Yutaka Yamaguchi: The current state of the Japanese economy
Remarks by Mr Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, at the JCIF International
Finance Seminar, Bank of Japan, 17 October 2001.
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It is my great honor to be here at this JCIF seminar. Taking this opportunity, I would like to explain the
state of Japan's economy and the nature of confronting problems. I would also like to share my
thoughts on how to address the current difficult situation and, in particular, how the Bank of Japan
could contribute in such a process.
1. Global economic developments
I would like to start with the state of the global economy, in particular that of the United States, which
forms the basis of my assessment of Japan's economy. Currently, discussion about the prospect for
the US economy focuses on two issues. The first is the duration of the ongoing economic adjustment
process, which started in the IT-related areas, as well as the pace of the subsequent recovery. The
second is the economic impact of the tragic terrorist attacks in September.
The impact of the terrorist attacks in the US
Regarding the impact of the terrorist attacks, given great multi-faceted uncertainties, it is premature to
make informed judgement even if we narrowly focus on the economic areas. It is however safe to say
that we have succeeded in dealing with the most immediate challenge after the attacks, which was to
avoid market disruption and to maintain the well-functioning of financial markets with respect to
liquidity and settlements.
Soon after the attacks, central banks including the Bank of Japan, Finance Ministries, and financial
regulatory bodies in the world made a swift move while maintaining a close contact among each other.
In the area of central banking, central banks in major countries swiftly provided significant amount of
liquidity to money markets and declared their determination to secure the well-functioning of financial
markets and settlement systems. I think that these central bank actions exactly followed a textbook of
crisis management. At the same time, participants of financial markets also made their best efforts to
preserve the functioning of markets and to execute transactions smoothly. As such, thanks to the
coordinated efforts by the financial authorities, both at home and abroad, and market participants, we
successfully avoided disruption in financial markets, which could have extended subsequent negative
effects to the economy as a whole.
Currently, our focus has shifted to how the attacks and the subsequent developments will affect the
global economy especially that of the United States. On this point, as stated by the other financial
authorities abroad, we are confident that the attacks will not threaten a basis for economic growth in
the medium and long term. At the same time, however, we cannot deny greater uncertainties and a
loss of risk appetite in the near term. Looking at the US financial markets, for example, the stock price
has almost recovered the level recorded before the terrorist attacks, but still continues nervous
movements. In the meantime, credit spreads have remained widened. If such market situation
persists, it may affect corporate financing accordingly. In fact, downward revision of earnings involving
restructuring is spreading in the corporate sector and there is a risk that capital spending will be
depressed further.
Economic adjustment starting from the IT sector
In trying to assess the impact of the terrorist attacks, we should note that the adjustment in the IT
sector had already dragged down the US economic growth before the terrorist attacks. Therefore,
more fundamental issue for the prospect of the US economy is when the IT sector adjustment will end
and how rapidly the subsequent recovery will proceed.
Let me turn the clock back for a moment and review how the prospect for the US economy has
changed since the end of the last year. As you may recall, at the time of the FOMC meeting in
November last year, risks were weighted towards inflation rather than economic weakness. It was
early January that the FED started to lower the federal funds rate. Until this spring, however, prevailing
view was that the US economy would see recovery in the second half of this year, with the main issue
being the shape of the recovery: i.e. V or U or others. According to the Blue Chip Economic Indicators,
an average forecast for the US economic growth in 2001 was 2.6 percent in January, which was lower
than four percent-plus in 2000 but not a significant slowdown. The forecast has now markedly declined
to 1.1 percent, which is 2.4 percent point lower than the forecast made a year ago.
In retrospect, we can point out two pillars supporting the prevailing view until spring that the recovery
would take place in the second half of the year. The first pillar was the expectation that the IT-related
demand would recover relatively soon. Another was the belief that significant room for expansionary
macroeconomic policies, both monetary and fiscal, would be effectively used to prevent the economy
from falling into a serious recession. In addition, it was often pointed out as a favorable financial
condition that, unlike the post-bubble period in Japan, the US financial system did not have a serious
balance sheet problem.
