Kazumasa Iwata: The conduct of monetary policy under the new framework
Excerpts of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at a meeting
with business leaders, Akita, 8 June 2006.
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The conduct of monetary policy
The Bank of Japan terminated the quantitative easing policy in early March 2006, and is in the process
of reducing the outstanding balance of current accounts held by financial institutions at the Bank. The
outstanding balance, which was at around 30 to 35 trillion yen at the time of the termination, is
currently at around 12 trillion yen.
Some market participants take the view that the pace of reduction may be too fast, and speculate that
this may reflect the Bank's intention to raise the target for interest rates at an early date. Market
participants expect the Bank to raise the target for interest rates at some point during fiscal 2006, and
this expectation has been factored into current market rates.
The Bank, however, noted when the quantitative easing policy was terminated that it would take a few
months before the outstanding balance declined to a level near the reserve requirement. The Bank's
money market operations have been in line with this policy statement, and the Bank has not been
accelerating the pace of reduction in order to raise the target for interest rates at an early date. It has
been some time since money market transactions were conducted under normal market conditions, so
that some rates have risen due to trading friction. Nevertheless, on the whole the Bank's reduction of
the outstanding balance has been carried out in a stable manner.
New framework of monetary policy and policy implementation
The conduct of monetary policy is now based on the new framework announced in March this year
and on the findings from examining the risks affecting the economic outlook that are described in the
Outlook for Economic Activity and Prices (hereafter the Outlook Report).
Under the quantitative easing policy, monetary policy was conducted with an emphasis on the
underlying trend of the core consumer price index (CPI). To be more specific, with the overnight call
rate at virtually zero percent, the Bank made a commitment to maintain the quantitative easing policy
until the year-on-year rate of change in the core CPI registered zero percent or higher on a sustainable
basis in order to affect market expectations of the future path of interest rates.1 This effect is referred
to as the policy duration effect.
The effectiveness of the quantitative easing policy has been the focus of much debate and criticism. I
believe, however, that ultimately the policy achieved its initial aims, although this took some time.
There are two reasons for this success. First, the commitment by the Bank to maintain the quantitative
easing policy until the core CPI registered zero percent or higher on a sustainable basis provided an
anchor for stabilizing expectations concerning future price movements.
Second, the commitment to maintain the policy helped keep relatively long-term rates as well as
shortterm rates at low levels by affecting expectations regarding the future path of interest rates. As a
result, the burden of firms' debt was lightened, facilitating business restructuring. This restructuring
increased the effectiveness of resource allocation, leading to improvements in productivity and
corporate profitability, and ultimately pushed up the potential growth rate. In short, the combination of
low market interest rates and the increased rate of return on corporate nonfinancial assets acted as
the basic mechanism pushing the rate of change in the core CPI above zero percent.2 It goes without
saying that the Bank's ample provision of liquidity played a complementary role in stabilizing financial
markets and keeping interest rates low.
The quantitative easing policy was at times criticized as being extremely risky, being likened to driving
with one's eyes on the rearview mirror because the Bank relied on a price index, a lagging indicator, in
conducting monetary policy.
The Bank did not rely solely on the rearview mirror, however. In October 2003, the Bank provided a
detailed description of its commitment to maintaining the quantitative easing policy. One of the
conditions underpinning the commitment was that the Bank needed to be convinced that the
prospective core CPI would not once again drop below zero percent after terminating the policy.
Following the introduction of a new framework in March, the Bank disclosed the Policy Board
members' understanding of what constitutes "medium- to long-term price stability" in numerical terms.
The distribution ranged between the rate of year-on-year change in the CPI of zero and 2 percent, with
most members' median figures falling around 1 percent.
It is important to note here that the "understanding of medium- to long-term price stability" was not
kept within the Policy Board but was disclosed to market participants and made common knowledge.
In this way, the information could become a focal point of market interest and function as a catalyst in
forming a consensus concerning inflation expectations.3
With the change in the framework, the policy anchor for price stability shifted from the commitment in
terms of policy duration to the Policy Board's "understanding of medium- to long-term price stability."
Furthermore, in light of the "understanding of medium- to long-term price stability," the Bank decided
to examine periodically the risks facing the Japanese economy, both in the short term (one to two
years) and in the medium to long term, using the findings to formulate its thinking on the future
conduct of monetary policy. The Bank is thus able to implement short-term policy in a flexible and
timely manner based on due assessment of economic risks.
Returning to the metaphor of driving a car, the degree of divergence in the opinions of Policy Board
members regarding the destination has been made clear (increased transparency), and the Bank is
back to conventional driving with a close eye on the risks ahead, ready to react quickly when
necessary.
The new framework can be said to ensure transparency as well as timeliness and flexibility in two
senses.
First, disclosing the Bank's thinking concerning medium- to long-term price stability has enhanced the
transparency of its policy conduct, making it possible to conduct short-term monetary policy with
increased flexibility.
Second, given the fact that Japan's economy is in transition away from deflation and that structural
changes continue to take place in the economy, a review of the Policy Board's "understanding of
medium- to long-term price stability," to be conducted once a year as a rule, will enable a more flexible
response to changes in the economic outlook and ensure the transparency and flexibility of the Bank's
monetary policy.
In short, the new framework has articulated specific measures for realizing the principle of monetary
policy stipulated in Article 2 of the Bank of Japan Law: to contribute "to the sound development of the
national economy" "through the pursuit of price stability."
The key point here is that by stabilizing inflation expectations in the medium to long run, flexibility in
conducting monetary policy in the short run has been increased, and this in turn has made it easier to
achieve the objective of sustainable growth under price stability.
The "understanding of medium- to long-term price stability" is different from the Bank of England's
inflation target or the European Central Bank's quantitative definition of price stability, and is an
important first step toward the optimal monetary policy for realizing the principle stipulated in Article 2
of the Bank of Japan Law.
The policy interest rate - the basis for producing forecasts
In the most recent Outlook Report, the economic forecasts of Policy Board members were made
taking account of market participants' expectations of future policy rates, which were deduced from
market interest rates.4 Under the quantitative easing policy, it was natural to base forecasts on the
assumption that the policy interest rate would be constant until at least the year-on-year rate of change
in the core CPI registered zero percent or higher on a sustainable basis. Under the current framework,
however, this assumption would be rather unnatural. Prices of assets, such as stocks and land,
incorporate expected future movements in interest rates. Therefore, the assumption of constant
interest rates would generate a forecast based on asset prices that differ from those currently
observed. It goes without saying that ignoring actual asset prices when making forecasts is highly
counterintuitive.
This does not of course imply that Policy Board members base their economic forecasts directly on the
market's forecast of the policy interest rate. Mechanically adopting market forecasts of interest rate
developments in conducting monetary policy and preparing forecasts might cause economic and price
developments to diverge from the Bank's desired path. The new method does, however, take into
account market expectations in making economic forecasts, and thus its adoption is another important
step toward achieving an optimal monetary policy.
Conclusion
Against a background of high crude oil prices, major countries around the world are in the process of
economic adjustment, aiming for a soft landing near the potential growth rate while maintaining stable
prices. Financial markets around the world also are making adjustments, reflecting changes in the
economy as they seek a new equilibrium. The Japanese economy has so far been moving in line with
the forecast described in the April Outlook Report. Although various risks lie ahead, Japan's economy
is likely to achieve sustainable growth under price stability. I believe, however, that in order to make
this happen, it is vital that monetary policy is implemented appropriately so that the full potential of the
new policy framework can be realized.