Haruhiko Kuroda: Quantitative and qualitative monetary easing - theory
and practice
Speech by Mr Haruhiko Kuroda, Governor of the Bank of Japan, at the Foreign
Correspondents' Club of Japan, Tokyo, 20 March 2015.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
It is my great honor to have the opportunity to speak today at the Foreign Correspondents'
Club of Japan.
With the European Central Bank (ECB) having started its asset purchase program, most of
the major central banks, including the Federal Reserve and the Bank of England (BOE), now
have adopted quantitative easing (QE). If I may borrow the words of Professor Takatoshi Ito,
a friend and someone I greatly respect, "we are all QE-sians now." That being said, the
economic and price situation against which QE has been introduced, as well as the policy
transmission mechanism assumed, differ among countries and regions. Today, I would like
to clarify the characteristics of the Bank of Japan's current quantitative and qualitative
monetary easing (QQE) by focusing on similarities to and differences with the QE introduced
by other central banks. I will further explain how QQE has been producing the intended
effects.
I. The theory behind QQE
Similarities and Differences between QE and QQE
I just mentioned that "we are all QE-sians now." What brought us into this situation is the
global financial crisis in 2008. The U.S. and European economies deteriorated considerably
due to the global financial crisis and unemployment increased substantially, so that central
banks had to stimulate the economy through monetary easing. Initially, central banks in
Europe and the United States responded to the crisis by using the traditional policy tool of
lowering short-term interest rates, but since the economies deteriorated quite significantly,
those rates soon approached the zero lower bound (Chart 1). Facing the zero lower bound
on short-term nominal interest rates, central banks were therefore confronted with the
question of how to proceed with further monetary easing. The Federal Reserve's and the
BOE's answer was to introduce QE. QE mainly aims at stimulating the economy by lowering
long-term interest rates, which still had room to fall, through massive purchases of
government and other bonds by the central bank.
The Bank's QQE is similar to QE in that it aims to encourage long-term interest rates to
decline through massive purchases of government bonds. QQE, however, has another
element: to drastically change the deflationary mindset that had taken hold amid the
prolonged deflation. In order to understand this point, it is necessary to correctly diagnose
the problems ailing Japan's economy and identify appropriate remedies.
Japan's economy had been suffering from deflation since the mid-1990s, with the
year-onyear rate of change in the consumer price index (CPI) being about zero or slightly negative.
A key feature of deflation in Japan was that it was mild but persistent: the average of the
year-on-year rates of change in the CPI from fiscal 1998 to fiscal 2012 was only minus
0.3 percent, but the deflationary situation lasted for a decade and a half (Chart 2). Japan got
mired in deflation due to a variety of factors, including balance sheet adjustments by firms
and financial institutions following the bursting of the asset price bubble, the inflow of
lowpriced goods from emerging economies, and the excessive appreciation of the yen.
Whatever the reasons may be, a key problem that arose is that, as prices continued to fall
due to these factors for a prolonged period, a deflationary mindset took hold among the
public - that is, the belief became entrenched that prices would not increase but continue to
steadily decline. Once this deflationary mindset had taken hold, people engaged in economic
activity assuming that deflation would continue. As a result, the economy fell into a vicious
cycle of a decline in prices, a decline in sales and profits, stagnant wages and consumption,
and a further decline in prices. Moreover, under deflation, the real value of cash and deposits
increases with the decline in prices. Therefore, hoarding cash and deposits becomes a
relatively better investment strategy than actual investment, discouraging firms from taking
risks and investing in business facilities and in research and development to launch new
businesses. In this way, deflation in Japan perpetuated itself in a self-fulfilling manner and
the growth potential continued to decline.
In order to overcome this situation, it is necessary to change the entrenched view that "prices
will not rise" and achieve a state in which firms and households act based on the assumption
that "prices will rise moderately every year." In the economic jargon, people's view on how
prices will develop in the future is called inflation expectations. And although inflation rates
tend to fluctuate - reflecting not only the business cycle but also temporary factors such as
changes in commodity prices - they are likely to do so at around the level of inflation
expectations on average, if medium- to long-term inflation expectations are anchored at a
certain level.