Regarding the IT-related demand, as shown in the forecast by the industry, optimistic view on the
recovery has receded in terms of its timing as well as its pace. On the policy front, the FED has
reduced the federal funds rate from 6.5 percent at the beginning of the year to the current 2.5 percent
in early October. It is very unusual to reduce the rate by 4 percent point in just nine months. Tax
reduction of totaling $1,350 billion in the next ten years was decided and refunding started in July.
Additional fiscal measures are currently being discussed. Such decisive policy measures both in the
monetary and fiscal areas notwithstanding, the risks foreseen by the FOMC are still mainly on the
downside. In the corporate sector, adjustment in production and stocks has not managed to catch up
with a decline in demand especially in the IT-related sectors. It seems difficult to expect an early
recovery in fixed investment given a decline in a capacity utilization rate and deterioration in corporate
profits. Although consumption has so far shown resiliency, deterioration in employment and income
environment, together with adverse wealth effect caused by a fall in stock prices, have heightened
uncertainty. All in all, while significant uncertainty remains, more cautious views are warranted
regarding the near term prospect of the US economy.
Adjustment caused by a significant change in expectation
Observation of the significant change in expectation and the consequent pressure for economic
adjustment in the US prompts me to share a question with you. When bull expectation collapses, how
much can monetary policy alleviate the consequent economic adjustment? Since the mid-90s, the US
technology and telecom sectors have led the IT-related demand as they experienced an investment
boom with massive new entry to the market. The boom reflected a rise in the expected rate of growth
based on the good prospect for the Internet business. It also reflected the unique characteristics of the
information industry such as the economy of scale and the network externality. The significant
development in the IT areas has also raised the expected rate of growth for the US economy as a
whole. However, as economic slowdown becomes more evident, cautious views are apparently
growing with respect to the IT-led increase in productivity. In this regard, the new GDP series show
that growth rate of output and productivity for the period since 1998 have been significantly lower than
the previous estimate. The data revision made it necessary for us to re-evaluate the rise in productivity
growth in the second half of the 1990s, which has invited heated discussion under the title of "the rise
of the new economy." What I would like to discuss here, however, is not whether and to what extent
productivity growth accelerated during the period. Rather, I would like to ask how effectively monetary
policy can adjust an extreme swing in expectation and the resultant effects on activity. In this regard,
Chairman Greenspan stressed in his congressional testimony in July that monetary and fiscal policy
could not eliminate booms and busts in economic activity. He argued that often people were prone to
recurring bouts of optimism and pessimism and there was no tool to change such human nature. As a
central banker, with the current state of Japan's economy in mind, I read the Chairman's statement
with great interest as well as sympathy.
2. The state of Japan's economy
I have reviewed the global economic developments focusing on the US economy, which would
certainly affect Japan's economy in a significant manner. In the October monthly report, the Bank of
Japan disclosed its views on recent economic and financial development that was "adjustments in
economic activity are becoming more severe, as the substantial decline in production has a negative
influence on employment and income conditions." In April, the Bank published a half-yearly report
called "Outlook and Risk Assessment of the Economy and Prices" which showed relatively harsh
outlook at that point. But our views today are even more cautious than in April.
The "baseline scenario" we had in April was as follows. First of all, in the first half of this fiscal year,
the economy was likely to remain sluggish as a result of a decline in exports and production against
the background of a global economic slowdown. Second, in the latter half of this fiscal year, progress
in the adjustment in the US economy would lessen the downward pressure on Japan's economy.
Third, it would nonetheless take time for the economy to exhibit a clear recovery because of persistent
pressure on the economy arising from various structural problems. Fourth, it seemed likely that the
output gap would continue widening and prices would remain weak throughout this fiscal year. Against
this "baseline scenario", we identified four major risks: developments in overseas economies,
especially that of the United States, and in the IT-related areas; developments in asset prices such as
stock prices; the effects of structural adjustments including disposal of non-performing loans;
uncertainties felt by the public with respect to the future.
Reviewing the economic developments in the past six months, the negative effects of the first two risks
has proved to be evident. On the first risk, overseas economies have slowed down much faster than
expected. Consequently, exports and production continue to decline sharply and fixed investment
started to decrease against the background of deterioration in corporate profits. Such adjustment in
the corporate sector is now affecting household income through softening employment and wages.
