Masaru Hayami: Recent economic developments and monetary policy
Speech by Mr. Masaru Hayami, Governor of the Bank of Japan, at the Research Institute of Japan,
Tokyo, 7 March 2001.
* * *
1. Introduction
Two months have passed since the dawn of the new century. After Japan's economy went through a
very tough decade at the end of the twentieth century, it has yet to regain economic strength and
restore a full-fledged growth.
In 2000 Japan's economy was on a moderate recovery path as improvements became increasingly
evident mainly in the corporate sector. However, unsavory developments followed. In particular, US
economic growth slowed down in autumn 2000 more steeply than had been expected, and has
recently begun to exert a significant influence over Japan's economy.
In a longer-term perspective, there had been a number of incipient cyclical recoveries in Japan's
economy during the past decade, but they were followed not by a strong recovery but by a repeated
threat of recession. At present, pessimism seems to overwhelm Japan's economic outlook. This has
an aspect of both short-term business cycle and longer-term adjustment of Japan's economy.
Bearing these in mind, I would like to discuss, today, recent developments in Japan's economy as well
as financial markets, and offer my thought about monetary policy.
2. Recent economic and financial developments
Economic developments
Allow me first to discuss economic and financial market developments. To put it in short, the Bank of
Japan is of the view that Japan's economic recovery is slowing further and uncertainty over economic
prospects is growing. Accordingly, we are becoming increasingly cautious.
During the past two years, a moderate economic recovery has been supported by the following
mechanism. Growth in exports and demand for information technology (IT) has led recovery in
production as well as profits, which in turn induced increase in business investment. However, the
recovery in the business sector has exerted only a limited impetus to the personal sector because of
strong pressures of corporate restructuring. Nonetheless, wages began to grow year on year in
summer 2000. In other words, there was a momentum in the economy by which recovery in the
business sector led, albeit slowly, that in the personal sector.
In late 2000 it became gradually evident that growth in exports and production slowed under the
influence of rapid slowdown in US economic growth. In fact, Japan's exports stopped growing in the
final quarter of 2000, which is now being followed by a decline. In accordance with export
deceleration, production has come to a halt, and inventories have become somewhat excessive in
some areas of industrial materials and semi-conductors whose export demand fell sharply.
Consequently, some IT firms have announced a downward revision of their profit forecast although
they continued to expect an increase. Under these circumstances, some concern has begun to be
voiced with respect to the prospect for business investment. In view of the fact that economic recovery
has been pulled by manufacturing and other industries, the recent developments might as well be
considered to foreshadow economic outlook.
Downside risks
These discussions lead to the question of what are important risks in economic outlook and the
magnitude thereof. The economy always faces a variety of risks, but since last autumn, we have paid
particular attention to two downside risks, i.e. slowdown in world economic growth and instability in
capital markets both at home and abroad. These risks intensified in early 2001, and now appear to be
materializing gradually.
With respect to world economic slowdown, US economy has a key role to play. Having displayed a
rapid growth of 5 percent until mid-2000, US economy has slowed its growth considerably in the
second half. This slowdown proved to be more drastic than had been widely anticipated. Against this
background, the Federal Reserve, or the central bank of the United States, decided on a reduction of
its target interest rate by 0.5 percentage points at an unscheduled meeting of the FOMC at the
beginning of the year, followed by an additional reduction of 0.5 percentage points at the end of
January 2001. This sudden change in the economy is reflected in a significant downward revision of
the central tendency among FOMC members with respect to real GDP growth rate from 3 1⁄4-33⁄4
percent in July 2000 to 2-2 1⁄2 percent in February 2001.