A numerical definition of what central banks consider as price stability based on a specific
price index is about 2 percent in terms of the year-on-year rate of change in the CPI; this has
become the global standard in recent years. While I will not go into detail due to time
constraints, this figure - 2 percent - takes into account the upward bias in the CPI, that is,
the tendency of the index to overstate inflation, and provides a buffer allowing to sufficiently
lower real interest rates should the economy deteriorate.
For Japan's economy to overcome deflation, it was necessary to dispel the deflationary
mindset and raise inflation expectations - which had declined to about 0 percent - to about
2 percent and re-anchor expectations at that level. Changing people's expectations is the
main aim of QQE.
The theory behind QQE
Attempting to change people's mindset and perceptions through monetary policy is not
without historical precedent. For example, while the direction of desired change was the
opposite of that in Japan, the Federal Reserve under Chairman Paul Volcker was successful
in the late 1970s to early 1980s in substantially lowering inflation expectations, which had
been ratcheting upward, through powerful monetary tightening (Chart 3). Since both
unemployment and inflation were surging at the time, such stringent monetary tightening
created both political and social challenges. Despite such difficulties, however, it was quite
clear to Chairman Volcker what policy steps he had to take to lower inflation expectations: he
had to pursue strong monetary tightening by substantially raising short-term interest rates to
contain inflation. On the other hand, while QQE would not aggravate unemployment, it faced
another problem, namely that the tools for monetary easing were limited, given that
shortterm interest rates were close to the zero lower bound.
The thinking behind QQE is as follows. First of all, as I discussed earlier, given that
shortterm interest rates had declined to zero, the Bank, like the Federal Reserve and the BOE,
decided to put downward pressure on long-term interest rates through massive purchases of
government bonds.
The Bank then focused on the fact that what influences economic activity is not nominal but
real interest rates, that is, the interest rate level obtained by subtracting inflation expectations
from nominal interest rates. In this regard, the fact that inflation expectations in Japan were
well below the price stability target of 2 percent provided a way to break through the
deflationary mindset: if the Bank could raise inflation expectations, real interest rates would
fall, stimulating economic activity by firms and households. In this sense, raising inflation
expectations is both an objective of QQE and, at the same time, the key to implementing the
QQE transmission mechanism to overcome deflation.
This raises the question of how people's deflationary mindset can be changed and inflation
expectations can be raised. For firms and households with a deflationary mindset to start
thinking that "from now, we will act based on the assumption that prices will rise by about
2 percent every year," it is necessary above all that the central bank fully commits itself to
achieving 2 percent inflation. Based on these considerations, the Bank committed itself to
achieving the price stability target of 2 percent at the earliest possible time, with a time
horizon of about two years, and to maintaining the target in a stable manner. And as a
means to this end, the Bank introduced large-scale monetary easing in the form of QQE.
A decline in real interest rates can be expected to stimulate private demand such as
business fixed investment, private consumption, and housing investment. Such an increase
in private demand in turn reduces the output gap, that is, the amount of slack in the economy
as a whole, thereby putting upward pressure on prices. And once people actually experience
inflation, this will boost their confidence in the Bank's commitment, leading to a further rise in
inflation expectations and reinforcing the aforementioned processes, forming a virtuous
cycle. This is the mechanism through which QQE aims at raising inflation and inflation
expectations to 2 percent.
II. The practice of QQE
Effects of QQE
So far, I have talked about the theory of QQE, but to what extent has this policy actually been
exerting any effects?
First of all, as a result of the Bank's massive purchases of Japanese government bonds
(JGBs), long-term interest rates have further declined. Ten-year JGB yields have recently
been around 0.4 percent (Chart 4). Moreover, the average interest rate on new loans has
declined to historic lows of about 0.9 percent.
