Masaaki Shirakawa: The roles, missions and challenges of the central
bank
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Japan National
Press Club, Tokyo, 25 January 2013.
* * *
Introduction
Today, I am very pleased to appear before the venerable Japan National Press Club. The
first public speech that I gave as the Governor of the Bank of Japan was at this venue, just
one month after my appointment. We have experienced many things in the five years since
then, and central banks around the world, including the Bank of Japan, seem to be going
through the most turbulent times.
Looking back on the spring of 2008, I still remember my hesitation to embrace a view
expressed during a meeting between G-7 finance ministers, central bank governors, and
major financial institutions - held on the day after my appointment - that the worst might be
over. In fact, one of the largest U.S. investment banks, Lehman Brothers, went bankrupt in
September of that year. This led to extremely high stress levels in international financial
markets, and global economic activity fell off the cliff. The last months of 2009 saw the
European debt crisis, which was to subsequently intensify in waves, erupt in Greece. The
financial crises that occurred around the globe strengthened the risk-averse attitude of
investors, leading to heightened demand for the yen as a safe haven. Accordingly, the yen's
exchange rates staged a turnaround from a depreciating trend into 2007, and the yen
appreciated rapidly. Furthermore, in March 2011, we experienced a most tragic disaster -
the Great East Japan Earthquake. Needless to say, these events affected Japan's economy
in the most profound manner. Meanwhile, in a slightly different vein but just as important as
these three events is the rapid aging of the population that Japan's economy is experiencing,
and the procrastination relative to making the necessary adjustments to this situation is
giving rise to various vexing issues, including the decline in growth and deterioration in
government finances.
Central banks around the world, including the Bank of Japan, have done everything they can
in response to these events. When faced with a potential breakdown of market functioning,
the time-honored course of action for central banks is to act as the "lender of last resort".
Following this principle, central banks made every effort to stabilize financial markets and the
financial system, thereby averting a repeat of the Great Depression of the 1930s.
Nevertheless, given the enormity of debt incurred during the global credit bubble preceding
the crisis, global economic recovery remains anemic more than four years after the collapse
of Lehman Brothers. In metaphorical terms, one could say that, even if the acute symptoms
of the crisis are cured, we have not been able to put behind us the chronic symptoms arising
from paying off excessive debt.
Looking at monetary policy, short-term interest rates are effectively at zero in many
developed economies, including Japan. Central banks' liquidity provision and balance sheets
have also expanded to unprecedented levels. In addition, they are expanding the range of
assets they would buy. The Bank of Japan is buying not only government securities, but also
risk assets such as commercial paper, corporate bonds, exchange-traded funds, and real
estate investment trusts. In spite of mobilizing these measures - the so-called non-traditional
policy measures by central banks of developed economies including the Bank of Japan -
economic recovery is far from satisfactory, as I noted a moment ago. Issues differ from one
economy to another. For example, the United States and Europe are suffering from high
unemployment. The unemployment rate in the euro area stands at 11.8 percent, and in the
United States, despite coming down from its peak, the rate is at 7.8 percent. In the case of
Japan, the unemployment rate had risen only modestly, and is relatively low compared with
Europe or the United States, standing at 4.1 percent. On the other hand, inflation in Japan is
low, and the year-on-year rate of change in the consumer price index (CPI) is around
0 percent. Japan has not shaken off deflation. Meanwhile, in all developed economies the
importance and long-term benefits of fiscal consolidation and structural reforms aimed at
enhancing competitiveness are appreciated, but their implementation tends to lag, reflecting
pains that initially accompany these items. Against this backdrop, demands and expectations
on central bank policies are more heightened than ever.
As you know, the debate on monetary policy has never been so lively as that seen in recent
months. In addition, the Bank of Japan introduced additional steps at this week's Monetary
Policy Meeting to provide monetary accommodation in a decisive manner - namely, the
"price stability target" and the "open-ended asset purchasing method". The Bank also issued
a joint statement with the government on strengthening policy coordination. Although I am
aware of the fact that your interest in these measures is running high, I have already
explained them in detail at the press conference following the Meeting and elsewhere. In
view of this, my speech today carries the title "The Roles, Missions, and Challenges of the
Central Bank". I will spend about two thirds of my allotted time talking about what a central
bank is and the remaining one third on the Bank's most recent decisions; hopefully, this will
enhance the public's understanding of the decisions in a broader context. It would be my
greatest pleasure if, by describing the essence of central banking, I could succeed in
providing any useful input for people who are contemplating issues related to monetary
policy and the Bank.