With respect to US economic outlook, a low growth rate seems inevitable as far as the first half of
2001 is concerned. A more critical question concerns the likelihood and degree of rebound later in the
year. Economists and market players are divided in this regard: some expect a quick rebound, some
others a modest recovery, and others prolonged deceleration. Optimists, who expect V-shaped
recovery in the second half of 2001, point out the continued improvements in productivity bolstered by
IT revolution as well as wide room for actions of both monetary and fiscal policies. On the other hand,
it is pointed out that after an extremely high economic growth, the subsequent adjustment might prove
to be severe and also that the adjustment period is practically unpredictable before it is over. In recent
months, optimistic views appear to be receding. Under these circumstances, I would like to remain
vigilant as well as unprejudiced about the extent to which US economy regains its strength later in the
year.
As I have mentioned earlier, the US economic slowdown has already begun to exert a negative
influence on Japan's economy through a variety of channels including an indirect impact involving
economic slowdowns in East Asian countries that are closely linked to the US economy. In Japan,
production growth slowed under the influence of decreases in exports. If this leads to declines in
corporate profits and reductions in business spending, the momentum for economic recovery
stemming from the business sector will be put at a greater risk than before. Therefore, we all need to
examine carefully the ongoing production, profits, and investment plans for some time.
There is another downside risk for Japan's economy, i.e., capital markets both at home and abroad,
especially stock price developments and their impact. Weakness of Japanese stock prices has been
particularly pronounced in recent months. Nikkei Stock Average renewed its lowest record during the
post-bubble period beginning in 1990 although one must make allowances for the technical changes
in the index of April 2000. It is by no means easy to identify the causes for weak stock price
developments, but they seem to be influenced by not only US stock market adjustments but also
bearish sentiment in the market with respect to Japanese economic outlook. They may as well be a
reflection of concerns that the markets both at home and abroad have with respect to delays in
addressing a number of structural problems that Japan's economy has. The Bank of Japan will remain
vigilant about the influences that these weak stock prices will have on consumer and business
sentiment as well as corporate finance.
Price developments
Against the background of recent economic and financial market developments, analysis of price
developments is becoming an issue of renewed interest. In recent months, a variety of price indices,
such as domestic wholesale prices, consumer prices, and corporate service prices, have been
showing small declines year on year, and are expected to be weak for some time.
These price developments have obviously been influenced by both supply and demand elements. A
wide output gap remains after a significant improvement on the demand side since the economy hit
the bottom two years ago. Because economic growth is decelerating further at present, there is a
concern that downward pressures on prices stemming from weak demand might intensify in coming
months. On the supply side, a variety of elements are at work, e.g., technological innovation, increase
in efficiency in the distribution system, and deregulation, all of which exert a downward pressure on
prices. Take domestic wholesale prices for example. Declines in prices of electric equipments and
other machines have been most pronounced under the influence of a very rapid technological
innovation. For another example, declines in consumer prices have been accounted for in large part
by imports and import competitive goods, e.g., clothing.
Let me hasten to add to it by saying that the Bank of Japan has never argued for so-called "good price
declines." Instead, the Bank has repeatedly said that the present price developments have been under
the complex influence of both demand and supply elements, and therefore, no one can afford to
understand on the basis of movements of price indices alone whether the ongoing price developments
are consistent with sound developments in the economy. The issue of utmost importance is whether
the current weak prices will invite declines in corporate profits and/or incomes of workers, leading to a
deflationary spiral, or vicious cycle of economic recession and price declines. The Bank of Japan is of
the view that Japan's economy has so far avoided such a deflationary spiral, but that because
economic growth has recently weakened further as I mentioned a few minutes ago, the economy has
entered the phase that warrants enhanced attention to price developments.
3. Deliberation on monetary policy
a. Improvements in the way of liquidity provision and reduction in interest rates
Decisions of February 9 and February 28, 2001
Now let me offer my thought about monetary policy on the basis of the economic and financial
developments I have discussed. As you are well aware, the Bank of Japan decided at its Monetary
Policy Meeting of February 9, 2001 on both improvements in the way in which liquidity is provided to
the market and a reduction in the official discount rate by 0.15 percentage points. With respect to
liquidity provision, we decided upon three specific measures: introduction of a Lombard-type standby
lending facility, active use of outright purchase operations of short-term government securities, and
preparation for bill purchase operations at all offices of the Bank.