In addition, people's perception of inflation has clearly changed. Various indicators of
medium- to long-term inflation expectations show clear increases since the introduction of
QQE. For example, the figure presented in the Consensus Forecast was 0.8 percent in
October 2012 but has risen to 1.5 percent of late. Therefore, real interest rates, including
longer-term ones, have become clearly negative.
Also, people and businesses feel that, in their daily life, the inflation environment has been
changing substantially. Let me cite two noteworthy examples. First, the year-on-year rate of
change in the CPI has been positive for 20 months since June 2013. This is the first time
since 1998 that people have experienced inflation for such a long period. It means that this is
the first time ever for people in their 20s or younger to experience rising prices. Second,
since last year, nominal wages have been rising. Of particular note is that during the annual
wage negotiations last spring, the so-called spring offensive, base pay rose for the first time
in about 20 years, and rising base pay is likely to be seen in increasingly many firms this
year.
Both examples represent landmark changes for Japan, which has experienced deflation for
such a long period. While the word "deflation" - defure in Japanese - had become part of
everyday conversation, recently the term can rarely be heard.
Furthermore, this momentum toward overcoming the deflationary mindset has continued
even amid the decline in CPI inflation reflecting the effects of falling crude oil prices. Looking
at indicators of inflation expectations, while market-based indicators such as the break-even
inflation rate - as in Europe and the United States - have declined, various surveys of
economists and households suggest that medium- to long-term inflation expectations
continue to be on an upward trend. We believe this is because the Bank's expansion of QQE
last October - undertaken as a preemptive response to the risk that falling crude oil prices
could affect wage negotiations and price-setting by lowering inflation expectations - has
been effective.
As I have explained, QQE has been exerting its intended effects and it seems safe to say
that QQE works both in theory and practice. The Bank believes that it can achieve the price
stability target of 2 percent by continuing to steadily pursue QQE going forward.
In the following, I will offer my view on the economic and price situation in more detail, and
explain why I think that QQE will lead to the realization of the price stability target of
2 percent.
Economic and price situation
Let me start with economic activity. The corporate sector is buoyant. Profits have continued
to improve and have reached new peaks (Chart 5). The decline in crude oil prices will further
benefit the sector by reducing costs. In addition, exports and production have been picking
up. In this situation, firms have maintained their positive investment stance and their demand
for labor has remained strong.
Against the backdrop of the strong demand for labor in the corporate sector, labor market
conditions remain tight and Japan is close to full employment. Specifically, the
unemployment rate has declined to around 3.5 percent, which is roughly the same level as
the structural unemployment rate (Chart 6). The tightness in labor market conditions has
been exerting upward pressure on nominal wages, which are expected to continue rising.
Against the backdrop of this steady improvement in the employment and income situation,
private consumption as a whole has been firm. In this situation, downward pressure
stemming from the decline in demand following the consumption tax hike has been waning.
The decline in crude oil prices will also have a favorable effect on private consumption.
Given the various tailwinds to economic activity, the Bank expects Japan's real GDP growth
in fiscal 2015 to be about 2 percent. In the Bank's January interim assessment of the
October 2014 Outlook Report for Economic Activity and Prices, the real GDP growth rate
was projected to be 2.1 percent in fiscal 2015 and 1.6 percent in fiscal 2016 (Chart 7).
In the current improving economic situation, the output gap has improved substantially
mainly due to the tightening of the labor market. It has become about 0 percent, that is, close
to the long-term average. Going forward, with Japan's economy continuing to grow above its
potential growth rate, which is estimated to be around 0.5 percent or lower, the output gap is
expected to further improve. In addition, as mentioned earlier, medium- to long-term inflation
expectations have remained on an uptrend. The underlying trend in inflation has been
increasing as its two determinants, namely, the output gap and medium- to long-term
inflation expectations, are improving.
