level of the real
interest rate neutral to economic activity and prices. The bigger the difference in these rates,
the more effective the monetary easing or tightening will be.
The potential growth rate and expected growth rate are considered proxies for the "natural rate
of interest." As Japan has continued to struggle with a trend decline in the potential growth rate
since the bubble burst, the Bank has lowered its policy rate to ensure the monetary easing
effects (Chart 3). In 1999, it introduced the zero interest rate policy. Starting in 2001, the Bank
conducted unconventional monetary policy measures such as quantitative easing and
Comprehensive Monetary Easing. Nevertheless, the monetary easing provided by those
policies proved insufficient to overcome deflation.
Mechanism of QQE
Based on this experience, in 2013, the Bank set the price stability target of 2 percent, and with
a view to achieving the target at the earliest possible time, it launched QQE. The transmission
mechanisms of QQE are also expected to operate through real interest rate effects. QQE aims
to raise inflation expectations through the Bank's strong and clear commitment to achieving
the price stability target of 2 percent and through large-scale monetary easing that underpins
the commitment. At the same time, the Bank exerts downward pressure on nominal interest
rates across the entire yield curve through purchases of JGBs. The compound effects through
these channels compress real interest rates. This decline in real interest rates boosts firms'
and households' economic activity, which in turn leads to higher inflation rates, supported by
higher inflation expectation. It was assumed that, as people actually experience inflation,
inflation expectations correspondingly would rise further (Chart 4). This last point is called an
"adaptive formation mechanism" of inflation expectations, and it is a key concept of what I will
talk about later.
The innovative quality that might stand out in comparison with measures previously taken by
the Bank of Japan and other central banks is that QQE focuses on inflation expectations.
Specifically, based on the Fisher Equation, which states that the nominal interest rate is equal
to the sum of inflation expectations and the real interest rate, QQE aims to lower real interest
rates by raising inflation expectations while compressing nominal interest rates.
Economic activity and prices under QQE
This mechanism has worked and produced intended effects. QQE brought about a decline in
the real interest rate by raising inflation expectations and lowering the nominal interest rate.
As I mentioned earlier, the "natural rate of interest" has been on a trend decline. Despite that,
the level of the real interest rate has been pushed down significantly lower than the "natural
rate of interest" and the financial conditions have improved. Specifically, a moderate increase
in lending coupled with a decline in interest rates, a rise in stock prices, and depreciation of
the yen have been observed, and these have boosted economic activity. As a result, regarding
economic activity, corporate profits marked a record high level and the unemployment rate,
released last week, has declined to a remarkably low level of 3.0 percent. As for wages, the
annual labor-management wage negotiations in 2014 resulted in base pay rises for the first
time in two decades; base pay rises have continued for three consecutive years since then.
Looking at the economy as a whole, the output gap has improved close to the long-term
average of 0 percent. On the inflation front, on a basis excluding fresh food and energy, the
year-on-year rate of change in the CPI, which had been around minus 0.5 percent before the
introduction of QQE, turned positive, and thereafter has remained in positive territory for two
years and ten months (Chart 5). This is the first time since the late 1990s, when Japan's
economy fell into deflation, that the CPI inflation rate has remained in positive territory over a
protracted period. I think Japan's economy is no longer in deflation, which is commonly defined
as a situation where prices decline on a sustained basis.
Reasons for missing 2 percent price stability target
However, it is true that the price stability target of 2 percent has not been achieved. This also
has to do with developments in inflation expectations, which is a key factor for real interest rate
effects to operate. Looking back, the mechanism worked as expected or better than expected
over the first year or so from the introduction of QQE. Thereafter, however, exogenous factors
emerged such as a decline in crude oil prices and weakness in demand following the
consumption tax hike from the beginning of fiscal 2014. This was compounded by the
slowdown in emerging economies from summer 2015 that accompanied volatile developments
in global financial markets. As a result, the observed inflation rate has declined, and inflation
expectations, which are formed in an adaptive manner, stalled. This seems to be the main
factor that hampers achieving the price stability target of 2 percent (Chart 6).
It is widely accepted that people's inflation expectations are formed by two factors: a
"forwardlooking formation mechanism" and an "adaptive formation mechanism." In Japan, the effects
of the "adaptive formation mechanism" seem to have dominated. This seems to be partly
because the price stability target has been missed under prolonged deflation. In addition,
during wage negotiations in Japan, such as the so-called spring offensive or shunto in
Japanese, wages are decided on a basis of the actual price developments in the previous
fiscal year. This may have been one of the factors behind the "adaptive formation mechanism."
The Bank, by continuing with QQE, has been trying to enhance the "forward-looking formation
mechanism" and thereby to raise people's inflation expectations and anchor them to the price
stability target of 2 percent. As a result, perhaps we have managed to deanchor the
deflationary expectation that the prices would never rise. But inflation expectations are still in
transition to be reanchored at 2 percent.