I. Four episodes illustrating the role of the central bank
Now, what does a central bank do? In order to answer this question, I would like to start by
referring to three well-known quotes on central banking. The first is by the U.S. comedian
Will Rogers, who enjoyed enormous popularity in the 1920s and 1930s. He compared central
banking with the fire and the wheel, calling these the three greatest inventions of mankind. It
may be a bit of an exaggeration to count central banking as one of the three great inventions,
but the quote conveys how important the central bank is to the lives of people. The second
quote is from William McChesney Martin, who served as the Chair of the Board of Governors
of the Federal Reserve System for nearly 20 years in the 1950s and 1960s. He said that the
role of the central bank is to "[take] away the punch bowl just when the party is getting good".
The third quote is from Helmut Kohl, the German Chancellor who oversaw the reunification of
East and West Germany. "As the Federal Chancellor, I sometimes have a problem with the
Bundesbank. As a citizen, I'm glad that it exists." The last two remarks refer to the role of the
central bank, relating this to its independence.
Instead of using these figurative remarks, one could approach the question from a systematic
angle and say that the central bank pursues "price stability" and "financial stability". Looking
at central bank laws around the world, the objectives of the organization written into them
reflect the historical influences at the time of their adoption, and tend to be more complex
and somewhat ambiguous in older laws. Nevertheless, the overwhelmingly prevailing trend
over the last 20 years, including the Bank of Japan Act, is to establish two pillars: "price
stability" and "financial system stability". I also believe that the pursuit of these two is the
fundamental role of the central bank. At the same time, these abstract ideas alone cannot
give a good idea of what role the central bank is actually playing in the economy.
Having said this, in the following sections, I will try to illustrate the roles and missions of the
central bank by looking at specific episodes from the last five years. I will attempt to take up
as many aspects of a central bank's operations as possible. The episodes are the Lehman
shock, the European debt crisis, the Great East Japan Earthquake, and the rapid aging of
Japan's economy.
Lehman shock
Let me begin with the collapse of Lehman Brothers in September 2008, which sent huge
shockwaves throughout the global financial market. This event showed that real economic
activities are significantly affected by impairment of the financial system. The stability of the
financial system is akin to the air around us, although its importance is usually taken for
granted. Nonetheless, it is one of the most important factors in the smooth functioning of the
economy.
This episode demonstrated the many roles played by central banks. The first and most
evident was their role as the "lenders of last resort". The Bank of Japan also acted promptly
as the lender of last resort. In Japan, the problem was most acute in the funding market for
U.S. dollars. In a very short period of time, both financial institutions and non-financial firms
were finding it difficult to secure dollar funds. Perceiving this problem, the Bank also supplied
dollar funds in the Japanese market - the dollars being obtained from the Federal Reserve
through foreign exchange swap arrangements. The yen interbank market, meanwhile, was
relatively stable, but as the conditions in the commercial paper and corporate bond markets
rapidly deteriorated, reflecting concerns over credit risk, the Bank decided to purchase
commercial paper and corporate bonds in the market. This was an unusual action for a
central bank, in that it resulted in the bank incurring credit risk of individual firms.
The second role, which may not be glamorous but which I wish to emphasize, was the
central banks' catalytic role in improving the payment and settlement systems. For example,
six years before the Lehman shock, in September 2002, a system was introduced that linked
the two settlement legs of foreign exchange transactions, e.g., the dollar and yen legs in the
case of settling dollar-yen trades. The disruptions in the financial markets caused by the
collapse of Lehman Brothers would have been much larger if such a system were not in
place before the event. Central banks, including the Bank of Japan, played a leading role in
the six years leading up to the launch of the system.