Consumption has held up relatively well but we are now seeing weaker indicators there. The negative
impact of the second risk, i.e. weaker asset prices, is also becoming evident. In particular, a fall in
stock prices has not only hurt the business and household sentiment but also weakened the capacity
of financial institutions.
Under the circumstances, prices continue to decline. As often discussed, we cannot ignore the
supply-side factors in explaining the current price decline in Japan. As global competition intensifies,
firms are increasingly utilizing low cost imports. Supply-side factors also include rationalization of
distribution system and the effects of deregulation. The price development this year, however, appears
to be affected equally or even more by weak demand rather than the supply-side factors.
3. Monetary easing measures since March
Against the background of such severe economic developments, the Bank adopted in March strong
monetary easing measures with firm determination to prevent a continuous price decline and to form a
basis for a sustainable growth. In August, the Bank took further easing steps based on the framework
adopted in March. Furthermore, after the terrorist attacks in September, the Bank took every
necessary measure in monetary operations in order to secure smooth fund settlement and financial
market stability. The current monetary easing measures consist of four components.
First, the main operating target for monetary operations was changed from the overnight call rate to
the outstanding balance of current accounts held at the Bank of Japan. The new target was raised
from about four trillion yen to five trillion yen in March and further to six trillion yen in August. As I will
discuss a moment later, the Bank did not simply raise the target regardless of demand. The Bank
decided the level of the target such as five trillion or six trillion based on a judgement that it was the
maximum demand for the current account balance at the time. In September, the Bank swiftly
responded to a surge in demand for liquidity following the terrorist attacks. At the subsequent
Monetary Policy Meeting, the Bank decided to provide ample liquidity aiming at above six trillion yen,
without specifying the limit. In practice, the outstanding balance of the current accounts increased
toward the end of September going beyond twelve trillion yen. In October, as money market conditions
relaxed after successfully passing the September-end, the half-year book closing, the outstanding
balance has declined from its peak but still stays at far above six trillion yen, the level before the
terrorist attacks. As such, the call rates stay at effectively zero, reflecting the fact that ample liquidity
has been provided to the market far exceeding the required level under the reserve requirement
system, about four trillion yen.
Second, the Bank committed itself that the new monetary policy framework would continue until the
CPI inflation rate will stably stay at or above zero percent. This is the clear commitment on the
continuation of monetary easing in the future which is expected to extend easing effect to interest
rates with longer terms. This effect is often called "commitment effect" or "duration effect."
Third, the Bank decided that, while setting an upper limit, it would increase the outright purchase of
long-term government bonds if it deemed necessary for providing liquidity smoothly. Based on this
decision, in August, the Bank increased the outright purchase from 400 billion yen per month to
600 billion yen per month in terms of volume and from twice a month to three times a month in terms
of frequency.
Fourth, the Bank established the so-called Lombard-type lending facility. Using this facility, financial
institutions with collateral can always borrow funds from the Bank at the official discount rate under the
conditions pre-specified by the Bank. The facility strengthens the monetary easing effect by reducing
concerns over available liquidity and stabilizing market rates. The official discount rate, which is
applied to the Lombard-type facility, was reduced twice in February and September and is currently at
0.1 percent.
4. The effect of monetary easing
The Bank believes that the current easing measures are very strong in nature. In fact, the policy to
induce short-term interest rates to effectively zero and to make commitment about future policy based
on CPI is an unusual step into uncharted territory. Nonetheless, in view of the worsening economic
conditions, we decided to take such an unusual step into uncharted waters as long as some effects
were thought to exist at least theoretically. The textbook of economics does not give us any guidance
regarding the uncharted territory we have stepped in. At best, the theoretical concept of "liquidity trap"
presented by Keynes is close to the current situation of Japan's economy. Still, Keynes did not provide
monetary policy prescription to exit "liquidity trap," for he simply argued that monetary policy would be
ineffective and fiscal expansion was necessary in such a situation. In conducting monetary policy,
therefore, we have endeavored to carefully avoid the risk of being caught by dogmatic views regarding
the effects and limits of our entrusted policy tools.