Looking ahead, as the observed inflation rate is expected to revert to a gradual rising trend,
inflation expectations will be pushed up by the "adaptive formation mechanism." However,
given that the observed inflation rate is likely to hover at slightly negative or about 0 percent
for the time being, uncertainty persists about this point. For this reason, I think it is all the more
important for the Bank to firmly maintain its commitment to achieving the price stability target
of 2 percent at the earliest possible time from the viewpoint of enhancing the "forward-looking
formation mechanism." The comprehensive assessment is conducted with the aim of achieving
the 2 percent target at the earliest possible time. To avoid any possible misunderstanding, this
was explicitly referred to in the statement released after the MPM in July 2016. At the
forthcoming MPM, we will discuss what needs to be done to achieve the 2 percent target at
the earliest possible time. Means toward reducing the level of monetary policy accommodation
will not be on the agenda.
III. Effects and impact of "QQE with a negative interest rate"
Issues of the comprehensive assessment
Let me now move on to the topic of the negative interest rate policy.
In terms of the transmission mechanism of policy effects, "QQE with a Negative Interest Rate"
is an extension of the aforementioned policies. Namely, the Bank considers real interest rate
effects as the basic mechanism. Against the backdrop of weak inflation expectations that had
started to descend further, the Bank decided to keep real interest rates lower by reducing the
nominal interest rates beyond the zero bound. By applying the negative interest rate to a
portion of financial institutions' current account balances with the Bank, in combination with its
JGB purchases, the Bank intended to further compress interest rates on JGBs across the entire
yield curve. This was expected to affect various interest rates, including those for lending,
corporate bonds, and CP, spreading the effects of a decline in the real interest rate to economic
activity and prices. On the other hand, from the inception of the negative interest rate policy,
the single most important issue has been that the policy should avoid having an excessively
negative impact on financial institutions' profits, thus impairing the financial intermediation.
Based on the experience of the past six months, the Bank will also assess the effects and
impact of this policy. This will be the second pillar in our comprehensive assessment.
What we learned over the last six months
In my opinion, there are six points we have learned over the last six months since the
introduction of "QQE with a Negative Interest Rate." Let me elaborate.
First, a combination of the negative interest rate policy and JGB purchases proved extremely
powerful in exerting downward pressure across the entire yield curve. This seems to have
operated through the mechanism in which (a) the negative interest rate applied to financial
institutions' current account balances with the Bank has resulted in a decline in short-term
interest rates, and (b) financial institutions have been discouraged to hold current account
balances through JGB sales, and this, together with a decline in risk premiums caused by JGB
purchases, has lowered long-term interest rates. Moreover, the so-called search for positive
yield by investors has boosted the demand for assets with positive yields, substantially
lowering yields on super-long-term JGBs. Such mechanism has exerted downward pressure
and flattened the yield curve, particularly toward the longer end. This first point has proven the
effectiveness of "QQE with a Negative Interest Rate" as a monetary policy tool (Chart 7).
Second, some were concerned that lower risk-free rates, or JGB yields, might not lead to a
decline in banks' lending rates or interest rates on corporate bonds and CP, as room is limited
for a decline in rates on deposits, the main source of funding for financial institutions. I also
considered that such concern deserves attention, but banks' lending rates, as well as interest
rates for corporate bonds and CP, have fallen significantly thus far, each marking historical
lows (Chart 8).
Third, new developments relating to corporate finance have emerged recently; for example,
the issuance of corporate bonds with a maturity of over ten years and firms' borrowings through
subordinated loans have increased. Super-long-term funding had been observed mainly in
infrastructure firms such as those related to electricity and transportation, but now is
increasingly shared by a wider range of industries (Chart 9).
Fourth, according to the results of surveys such as the Short-Term Economic Survey of
Enterprises in Japan (Tankan) and the Senior Loan Officer Opinion Survey on Bank Lending
Practices at Large Japanese Banks (often dubbed the Loan Survey), financial institutions'
lending attitudes have remained proactive. Thus far, we have seen little evidence that the profit
squeeze caused by the negative interest rate is adversely affecting their intermediary functions
(Chart 10).
Fifth, however, the flipside of such positive developments is the growing pressure on financial
institutions' profits. This can be seen from the larger fall in lending rates relative to a marginal
decline in rates on deposits. For Japan, the impact of the negative interest rate policy on the
profits of financial institutions tends to be relatively large. This is due to such factors as the
amount outstanding of deposits far exceeding that of lending, and the interest margin already
being extremely small following prolonged competition among financial institutions. Given that
profitability affects the soundness of financial institutions in a cumulative manner, we are fully
aware of the fact that the impact can vary depending on the duration of the policy. The view
that the Bank might disregard the intermediary function performed by the financial sector is
totally unfounded. In fact, ever since our homegrown financial crisis in the 1990s, we have
committed ourselves to maintaining financial system stability, which is a mandate given to us
under the Bank of Japan Act. Besides, the banking system is the key transmission channel for
monetary policy.