The third role was to prevent bubbles and ensure the stability of the economy and financial
system. Looking at the economic stagnation after the Lehman shock, one is confronted with
the question of why an extraordinary credit bubble was allowed to form into the middle of
2000s, which was the root cause of the global financial crisis. In this regard, it is often said
that the policy responses of the Federal Reserve after the bursting of the bubble were more
aggressive than those of the Bank of Japan. Nevertheless, when one examines the
economic performance of the United States and Japan over the six years after the bursting of
their respective bubbles, recovery in the United States in terms of real GDP is more sluggish
than that of Japan in the 1990s. A precise comparison of economic performance is beside
the point. The important lesson from the experiences of the two economies is that, when
borrowing by firms and households ballooned, resulting in a credit bubble, the consequences
were quite serious. When a bubble bursts, firms and households are forced to prioritize their
debt pay-downs. In the case of this particular episode, this resulted in reduced investment
and consumption, depressing economic activity more generally, and brought about a
prolonged period of low growth. It may seem unbelievable in hindsight, but the
overwhelmingly prevailing view overseas, before the collapse of the most recent credit
bubble, especially among the members of academia and policy makers in the United States
was that aggressive monetary policy could adequately deal with the consequences of the
collapse of bubbles. In other words, "mopping up" after the fact was regarded as important.
The reason why monetary policy remained loose during the bubble was partly because
prices were stable. This was the case both for the United States and Japan. In Japan, prices
rose by only fractions of 1 percent in 1987 and in 1988. While it was true that credit was
expanding and asset prices were rising rapidly, there was no recognition of the risk that
economic stability in the long term could be compromised through such accumulating
imbalances. Of course, the causes of bubbles are complex, and sometimes can only be
attributed to people jumping on the bandwagon. Bubbles do not result solely from monetary
easing, and they cannot be completely prevented through good financial regulation and
supervision. Having said that, I must also stress that appropriate monetary policy, as well as
adequate regulation and supervision, do have important roles to play in preventing bubbles
or an excessive build-up of debt. In this regard, what I find notable is that there was a
remarkable shift in conventional wisdom regarding bubbles and monetary policy over the
course of just five or six years. Furthermore, I feel that we tend to forget the fact that bubbles
and financial crises have happened repeatedly. One must, therefore, remain humble when
taking the wheel of policy.
European debt crisis
The second event that I wish to take up is the European debt crisis. As we know, this crisis
emerged following the extensive revision of past fiscal balance statistics by the Greek
government. Adding to the three roles of the central bank that I have just mentioned
regarding the Lehman shock, there are a few facts and lessons to be learned with respect to
the European debt crisis regarding the relations and interactions between the central bank
and markets, governments, and society at large.
The first is the importance of fiscal prudence. While it was widely viewed that confidence in
fiscal sustainability would be essential to maintaining confidence in the currency, the
European debt crisis demonstrated that fact in real time. When government finances become
unsustainable, the options to correct this are, conceptually, fiscal consolidation, default of
government debt, or inflating away the real value of debt. If the government defaults, or if it
will not pay its debts, financial institutions that hold government debt would see their capital
eroded, and in the extreme, people would lose confidence in the safety of bank deposits,
which are debts of banks. Even if the situation does not deteriorate that far, banks would cut
back on lending to the private sector and the real economy would suffer as a result. If the
central bank would then buy government debt in order to prevent such damage, the
consequent excessive issue of money would result in inflation. In all the cases, the value of
the currency would be impaired. In sum, confidence in the currency hinges on the prudent
management of government finances over the medium to long term.
The second is the appropriate distance between the central bank and financial markets. The
fluctuations in government bond yields since the introduction of the euro starkly illuminate
this issue. In the euro area, there was an expectation that the economic fundamentals of the
member countries would converge through the introduction of the single currency.
Accordingly, the government bonds of the member countries quickly came to enjoy terms of
issuance mirroring those of Germany. For over ten years, bond yields for the peripheral
economies, including Greece, Ireland, and Portugal, remained at the same level as that of
Germany. However, when the yields began to rise, they did so significantly. Looking at the
yield spread over Germany, while the Greek spread may be a little extreme, the Spanish
spread was just 0.7 percent three years ago. At its widest, this reached 6.4 percent in late
July 2012 and now stands at 3.5 percent. Even if I will have to reserve my judgment on what
the normal spread is, the experience shows that confidence - the determinant of spread - is
fragile.
Third, there is the issue of the interaction between central bank actions and society at large.
