Haruhiko Kuroda: How unconventional monetary policy stimulates
demand - theory and practice
Remarks by Mr Haruhiko Kuroda, Governor of the Bank of Japan, for the Panel Discussion at
the Bank for International Settlements Annual General Meeting, Basel, 28 June 2015.
* * *
It is a great honor to be able to participate in this panel discussion today.
The Bank of Japan introduced its Quantitative and Qualitative Monetary Easing (QQE) in
April 2013. One tentative conclusion that can be drawn from the experience of a little over
two years is that central banks can overcome the zero lower bound, as long as the policy
maker commits decisively to fulfilling its mandate with well-designed unconventional policy
measures. To give you some idea of the outcomes since the beginning of the QQE, the
unemployment rate has fallen 0.8 percentage point, and CPI inflation has risen about 1
percentage point. Other major central banks have also been successful in stimulating
demand through their own unconventional policies.
It has become a common understanding among the central bank community that
unconventional monetary policy, despite some lingering skepticism from the academic front,
has actually proven to be effective. This is best characterized by a famous quote from the
former Fed Chair, Ben Bernanke: "The problem with QE is it works in practice but it doesn't
work in theory." In that case, the question remaining about unconventional monetary policy is
not whether it works, but why it works. The rest of my remarks will focus primarily on this
issue from both theoretical and practical perspectives.
First, let me start with term premiums. Whether central banks' large-scale asset purchases
succeed in reducing term premiums hinges upon whether the preferred habitat hypothesis
holds.1 Some influential academics deny this effect, claiming that "open-market operations
should be largely ineffective to the extent that they fail to change expectations regarding
future policy."2 This argument is presumably what was in Mr. Bernanke's mind when he said
that QE didn't work in theory.
Among central bankers, however, it is becoming increasingly accepted that term premiums
can actually be reduced by large-scale purchases of long-term bonds through changes to
their demand-supply conditions.3 Experience has further convinced us that the fall in
longterm interest rates in turn affects the price of other financial assets such as equities and
private credits through portfolio rebalancing, as predicted by James Tobin's General
Equilibrium theory.4 Economists have recently started to embed this preferred habitat
mechanism in their macro-economic models so as to explicitly incorporate this transmission
channel of QE.5
1
Franco Modigliani and Richard Sutch, "Innovations in Interest Rate Policy," American Economic Review,
Vol. 56, pp. 178-197, 1966.
2
Gauti Eggertsson and Michael Woodford, "The Zero Bound on Interest Rates and Optimal Monetary Policy,"
Brookings Papers on Economic Activity, No. 1, pp. 139-235, 2003.
3
There are a number of empirical studies that attempt to decompose long-term government yields into the
expected path of short-term interest rate and premium components. For Japanese government bonds, see
Kei Imakubo and Jouchi Nakajima, "Estimating Inflation Risk Premia from Nominal and Real Yield Curves
Using a Shadow-Rate Model," Bank of Japan Working Paper, No. 15-E-1, 2015.
4
James Tobin, "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking,
Vol. 1, pp. 15-29, 1969.
5
Han Chen, Vasco Cúrdia, and Andrea Ferrero, "The Macroeconomic Effects of Large-Scale Asset Purchase
Programmes," The Economic Journal, Vol. 122, pp. F289-F315, 2012.
Second, forward guidance, which is another element of unconventional monetary policy, is
generally supported both in theory and in practice. In theory, forward guidance could pin
down the future expected path of policy rates by clarifying the central bank's policy reaction
function and thereby reducing the volatility of financial markets. In fact, forward guidance,
together with a strong commitment to policy objectives, has been used effectively in various
policy settings across jurisdictions.
Third, let me discuss the "quantitative" aspect of quantitative easing. Does the size of the
central bank's balance sheet matter in itself and, if so, why? Some theoretical economists
argue that QE is effective from the viewpoint of monetary financing of the government budget.
However, this is the opposite case of Ben Bernanke's quote: it works well in theory but cannot
be applied in practice. Monetary finance is widely understood to run the risk of eroding the
credibility of the central bank and thereby potentially increasing risk premiums rather than
reducing them. Furthermore, recent experience in the United States and the United Kingdom
has demonstrated that an unconventional monetary policy works even in the midst of
substantial fiscal consolidation. In the case of Japan, the joint statement of January 2013
clearly stated that the Bank of Japan would pursue a 2 percent inflation target while the
government committed to ensuring long-term sustainability of the public debt. Thus, from the
beginning there was no intention at all that QQE would work through facilitating fiscal
expansion.
While monetary finance is not on our agenda, the size of central bank balance sheets is, in
my view, important for a different reason. Since inflation is widely perceived to be ultimately a
monetary phenomenon, the creation of a massive quantity of money would be a strong signal
of a central bank's commitment to fighting deflation. It is in this context that an
unprecedented expansion of the monetary base plays an essential role in our QQE.
Fourth and lastly, I will discuss what I believe is a very critical transmission channel of
unconventional monetary policy: the expectation channel. This overlaps with the signaling effect
associated with the "quantity" that I just mentioned.6 One possible problem is that the theoretical
foundations seem not to be well established. Standard theories simply assume that rational
expectations automatically hold, while they tend to be silent on exactly what it would take to
change the way firms and households formulate their expectations. I am quite confident,
however, that a strong commitment to policy objectives, clear and consistent communication,
and decisive action to fulfill the commitment would collectively be powerful enough to have a
significant impact on inflation expectations, and therefore on the behavior of private entities.
This expectation channel is crucial for Japan in particular, where the deflationary mindset, so
firmly embedded for such a long period, needs to be dispelled completely.
Before I conclude, I would like to quote the words of Walter Heller, economic adviser under
Presidents Kennedy and Johnson: "An economist is a man who, when he finds something
works in practice, wonders if it works in theory." If this adage is true, I suppose we can look
forward to a much deeper theoretical understanding of the secrets of unconventional
monetary policies in the coming years. At the same time, practitioners in central banks
cannot afford to be complacent. Speaking of the Bank of Japan, for example, inflation is still
well below our target, although this is partly due to the temporary influence of low oil prices.
While our projection is that inflation will be in the neighborhood of 2 percent most likely
around the April-September period of 2016, the risks to that scenario cannot be ignored,
particularly when the global economy is full of uncertainty, including over geopolitical factors.
That being said, our commitment to achieving the 2 percent inflation target will never be
compromised. With our unwavering determination, I am confident we can achieve that goal.
Thank you.