As a result, as time passes, we have accumulated more knowledge about the effects and limits of
monetary easing measures in the uncharted territory. Based on the experience in the past six months,
I would like to provide tentative answers to the questions and hypothesis that I had before the
adoption of the current easing measures.
The outstanding balance of current accounts
The first question was whether a central bank could increase the outstanding balance of current
accounts even after short-term rates had reached zero. Given the fact that we experienced a shortfall
in bids, or "under-subscription," for open market operations under the previous zero interest rates
policy, we were not so certain whether we could increase the current account balance smoothly. On
this point, our tentative conclusion, to no surprise, is, "with little room left for a rate decline, the current
account balance can be increased only when there is demand for it and cannot be increased without
demand."
In fact, in May, the Bank frequently experienced a shortfall in bids even at 0.01 percent. To cope with
the situation, the Bank decided to change the unit of bidding rates for open market operations from
0.01 percent to 0.001 percent, which enabled the market operation rate to decline further. As a result
of this change, we have not experienced a shortfall in bids so far. If such a shortfall happens again for
some reasons, however, can we cope with the situation by simply reducing the unit of bidding rates
further to 0.0001 percent? This is an interesting theme for economics but I remain skeptical.
In any case, however, the Bank can increase the current account balance flexibly as long as demand
for liquidity increases. Demand for liquidity could rise for variety of reasons such as concern for
smooth operation of settlement system or financial system instability. In sum, the current account
balance can be increased when a certain stress gives incentives for financial institutions to hold larger
amount of liquidity in the current account from a precautionary motive. In practice, the balance was
raised substantially in response to such a precautionary motive in the end of 1999 in preparations for
the Y2K problem and in early 2001 during the process of introducing the Real Time Gross Settlement
system. We could raise the current account balance above 12 trillion yen in September because of a
surge in demand for liquidity caused by the terrorist attacks, the collapse of a large retailer, and a fall
in stock prices. The effects of those factors were also amplified in the period approaching the end of
September. The rising demand for liquidity also reflected waning incentives of financial institutions to
invest their funds in money markets. Investing 10 billion yen overnight earns merely 273 yen, which is
not sufficient to cover various transaction costs. When interest rates significantly decline, financial
institutions prefer to hold funds with the Bank of Japan even without any interest earnings. Once such
movement spreads among financial institutions, funding in money markets becomes more difficult
which will force the borrowers to build up the current account balance from a precautionary motive.
What is important therefore is not whether we can increase the current account balance under the
effectively zero interest rate but what effects such an increase may have. The surge in demand for
liquidity after the terrorist attacks is not a favorable development as it reflects rising concern in the
financial markets. It may not stimulate economic activities. Having said this, increasing the current
account balance in response to rising demand for liquidity is one of significant contribution that a
central bank could make because it relieves concern in the markets.
Interest rates, foreign exchange rates, and stock prices
The second issue was whether a substantial increase in the current account balance would affect the
asset prices such as interest rates, foreign exchange rates and stock prices. The effect of monetary
policy permeates to the real economy through significant changes in these asset prices. Needless to
say, an increase in the current account balance results in a decline in overnight interest rates. Once
overnight interest rates reach zero percent, however, we can no longer expect a change in interest
rates to promote portfolio rebalancing. Therefore, if an additional supply of current account balance
results in a change in the prices of financial assets, it could be achieved either through a) reallocation
of money from no-risk-no-return current accounts to higher-return-higher-risk assets, or b) effects on
inflation expectation for the future. Such effects through these routes could exist at least theoretically
and qualitatively.
Let me review the financial market developments since March from the above viewpoints. Not
surprisingly, short-term interest rates declined to effectively zero thanks to ample liquidity provision.
The Lombard-type facility also helped to stabilize interest rates. Interest rates in the medium-term
zones also went below the level experienced under the previous zero interest rate period as the
"duration effect" worked strongly. In contrast, long-term rates have risen somewhat compared to the
level recorded before the March easing measures. They did not decline even after an increase in the
outright purchase of the long-term government bonds in August. Rather, in these days, the JGB
market is becoming sensitive to the news implying a possible increase in JGB issuance such as the
prospect for the supplementary budget. On the other hand, stock prices once rose soon after the
monetary easing in March but have continuously declined after May, reflecting deterioration in
economic activities in general and corporate profits in particular. Stock prices did not respond to the
monetary policy change in August. Looking at foreign exchange rates, against the background of the
more than expected slowdown of the US economy, the yen has not depreciated in comparison to the
March level.