Since the beginning of the crisis, market sentiment repeatedly shifted between optimism and
pessimism. When tensions arose, the European Central Bank (ECB) supplied funds to the
market so as to stabilize financial markets. When those actions succeeded in mitigating the
tensions, there was a loss of momentum regarding reforms that were discussed under
market duress. As a result, tensions returned and the ECB had to inject more liquidity. This
was repeated over the last three years. Liquidity injection by the ECB is a policy to "buy
time". Structural reforms in the economy and government finances must be pursued during
the bought time. This is a difficult balancing act, in which the central bank must maintain the
stability of the economy and the financial system while keeping enough momentum in society
for implementing reforms.
These experiences and lessons from the European debt crisis seem to offer rich material for
us in Japan to contemplate regarding the role of the central bank.
Great East Japan Earthquake
The third event to examine when considering the role of the central bank is the tragic Great
East Japan Earthquake. The earthquake confirmed the vital role played by the central bank
in maintaining the essential physical integrity of the financial system infrastructure.
Confidence in the central bank faces a severe test when a disaster strikes, and in order to
pass that test, the bank must succeed in guarding the physical in addition to the functional
stability of the financial system and the markets of the economy. As we know, the tremor
struck just before 3PM on a Friday, as financial institutions were winding down the week's
business. As a result, there was very little remaining activity in the market, but the Bank took
steps to ensure that all settlement of yen funds for the day would be completed without any
disruption. On the following Monday, the Bank cut short its Monetary Policy Meeting to one
day, and with a view to preventing negative effects on the real economy from the
deterioration in business confidence and heightened risk aversion in financial markets,
decided to increase its purchase of financial assets (mostly riskier assets). It also supplied
ample funds to the market to prevent disruptions in the financial markets. The offer of funds
amounted to 21.8 trillion yen on that Monday alone. Meanwhile, the BOJ-NET, which is the
backbone of the Japanese payments system, functioned without a hitch. Furthermore, the
Bank took care to make sure that damaged banknotes and coins - for example, those swept
away by the tsunami and soaked in water - could be exchanged as quickly as possible by
setting up temporary exchange desks and sending extra staff to the stricken areas.
In a country like Japan, which is prone to earthquakes, it is important to maintain the physical
integrity of infrastructure. The Bank believes that it was able to discharge its responsibilities
in the wake of the earthquake. The Bank has deployed significant resources to this end. It is
now in the process of further enhancing its business continuity planning, including responses
to potentially deadly earthquakes in the South Sea Trough and in the Tokyo area.
Rapid aging of Japan's population
The last theme I'll use to illustrate the role of central banking is the rapid aging of Japan's
population. The reason why I look at aging in relation to the role of central banks is because
it offers insights into the implications of the potential growth rate, which is a given in the short
term with respect to the conduct of monetary policy. Economic developments determined by
the supply side of the economy and other real factors are beyond the direct control of the
central bank. While the central bank hopes to positively influence the supply side through
bringing about a stable financial and economic environment, monetary policy tries to
influence prices and economic activity through acting upon the demand side - the spending
decisions of economic agents. When demand lies below the potential of the economy, there
is a negative output gap. When demand lies above the potential of the economy, there is a
positive output gap. Currently, the negative output gap in Japan is about 2 percent, and
during the process of closing this gap, growth will accelerate. When the gap is closed, growth
will be in line with the increase in the potential of the economy - in other words, the potential
rate of growth. The problem faced by Japan's economy is that this potential growth rate is
gradually declining. To a large part, this decline is brought about by aging, which is
progressing at a speed heretofore unequaled by any other economy. The aggregate
economic activity of an economy is determined by the number of people working and the
amount of output produced by each working person, i.e., value added per worker. In the case
of Japan, if one assumes that the present rates of labor participation for gender and age will
remain stable, the numbers of workers will decline at an annual rate of -0.6 percent during
the 2010s. In other words, from the perspective of the number of workers, real GDP is going
to decline at an annual rate of -0.6 percent. This is a very strong headwind. Meanwhile,
looking at the rate of increase in value added per worker, the average for G-7 economies
over the last 20 years is 1.3 percent. For Japan, the figure is 1.5 percent for the relatively
good times between 2000 and 2008. These numbers enable us to make a calculation of the
potential growth rate, which is below 1 percent.