However, in terms of the year-on-year rate of increase in the CPI excluding fresh food
stripping out the direct effects of the consumption tax hike, inflation has slowed since last
summer due mainly to the substantial decline in crude oil prices and registered 0.2 percent in
January (Chart 8). Going forward, the rate of increase is expected to be about 0 percent due
to the effects of the decline in energy prices and is likely to remain at that level for the time
being. However, the underlying trend in inflation is expected to continue to steadily increase
in the future. Therefore, as the effects of falling crude oil prices on the year-on-year rate of
change, that is, the base effect, dissipate, CPI inflation will accelerate and achieving
2 percent CPI inflation will come in sight. Based on the assumption that crude oil prices will
rise moderately from their recent levels, CPI inflation is expected to reach 2 percent in or
around fiscal 2015 (Chart 7). The timing of this could be somewhat sooner or later than
envisaged depending on developments in crude oil prices. However, if it is clear that the
timing in which the 2 percent target will be achieved depends mainly on fluctuations in
energy prices, market participants will not draw any unwarranted conclusions with regard to
monetary policy, as they know that the base effect caused by changes in energy prices will
eventually disappear.
Needless to say, the Bank maintains its policy stance that it will make adjustments as
necessary without hesitation, when there are changes in the underlying trend in inflation,
especially in developments in inflation expectations, in order to achieve the price stability
target at the earliest possible time.
III. The government's growth strategy and the bank's monetary policy
To conclude my speech, I would like to talk about strengthening the growth potential of
Japan's economy. Japan's potential growth rate has been on a declining trend since the
1990s (Chart 9). Reasons include demographic trends such as the decline in the
workingage population as well as regulatory and institutional factors that have hindered corporate
activities and impeded competition. In order to raise the growth potential, it is necessary to
remove such factors that hamper private entities' proactive economic activities.
Consequently, it is encouraging that various regulatory and institutional reforms have steadily
been implemented through the government's growth strategy.
In this context, I would like to highlight that overcoming deflation itself will contribute to
raising Japan's growth potential. Investment and innovation in the private sector are key to
economic growth, and the role of the government's growth strategy is to create an
environment in which firms can thoroughly pursue business opportunities. In addition,
overcoming deflation and achieving an economy and society in which economic entities take
action on the assumption of 2 percent inflation will revive firms' and households' animal
spirits. If that happens, people will start to take more risks and invest in new ventures, which
in turn is likely to give rise to innovations. With firms and households becoming more
proactive, it will become even clearer which regulatory and institutional aspects have
hampered growth. I think one of the reasons why only some progress has been made in
regulatory and institutional reforms is that the momentum toward reforms was lacking as
private entities were not sufficiently proactive. The emergence of real needs for reforms will
be a major driving force to push ahead with regulatory and institutional reforms.
Under QQE, the deflationary mindset is steadily being dispelled. The Bank aims to contribute
to strengthening the growth potential of Japan's economy through its continued efforts
through QQE and by achieving the price stability target of 2 percent at the earliest possible
time.
Concluding remarks
Today, I have talked about the challenges facing Japan's economy and the characteristics of
QQE as a remedy for those challenges. The greatest lesson from Japan's experience is that
the best is not to fall into deflation in the first place, since there is the danger that, once the
economy has fallen into it, deflation becomes protracted. If there is a risk of deflation, policy
authorities should make every effort to prevent the economy from falling into it.
Having said that, even if the economy becomes trapped in deflation, it is possible to
overcome deflation through innovative monetary policy. By succeeding in getting the
economy out of deflation through QQE, the Bank hopes to provide a case in point.
If the Bank can show that even if the economy falls into deflation, there are policy measures
to escape from it, this will strengthen confidence in central banks' ability to achieve their price
stability targets, which reinforces their ability to anchor inflation expectations. Well-anchored
inflation expectations, in turn, help to prevent the economy from falling into and becoming
trapped in deflation in the first place. In this regard, success of the Bank's QQE has important
implications not only for Japan's economy but also for monetary policy around the globe.
Thank you very much for your attention.
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