At the Monetary Policy Meeting of February 28, 2001, the Bank decided to reduce, by 0.10 percentage
points, both its target level of overnight call rate to 0.15 percent and the official discount rate to 0.25
percent.
Lombard-type lending facility and the new role of the official discount rate
Among these policy measures, the Lombard-type lending facility is new to Japan. Officially, it has a
name of "Supplementary Lending Facility." Under the existing framework of liquidity provision, the
Bank of Japan selects its counter-parties and decides on the timing as well as amount of lending. In
contrast, the Lombard-type lending facility entitles financial institutions to borrow at the Bank of
Japan's discount window the amount that they want at any time they wish, as long as collateral is
properly set against the borrowing and the borrower meets the conditions pre-specified with respect to
eligibility of collateral and other technical aspects. From a viewpoint of financial institutions, this is a
means of funding available any time.
The most important function that this supplementary lending facility performs is to stabilize interest
rates in the market. Under usual circumstances, the overnight call rate fluctuates below the official
discount rate because the former is the rate of which the Bank of Japan sets such a target level. When
end-of-fiscal year pressures mount or a shock arises in the market, e.g., steep declines in stock prices
or rumors of a large bankruptcy, interest rates tend to go up in the market. Even in that case, overnight
market rates will be kept below the official discount rate because financial institutions are able to
borrow at the Bank of Japan's discount window at their discretion. Moreover, because financial
institutions are freer from anxiety over funding capabilities, this will have a stabilizing effect on not only
the overnight call rate but also other short-term interest rates across the board. This effect has been
strengthened further by two reductions in the official discount rate amounting to 0.25 percentage
points in February 2001.
Now let me say a few words about the roles that the official discount rate plays. In the past, the Bank's
decision as to the official discount rate was a basic tool of monetary policy. Therefore, change in that
rate had an announcement effect since it embodied change in the basic stance of monetary policy. In
1994, however, deregulation of interest rates was complete, and the institutional linkage between the
official discount rate and bank deposit rates disappeared. In 1996, the Bank of Japan made it clear
that the Bank would no longer use the discount window lending, to which the official discount rate was
applied, as a means of monetary operations. Consequently, the role of the discount rate as a policy
variable was played down, whereas the target level of the overnight call rate began to assume that
role.
By the introduction of the Lombard-type lending facility, however, the official discount rate is given a
new function of setting a ceiling on call rates and thereby ensuring stability of short-term interest rates
in the market. The Bank of Japan will continue to guide the call rate at an intended level by daily
market operations, but at the same time it will begin to use the new function of the discount rate as a
means to supplement the effects of market operations.
Timely and flexible implementation of monetary policy
Having explained the policy decisions made at the two Monetary Policy Meetings in February 2001,
allow me to elaborate on their background. First of all, we have taken these policy measures on the
basis of our understanding of economic and financial developments at present and in the future. As I
said a few minutes ago, economic recovery is weakening in Japan and uncertainty over economic
prospects have intensified under the influence of overseas economic slowdown and declines in stock
prices. In part of money and capital markets, there was a certain degree of instability, reflecting
concerns over the future. Under these circumstances, we decided on the policy measures with a view
to ensuring both smooth functioning and stability of the financial market as well as to strengthening
monetary support for economic recovery. Subsequently, not only the overnight call rate but also
interest rates of longer maturities, e.g., those maturing beyond the fiscal year end and even long-term
interest rates, declined by a considerable degree.