I do not wish to say here that low growth is inevitable. Demography cannot be changed
quickly. Nevertheless, it is possible to raise the growth potential by changing the many
elements that can be influenced by deliberate actions. First of all, the number of workers can
be increased by raising the labor participation rate of women and elderly people. For
example, if by 2030 the participation rate of women increases to the level now seen in
Sweden, the participation rate of the 60 to 64 age group is raised to the current level of the
55 to 59 age group, and there is an in-line increase in participation by people aged 65 and
older, the labor supply during the 2010s will increase by 0.2 percent annually, not
-0.6 percent as I mentioned a short while ago. Meanwhile, in order to accelerate the
increase in the value added per worker, it is essential to develop goods and services that are
in demand both domestically and abroad, and build successful businesses on them. For
example, in terms of cultivating domestic demand, businesses must, in a timely manner,
provide services that fulfill new potential demand arising from aging. In order to encourage
businesses to take up such a challenge, there is a need to aggressively create a more
favorable environment through such means as deregulation, for example. If growth potential
is enhanced through these efforts, the business outlook will improve and inflation will
gradually become higher.
II. Overcoming deflation as early as possible and achieving sustainable growth
with price stability
Following these views on the roles of the central bank, let me now turn to the challenges
faced by central banks. Of the many challenges, the greatest for Japan and hence the Bank
of Japan is obviously to overcome deflation as early as possible and return to the sustainable
growth path with price stability. The Bank realizes the utmost importance of meeting this
challenge, and thus has pursued aggressive monetary easing.
There are two elements to the Bank's decision at the Monetary Policy Meeting held earlier in
the week.
"Price stability target" and the "open-ended asset purchasing method"
The first is the introduction of the "price stability target", at 2 percent. The Bank recognizes
that the inflation rate consistent with price stability on a sustainable basis will rise as efforts
by a wide range of entities toward strengthening competitiveness and growth potential of
Japan's economy make progress. Based on this recognition, the Bank sets the price stability
target at 2 percent in terms of the year-on-year rate of change in the CPI. Under the price
stability target specified above, the Bank will pursue monetary easing and aim to achieve this
target at the earliest possible time. Taking into consideration that it will take considerable
time before the effects of monetary policy permeate the economy, the Bank will ascertain
whether there is any significant risk to the sustainability of economic growth, including from
the accumulation of financial imbalances.
The second element is the introduction of the "open-ended asset purchasing method". The
Bank will pursue aggressive monetary easing, aiming to achieve the above-mentioned price
stability target, through a virtually zero interest rate policy and purchases of financial assets,
as long as the Bank judges it appropriate to continue with each policy measure respectively.
As the Bank has already announced, the size of the current Asset Purchase Program is set
to increase by nearly 40 trillion yen over the course of this year. Furthermore, the Bank has
introduced from the beginning of this year a scheme to provide financing to financial
institutions, up to the amount of net increases in lending at each financial institution. More
than 15 trillion yen would be provided through this scheme by the spring of 2014. Meanwhile,
with respect to the Asset Purchase Program, after completing the current purchasing
method, from January 2014, the Bank will introduce a method of purchasing a certain
amount of financial assets every month without setting any termination date. The outlook just
published by the Bank for the CPI inflation rate for the 2014 fiscal year is 0.9 percent
excluding the effects of the increase in the Consumption Tax rate. From the beginning of
2014, for some time, the Bank will buy financial assets totaling about 13 trillion yen every
month, including 2 trillion yen in long-term Japanese government bonds. Consequently, the
size of the Asset Purchase Program alone will increase by about 10 trillion yen over the
course of 2014, and the size of the Program is expected to stay at that level from then on.
The Bank will thus provide strong monetary stimulus without interruption.