Sixth, as long-term and super-long-term rates have declined significantly, the rates of return
on investments of insurance and pension products have declined, the sales of some
savingtype products are suspended, and the net present value of retirement benefit obligations has
increased. Although direct impacts of these developments on the entire economy may not be
substantial, we should take account of the possibility that such developments can affect
people's confidence by causing concerns over the sustainability of the financial function in a
broad sense, thereby negatively affecting economic activity.
Thinking on the monetary policy management
"QQE with a Negative Interest Rate" must be pursued as the most appropriate macroeconomic
policy, by striking the right balance between the powerful policy effects described in the first
four points I mentioned and the possible adverse effects on financial intermediation that I listed
as the fifth and sixth points. There is usually a trade-off between these two aspects, but the
way we balance them must be dynamic. For example, a static and uniform judgment that rules
out any further cuts in the negative interest rate in view of financial institutions' profits would
not be the right approach. Depending on the situations for economic activity, prices, and
financial conditions, further measures may still be deemed necessary after weighing policy
effects against the cost on financial intermediation. Through numerous discussions I have had
with the leaders of financial institutions, I think I fully recognize the effects of the large-scale
monetary policy on financial institutions and financial markets, and the likely impacts if the
policy is to continue. Based on this recognition, we will take measures that we judge necessary
for Japan's economy.
It is from this standpoint that I will participate in discussions of the comprehensive assessment
at the next MPM. Based on a candid assessment, we will decide whether or not it will be
necessary to make adjustments to the current policy framework, and if judged necessary, in
what way it should be adjusted.
Closing remarks
Lastly, let me talk about the relationship between the Bank's monetary policy and the
government's fiscal management and a growth strategy.
The first relationship is that with the government's fiscal management. Usually, when the
government increases fiscal expenditures by issuing government bonds, interest rates on
government bonds will rise, which discourages private-sector investment. This effect is called
"crowding out." In this regard, in a "policy mix" where the central bank pursues monetary easing
at the same time, the rise in interest rates will be contained, thereby preventing "crowding out"
effects. In the current Japanese context, this is exactly what is taking place. Market interest
rates in Japan have been in negative territory across a wide range of maturities due to the
effects of the Bank's "QQE with a Negative Interest Rate." In this situation, the economic
stimulus of the government's fiscal expenditure, coupled with the monetary expansion, is
bound to prove very powerful due to the synergy effects. This type of powerful "policy mix" has
been in place in Japan over the last three years and is likely to be reinforced further with the
new large-scale fiscal "stimulus package" in combination with "QQE with a Negative Interest
Rate."
The second relationship is that with a growth strategy. As I said earlier, it is important that the
Bank lowers the real interest rate while at the same time the government raises the natural
rate of interest by promoting a growth strategy. In this regard, there should be an emphasis on
"at the same time." Structural reforms raise potential growth and reduce uncertainty about the
future, so that firms and households spend more today in anticipation of higher profits and
incomes in the future, thus raising current demand. On the other hand, demand stimulus from
monetary easing raises potential output through an increase in the capital stock as well as
labor input. Thus, I believe monetary policy to overcome deflation and supply-side reforms to
raise the growth potential must be pursued in tandem, or "at the same time," to bring Japan's
economy back on track toward sustained growth. The Bank should continue with the monetary
easing that successfully reshaped Japan's economy such that it may be described as no longer
being in deflation, move further to terminate deflation, and achieve the 2 percent target.
Meanwhile, I think that it is worth noting that the government's recent economic measures
focus on "investment for the future."
It has been thirty-eight years since I joined the Bank of Japan. During this period, the economic
and financial environment surrounding Japan has changed dramatically and the policy agenda
for the central bank shifted accordingly. As a freshman, I could hardly imagine that this central
bank traditionally renowned as an inflation fighter was going to be engaged in such a difficult
struggle to overcome deflation. Such changes never lose steam. More recently, after the
collapse of Lehman Brothers, active discussions have taken place around the world about
policy responses to the slower growth trend and the framework of the monetary policy in such
a situation, ignited by Larry Summers' Secular Stagnation Hypothesis. I already expressed my
opinion in New York earlier this year, so I will not repeat this today. However, I have an
impression that some topics that formerly had been confined to academic circles are today
openly discussed as practical policy challenges that need to be addressed from a medium- to
long-term perspective. I really feel this when attending international meetings and conferences.
The answers vary from country to country, and they are not as straightforward as those
provided in textbooks. For policy makers around the world, I sense that this has become a
common challenge that underlies contemporary policy discussions and practices. I am
reminded that, in order for policy makers at central banks and governments to appropriately
keep abreast of the speed and dynamism with which the environment changes, they should
not adhere simply to past common sense. Recently, I often think that we central bankers must
have the courage to evolve with the times and adapt to the environment while cherishing the
central bank's DNA; that is, "the policy actions based on theory and research." This last point
is somewhat superfluous and clearly outside the scope of the upcoming comprehensive
assessment, and I would like to finish my speech by reminding you that this is just my thought.
Thank you for your attention.
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