Another point I would like to emphasize is the fact that the Bank of Japan continues to conduct
monetary policy in a timely and flexible manner, in view of changes in economic conditions. As I said
earlier, Japan's economic recovery has decelerated further against the background of sudden
slowdown of US economic growth and other elements. In light of these developments, we believe we
have taken appropriate policy actions in a timely manner, and will continue to do so in the future. At
the same time, the Bank of Japan hopes that the policy measures that it took in February 2001 will
contribute to autonomous economic recovery led by private demand.
b. Monetary policy stance in the future
Now let me leave aside the discussion of a series of policy measures the Bank of Japan decided in
February and take up something else. There continue to be a variety of arguments about monetary
policy in Japan. For example, we sometimes hear the views that the present monetary ease is
insufficient, and therefore, the Bank of Japan should resort to so-called "quantitative easing" or return
to the zero interest rate policy. I would like to explain the basic thought about monetary policy on the
basis of the discussions held at the Policy Board of the Bank of Japan.
First of all, I would like to emphasize the fact that the Bank of Japan has implemented aggressive
monetary easing to a degree unprecedented in the history of central banking in the world in terms of
both interest rates and volume. Under the influence of this monetary easing, both short and long term
interest rates have been kept extremely low. The Bank has also provided the market with ample
liquidity and consequently, the monetary base, which consists of money that the Bank directly provides
the system with, has shown a considerable growth, to which I will come back later.
A second point I would like to make is whether or not the Bank should resort to additional measures
such as "quantitative easing" hinges crucially upon conjectural analysis of growth and price
performance of the economy. The word "quantitative easing" is meant differently across people who
use this term. For example, there is an argument for stepped up outright purchases of long-term
government bonds. The Bank of Japan has been buying such bonds in line with a trend growth in
banknotes in circulation. This purchase amounts to \5 trillion per year. If the Bank increased its
purchase dramatically, that would have some positive effects but at the same time it might be
accompanied by negative side effects. Therefore, a careful examination of both positive effects and
side effects must be in place before that policy is implemented. The possible effects of the stepped up
bond purchases include a decline in long-term interest rates or a rise in expected rate of inflation. In
light of the serious budget situation of today, however, the possibility that such a bold measure would
damage credibility of fiscal discipline and in turn raise long-term interest rates cannot be ruled out.
A policy to induce a massive depreciation of the yen's exchange rate is another drastic,
unconventional policy. In the present legal framework, it is the Ministry of Finance that has the
authority for exchange market intervention. Leaving this issue aside, it is uncertain how effective
official intervention can be in affecting exchange rates. Neither is it certain how to cope with
terms-oftrade losses stemming from rises in import prices and adverse influences over Asian economies.
After all, before the Bank embarks on unconventional policies like the ones categorized by quantitative
easing and the zero interest rate policy, it has to judge that the conditions of the economy and prices
warrant such policies. In this regard, the Bank of Japan will continue to examine and analyze the
situation with its full force and on that basis it will seek the most appropriate policy that the central
bank can take.
A third point I would like to emphasize is we all have to face the reality that during the past decade
both monetary and fiscal policies have been eased dramatically and yet they have failed to meet with
robust economic growth. There are reasons for it.
Let me mention three numbers here. During the past five years the monetary base expanded at an
annual rate of 7.3 percent, the money stock at 3.3 percent, and nominal GDP at 0.4 percent. In
contrast to the 1970s and 1980s, when all three indicators grew pari passu, what large differences
exist between them in recent years.
The difference between the growth rate of monetary base and that of money stock can be interpreted
in the following. The monetary base consists of all banknotes and all current deposits that banks and
other financial intermediaries hold at the Bank of Japan. A textbook of monetary economics tells you
that the Bank of Japan supplies the monetary base, on which basis banks extend credit so that the
monetary base creates a multiple increase in the money stock. In the course of discussions about
monetary policy at present, an argument is sometimes made as if the monetary base were in
shortage. As I pointed out a minute ago, the monetary base has been expanding at a relatively high
rate. Despite this, however, the money stock failed to increase as much. It is mainly credit extension of
financial institutions through which the money stock is supplied, but bank lending, which constitutes
the core of credit extension, has decreased at an annual rate of 1.4 percent during the past five years.