Achieving the target
A few moments ago, I explained that the Bank recognized that the inflation rate consistent
with price stability on a sustainable basis would rise as efforts by a wide range of entities
toward strengthening competitiveness and the growth potential of Japan's economy made
progress, and, based on this, the Bank decided to set the price stability target at 2 percent in
terms of the year-on-year rate of change in the CPI. Looking back at historical rates of
inflation, the average year-on-year inflation rate, even during the bubble years - the latter
half of 1980s - was 1.3 percent. If one takes the average between 1985 and 2011, the
average inflation rate was 0.5 percent. In order to bring about sustainable growth with price
stability, I believe that serious efforts from a wide range of entities are essential. As I noted in
relation to the rapid aging of the population, it is not appropriate to become pessimistic
regarding the possibility of raising the growth potential. Indeed, quite often we see
comparisons of current real GDP levels with that before the Lehman shock, and find that
Japan, like many European economies, is still undershooting the level of GDP seen in 2007.
per capita
In contrast, when one looks at the current real GDP, major economies including
the United States are still below 2007 levels, but Japan's output loss is relatively small.
Furthermore, in terms of the rates of increase in GDP per worker, while the U.S. and
European economies have not regained 2007 levels, Japan has surpassed its 2007 level. In
other words, Japan realizes low growth as an economy because its workforce is declining,
but each Japanese worker is contributing more to increasing output at a faster pace than
U.S. or European workers. This shows that not only is it inappropriate to become excessively
pessimistic, we should actually be more confident about our potential. If I may add a few
words on the recent joint statement between the Japanese government and the Bank of
Japan regarding the strengthening of policy coordination, there is a clear recognition of the
role that each entity will play: the Bank will pursue aggressive monetary easing and the
government will formulate and promote measures for strengthening competitiveness and the
growth potential of Japan's economy. It also states that the government and the Bank will
work together to overcome deflation early and achieve sustainable economic growth with
price stability. This is very significant.
The importance of flexibility in monetary policy
The decision on the "price stability target" by the Bank was both a decision on a "target" and
a flexible inflation targeting framework. As such, let me also explain the latter element.
Obviously, the effects of monetary policy permeating economic activity and thereafter prices
require a considerable and variable time lag. The conduct of monetary policy has to be
flexible by examining various risk factors, including those related to financial imbalances, in
addition to the assessment of current developments and outlook for economic activity and
prices, from the perspective of achieving sustainable growth with price stability. Such
understanding has been widely shared around the globe; particularly, in the aftermath of the
global financial crisis, major economies of the world have come to emphasize flexibility in the
conduct of monetary policy - by, for example, publicly articulating the importance of paying
due attention to financial system stability. Over the last year, there has been an increasing
awareness of such understanding in Japan as well.
In such circumstances, it is judged transparent and appropriate to use the expression,
"target", in order to explain the Bank's thinking on price stability.
The purpose or principle of monetary policy by the Bank is clearly stated in the Bank of
Japan Act - namely, it is "achieving price stability, thereby contributing to the sound
development of the national economy". Obviously, therefore, the Bank will manage monetary
policy as guided by this aim and pursue the new price stability target set under this aim. With
a view to achieving sustainable growth with price stability, the Bank will examine the current
state of the economy and prices and the outlook thereof, and ascertain whether there is any
significant risk, including financial imbalances. Such a policy framework is the same as those
currently adopted by many other central banks. In this regard, if one is to call this "flexible
inflation targeting", the Bank's framework may be regarded as such.
Looking at the practices of overseas central banks, irrespective of the adoption of inflation
targeting, no specific date has been set for achieving price stability. The Bank's view on price
stability is based on a similar understanding in that the Bank aims to achieve price stability
on a sustainable basis.
The Bank is implementing the easing measures that I have just explained, and aims to
achieve the target at the earliest possible time. The effects of easing will be amplified and
brought forward if and when firms and other economic agents aggressively take advantage
of the accommodative financial conditions. Nevertheless, it is not possible at this juncture to
accurately predict how and when that would happen. In addition, considering that Japan has
a prolonged experience of low inflation, it also is not possible to foresee the potential
changes in the behavior of firms and households as the year-on-year rate of increase in the
CPI accelerates. Furthermore, the severity of the government's fiscal problems makes it
difficult to gauge the reactions of domestic and overseas financial markets. The Bank is fully
committed to pursuing achievement of the target as early as possible, under the aim stated in
the Bank of Japan Act, i.e., "achieving price stability, thereby contributing to the sound
development of the national economy". In my view, this policy stance of the Bank's is
consistent with the prevailing views of the Japanese people. For example, looking at the
results of the Opinion Survey on the General Public's Views and Behavior, which is
conducted by the Bank on a quarterly basis, the desirable "price stability" for most of the
population