Corporate financing in capital markets
The third issue is the effect of a current account balance increase on the corporate financing
environment in capital markets such as the CP and corporate bond markets. Facing the weakening
role of banks as financial intermediaries, enhancing the function of capital markets could be an
important route of monetary easing. In this regard, the environment for corporate financing has
improved after the easing measures in March. In particular, the outstanding balance of CPs has
maintained the historical high and the outstanding balance of corporate bonds has been showing a
two to three percent growth on a year-on-year basis. Credit spreads of CPs and bonds have been
narrowing, indicating more risk appetite of investors. Against this background, corporations are more
willing to issue CPs and bonds. It should be noted, however, that those firms capable of issuing CPs
and bonds often enjoy relatively high credit ratings and, therefore, such monetary easing effect has
not benefited those businesses without access to capital markets.
Bank lending
The fourth issue is the impact on bank lending. In this regard, the easing measures since March have
not apparently changed banks' lending behavior. In practice, the declining trend in bank lending has
mildly accelerated. On the other hand, growth in money supply, deposits held by households and
corporations, has changed little at an annual rate of around three percent. The decline in bank lending
and moderate growth in deposits should result in an increase in some other investment. In the past
year, banks increased investment in the government bonds and the current accounts with the Bank of
Japan, both assets free of credit risks.
Then, why doesn't bank lending increase? I will try to give an answer to this question by focusing on
financial institutions' lending behavior against the background of the relatively weak credit demand. At
the time of an economic downturn, creditworthiness of corporations generally deteriorates and banks
have to widen spreads for lending; otherwise they lose profits. However, with deteriorating corporate
profits, banks face a decline in the number of projects with sufficient profits to cover wider spreads. In
ordinary financial environment, even with the widening of spreads, monetary easing brings lending
rates down by lowering banks' funding costs and, consequently, can eventually promote an increase in
lending. In the current situation, banks' funding costs cannot go down further because interest rates
are effectively at zero. To make matters worse, banks hold a large amount of non-performing assets
and unprofitable loans in their portfolio built up in the past. By holding such unprofitable loans for a
long time, it will become more difficult for banks to cover by operating profits the necessary cost to
deal with the non-performing assets. Needless to say, banks are making efforts to improve profitability
of their lending activities by enhancing the credit quality of unprofitable but viable companies through
various supports. Nevertheless, there are a substantial number of non-viable companies. Furthermore,
making progress in structural reforms in the economy and industries means, looking from the other
side, a reduction of banks' unprofitable loans and non-performing assets. Therefore, from a macro
perspective, it is inevitable to a certain degree that banks' lending and balance sheet shrink in the
process of structural reforms in the economy and industries. Also, for the purpose of restoring sound
financial system, it is a necessary condition that banks put emphasis on profitability.
To sum up, the Bank of Japan's abundant liquidity provision has induced desirable impact on the CP
and corporate bond markets but the overall effect has not sufficiently transmitted to agents outside the
financial system. As a result, we have not seen improvement in economic and price developments.
How can we change such a situation? That is the big challenge for Japan's economy and for the
conduct of monetary policy.
5. Inflation targeting
I would like to offer some of my thoughts on this difficult challenge in the final part of my speech. But
before doing that, I would like to touch upon inflation or price level targeting, which has been
frequently discussed. Can it be a prescription for the current problems confronting Japan's economy?