In contrast, bank holding of government bonds expanded at a remarkable rate of 15.7 percent. In
other words, financial intermediation took place during this period in the way that government bond
issues increased, financing government expenditure, through which channel money circulated to a
greater extent.
There is another discrepancy, i.e., the money stock and nominal GDP. The money stock grew at a
modest rate of 3.3 percent per annum. This amounts to as much as \20 trillion every year, but nominal
GDP stayed virtually unchanged notwithstanding. In sum, despite relatively ample supply of monetary
base, economic growth remains lackluster.
All this suggests the significance of structural obstacles in Japan's economy, e.g., problems of the
financial system, and on the flip side of the coin, corporate restructuring. Resolution of these problems
will prepare a foundation on which the effectiveness of monetary policy can be enhanced. I plan to
come back to this issue before closing my remarks today in conjunction with a topic of non-performing
assets.
c. Price stability and monetary policy
Allow me to turn to another topic: the relationship between price stability and monetary policy. I hear
often that it is nothing but monetary policy that can prevent deflation as well as inflation. Indeed, the
Bank of Japan Law stipulates that the Bank's purpose is the maintenance of price stability, and the
Bank in fact conducts monetary policy in accordance with that idea. In terms of practical
implementation of monetary policy, however, the relationship between the objective of price stability
and monetary policy is somewhat more complex.
This complexity is mentioned in the report that the Bank of Japan published last year with respect to
price stability. For one thing, the relationship differs, depending on the length of time you envision
about price stability. For example, during a very long period, say ten or twenty years, excess supply of
money in many cases corresponds to rises in prices while short supply does to price declines. This is
quite natural in light of the fact that prices are the rate of exchange between goods/services and
money. Based on this long-term relationship between prices and money, price fluctuations are referred
to as essentially monetary phenomenon and price stability is considered to be the objective of
monetary policy.
During a shorter period, say a few months or a few years, however, price fluctuations are influenced
by not only money but also a variety of other variables. Output gap of the whole economy, inflation
expectation, international commodities prices, exchange rates are interrelated in a complex fashion. In
such a complex world, it is no easy task to decide on how precisely monetary policy can control prices,
and also on how far it should do. Suppose an oil price shock gives rise to inflation pressures. If we are
to contain them in a short period, it will take a very tight monetary policy. The upshot may be a steep
decline in economic activity. This is inconsistent with sustainable price stability in the long run.
Conversely, at a time when prices decline on account of productivity gains based on rapid
technological innovation, a forceful reduction in interest rates with a view to raising prices may amplify
economic swings.
I firmly believe that monetary policy is an important determinant that ultimately influences price
developments, but in order to fulfill its responsibility in the long run, we must first analyze not only
superficial movements in price indices but also a variety of underlying developments, and see if the
ongoing price developments are consistent with sustainable economic growth. I believe that this is
indeed what the Bank of Japan Law means by its clause that the Bank's currency and monetary
control shall be aimed at, "through the pursuit of price stability, contributing to the sound development
of the national economy."
4. Concluding remarks
Having discussed monetary policy issues, allow me to close my speech today by touching on
structural problems of Japan's economy. In my view, efforts to enhance productivity by addressing the
supply side structure of the economy are essential for Japan's economy to achieve strong growth. The
fact that US and UK economies revived strongly in the 1990s can be attributed to such efforts. From
this viewpoint, it is of utmost importance that Japan speed up reform on the basis of common
understanding of the following issues.
First, economic growth stems from the innovative strength of the private sector. Creativity and
knowledge of the private sector are the key to bring the economy to its maximum potential. Excessive
dependence on the public sector is not the answer.
Second, strength of the private sector will materialize when the market mechanism functions fully.
Productivity of the private sector will improve when the resources of capital and labor are reallocated
and repositioned between the business area of high growth potential, efficiency, and profitability and
that otherwise. This process goes on most efficiently through the market mechanism.
Third, such reform is inevitably accompanied by a certain degree of pains. In the course of structural
reform, negative influences may arise to the economy, albeit temporarily, e.g., corporate bankruptcies
and restructuring. Opportunities must be accorded to those firms and workers who are defeated
amidst structural reform so that they can make a new attempt in the area they can take advantage of
their own competitiveness.
There are a variety of views with respect to specific forms of reform, but today I would like to say a few
words about my ideas that I have always been turning in my mind.
The first issue concerns the resolution of non-performing assets of banks. During the past three years
of my term as Governor of the Bank of Japan, Chairman Greenspan of the Federal Reserve and other
eminent people in the international circles have said to me that from the S&L problem and banking
crises in the United States, they had learned a lesson about the importance of removing
nonperforming assets off the balance sheet of the banks. On Japan's side, too, we have maintained that
mere provisioning against non-performing assets would not solve the problem and that it is essential to
remove them from the balance sheet. During the past several years, the aggregate non-performing
assets remained virtually unchanged in the magnitude of \30 trillion. This is a regrettable fact. Under
these circumstances, Minister for the Financial Services, Mr. Yanagisawa expressed his view that
banks should step up write off. We are of the same opinion. I consider his remark to be both
appropriate and timely.
I believe that increase in write off will facilitate structural reform. To promote write off, there are some
specific means. For example, a company be split into good and bad parts, and the bad part, or
nonperforming part be written off. Loan sales markets be also enhanced. It is to be hoped that such
specific actions be announced and put in practice soon. At the same time, I strongly hope that
management of banks will determine to embark on an enhanced write off. As for the assets classified
under the category of "special mention," the importance of sufficient provisions cannot be
overemphasized.
While such stepped up write off will contribute to the resolution of the non-performing problem, it might
accelerate bankruptcies and have an adverse influence over employment. The Bank of Japan is
prepared to conduct monetary policy to relieve the negative impact of this painful friction on the
economy.
The second issue I would like to mention is that it is absolutely necessary to invite the personal sector
to stock and bond markets in order to help resolve the problem of banks' non-performing asset as well
as to promote structural reform. At present, the aggregate financial assets in the personal sector
amount to \1,380 trillion, 54 percent of which is held in the form of cash and deposits.
In Germany a shift from indirect financing to direct financing has been going on successfully in recent
years, and as a result risk capital has increased. Between the early 1990s and 1998, the law has been
enacted three times to promote financial and capital markets, by which several reforms of the stock
market and investment trusts have proceeded. Specific measures include a reduction in the minimum
denomination of stock, lifting of a ban on Fund of Funds, improvement in product design of investment
trusts, promotion of senior citizens' fund. As a result, the proportion of cash and deposits within total
financial assets of the personal sector declined from 45.8 to 35.2 percent in Germany between 1991
and 1999, while in Japan it went up from 50.8 to 54.0 percent. The proportion of stocks and
investment trusts went up dramatically in Germany from 14.6 to 27.3 percent while in Japan from 10.9
to 10.4 percent.
Growth of investment trusts and mutual funds are expected to happen also in Japan. In this regard,
improvements in product design of investment trusts are an urgent task. In particular, a wide variety of
investment trusts should be marketed to meet a variety of demand of the personal sector, and at the
same time sound market practices should also be established.
Furthermore, establishment of investment funds can contribute to increasing flow of funds into risk
capital. Private Investment Funds Ripplewood, which established Shinsei Bank after acquiring the
Long Term Credit Bank of Japan, and Lone Star, which bought Tokyo Sowa Bank, are both equity
funds whose shareholders consist of mutual funds, pension funds, university endowments. In Japan
measures to promote the establishment of a large number of such funds should be taken.
If the financial assets of the personal sector that are currently held predominantly in cash and deposits
are to be invested more in financial and capital markets through a variety of channels, that would, I
hope, contribute to ensuring stability in the financial system through prompter resolution of the
nonperforming asset problem as well as to facilitating structural reform in Japan.