I will start by explaining what I think inflation targeting exactly is. In my understanding, inflation
targeting has been introduced as a mechanism to improve the transparency of monetary policy. But I
do not think that inflation targeting is the only way to increase transparency. I believe that the way to
increase transparency should be judged based on the unique situation of each country. For example,
in the United States, interest rates have been cut substantially in a short period of time this year but
the CPI inflation rate changed little during the course staying at around three percent. If inflation
targeting were adopted during this period, should there be any difference in the conduct of monetary
policy or subsequent developments in the US economy? Or could we expect more transparency
regarding monetary policy? I have to say that I am skeptical. Price development is one of very
important economic indictors and many central banks including the Bank of Japan carry price stability
as a policy objective. Still, I think it difficult to make monetary policy judgment solely based on the
development of a single price index.
Having said this, I do not deny the benefit of inflation targeting. Main reason the Bank of Japan thinks
it inappropriate to adopt inflation targeting is that, in the current economic and financial situation,
monetary policy alone cannot prevent a price decline. As I have already discussed, even after
exhausting orthodox policy measures, the Bank of Japan has been engaged in monetary operations to
significantly increase the current account balance as well as making use of the "duration effect".
Despite such dedicated efforts, however, economic activities have not been stimulated and prices
have not stopped declining. In that sense, it is indispensable to bring the economy back to an
"ordinary" state first. As stated in the Bank's report on price stability published in autumn last year, we
think that the adoption of inflation targeting is one of the issues to be examined when the economy
goes back to an "ordinary" state. Since this spring, the Bank has held the Workshop on Price Stability
for three times in order to promote the mutual understanding of the issues related to prices between
academics and the Bank staff. Making use of the outputs of such a workshop, the Bank will continue
studying the meaning of price stability and inflation targeting in the context of the conduct of monetary
policy.
6. Should the Bank buy any kind of assets?
But I think the ongoing discussion on inflation targeting here in Japan is somewhat different from the
discussion abroad which places inflation targeting as a tool to increase transparency. I dare say that
many argue that "the Bank of Japan should meet an inflation target by purchasing any kind of assets"
and claim that such policy is inflation targeting. In practice, those who call for the adoption of inflation
targeting argue that we can cause inflation if the Bank purchases all kinds of assets. Should the Bank
increase the outright purchase of long-term government bonds aggressively? Should the Bank
purchase foreign currency denominated assets or private debts? Discussions over these issues have
been widely covered in the minutes of the Monetary Policy Meetings, speeches by my fellow board
members, or papers written by the Bank staff. Therefore, I would like to touch upon the following two
issues from somewhat different perspective.
The first issue is the purpose of adopting such measures. By and large, it might be true that, if a
central bank continues purchasing all kinds of assets, almost by definition, inflation can be created in
the end. However, our goal is not to cause inflation but to realize a sustainable growth. As can been
seen in the past experience of Japan's economy, it is not correct to assume that inflation comes first
followed by an economic upturn or an increase in growth rate. What happened in the past was
opposite: an economic upturn and a rise in growth rate came first and inflation followed with a lag.
Therefore, the focus should be how to stimulate economic activities or, in other words, how to make
corporations invest more and households spend more.
The second issue is the governance of a central bank in a democratic society. The only explicit
constraint for the choice of assets to be purchased by a central bank is a legal one. The Bank of
Japan Law stipulates the type of assets to be purchased for the purpose of monetary operations. For
example, the Bank can and does purchase government bonds and commercial bills but cannot
purchase stocks. Real estates can be purchased for business use but not for the purpose of monetary
operations. Then, leaving such legal constraint aside, what kind of assets should a central bank
purchase?
Central banks in industrial countries usually do not purchase stocks or corporate bonds for the
purpose of monetary operations. It seems that there are probably two reasons.
The first reason is that stocks and corporate bonds have more credit risk compared to government
bonds or the short-term commercial bills with plural good names, meaning they are protected by the
credit of a bank and a company. If a central bank increases purchasing of stocks and corporate bonds,
it may earn profits but, with a certain probability, may incur a loss. A central bank itself does not
directly feel a pain because it can issue liabilities without interest rate cost. But taxpayers eventually
incur the loss as transfer from a central bank to the Treasury decreases. This is the very reason a
central bank is required to issue banknotes by purchasing safe assets. As a second reason, a central
bank needs to decide the specific names of stocks and corporate bonds to be purchased. Given the
fact that a central bank does not have any advantage over commercial banks in making judgment on
the quality of individual companies, it is a natural conclusion t