Kazumasa Iwata: The role of the price stability anchor in extricating
Japan from deflation
Summary of a speech given by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan,
at the Panel Discussion "Monetary Policy Strategies: A Central Bank Panel", at the
Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole,
Wyoming, 27 August 2005.
* * *
Introduction
I would like to talk about the issues relating to monetary policy strategies for the future, in the
light of Japan's experience in the last decade of stagnation as well as deflation, and the
subsequent struggle to overcome deflation under the zero bound on the nominal interest
rate.
After a pause in growth triggered by the bursting of the mini-bubble in the digital electronics
sector in spring 2004, Japan has resumed growth exceeding the potential growth rate, with
the rate of change in the consumer price index, excluding institutional and special factors
such as oil, telephone charges, rice and fresh food, registering virtually zero in recent
months.1 Currently we have good prospects to exit from a decade-long period of deflation. In
this context, I would like to draw some lessons from previous policy developments for the
future conduct of monetary policy, focusing on the role of the price stability anchor.
The quantitative easing policy and the price stability anchor
Japan is apparently viewed as a country that has not adopted an inflation targeting policy.
Yet it is my personal view that Japan implements implicitly a price stability target within the
framework of current quantitative easing policy (bank reserve target policy) which was
introduced in March 2001. This is primarily because of the strict observance of the
commitment on the policy duration to secure price stability.
The preceding "zero interest rate policy" in the period from February 1999 to August 2000
failed to bear fruit, in part due to the weak commitment on policy duration. In contrast, under
the quantitative easing policy, the Bank of Japan clarified and strengthened the commitment
on the duration of the policy by presenting in October 2003 the three conditions for ending
this policy. The three conditions can be summarized by a phrase such as "stably above zero
of the core consumer price index on a year-to-year basis" or "never return to deflation."
This commitment sends a signal to the market that the Bank of Japan finds it important to
secure price stability to achieve positive inflation rates, although the numerical upper limit is
not announced.2 It serves as an anchor of price stability to prevent a deflationary spiral under
the condition of the zero bound on the nominal interest rate.
Price level indeterminacy under the zero bound on the nominal interest rate
Under the Bank of Japan's quantitative easing policy, not only the uncollateralized overnight
call rate but also the rate of longer maturity of at least one year has virtually reached zero. It
is well known that monetary policy aimed at fixing the market interest rate faces difficulties in
controlling the money supply and the inflation rate. The difficulties are augmented under the
zero interest rates, because the association between the money supply and the price level
becomes much looser than normal. Therefore, it is all the more important for the central bank
to provide the price stability anchor to the market.3
Moreover, the zero bound on the nominal interest rate erodes the market mechanism in the
financial market as well as market discipline, thereby distorting the allocation of funds on the
market.
In the past several months, we encountered a difficulty in achieving the bank reserve target
due to undersubscription to our offers in open market operations, and allowed a temporary
deviation from the lower limit of the reserve target in early June, end-July, and early August.
The intention was to maintain the bank reserve target in the face of diminishing demand for
excess reserves by banks. In other words, the measure was designed to solve the trade-off
between strict implementation of the commitment and flexibility. It may be noted that the
additional flotation of government bonds to frontload the rollover of existing government
bonds concentrated in fiscal 2008 has made it more difficult to maintain the reserve target.4
Bank of England Governor Mervyn King (2004) once pointed out the importance of debt
management policy, namely, the shortening maturity structure of government debt, to
Japan's exit from deflation. The cash management by the government sector also seems
relevant to facilitate the efficient implementation of monetary policy.
At any rate, it is best to preempt the emergence of the zero bound on the nominal interest
rate, even though room remains for the central bank to affect the expected future path of
short-term rates by implementing the commitment on policy duration longer than is usual.
However, strict implementation of the commitment tends to limit flexibility in conducting
monetary policy.
Effect of quantitative easing policy on interest rates
A number of proposals have been made to overcome Japan's deflation. One of them
recommends widening the application of zero interest rates to longer maturity until the
deflation disappears. In the process of raising the bank reserve target, the extent of zero
interest rates has been widened to cover at least one year. This effect arises due to the
commitment to maintain an ultra-expansionary policy longer than anticipated by the market
participants under normal circumstances. We name this the "policy duration effect."
The increase in the bank reserve target seems to have exerted a signaling effect to solidify
the commitment and thus strengthen the policy duration effect, aside from the ample liquidity
provision to avoid systemic risk and a deflationary spiral. Both of the effects worked to
support the recovery and prompt the restructuring process of debtor companies under the
strain of balance-sheet adjustment, through the maintained low interest rates.
The price stability anchor implicit in the commitment is not specified in terms of a time frame,
but is highly data-dependent, as it is defined by the achievement of positive inflation rates.
Market participants, who once appeared to be skeptical of our scenario of registering a 0.3
percent rise in the core CPI in fiscal 2006, now seem to anticipate the likely end of the
current policy regime within one year, as observed in euroyen futures market interest rates.
This has led to a pickup in interest rates over a wide range of maturities. In this sense the
market informs us when the exit is coming.
President of the San Francisco Federal Reserve Janet Yellen once asked me why deflation
has subsided despite the existence of the output gap. My answer was, "It is because of the
speed limit effect." The narrowing output gap was brought about by the lengthy and
sustained recovery phase in and after 2002. It may be noteworthy that the effect of the speed
limit (narrowing the output gap) dominated the effect of the level of the output gap on the
deceleration of deflation.5 Now we have reached the stage where it can be said that a long
time is not needed to satisfy the conditions to end the quantitative easing policy.
Dynamic price stability target policy
To the extent that the combination of the provision of the price stability anchor with the
monetary easing policy based on our clear commitment has succeeded in bringing Japan's
economy to a virtually zero inflation rate, compared with deflation of the core CPI of about 1
percent in 2001, it seems reasonable to maintain the key elements underlying the
quantitative easing policy framework at succeeding stages.
About two years ago, I described the step-by-step approach to attain ultimate price stability
as a "dynamic price stability target policy" for extricating Japan from deflation, in contrast to
the "timeless perspective" price level target policy. I identified the three phases of the
dynamic adjustment process moving out from the deflationary equilibrium to the normal
equilibrium, thereby avoiding the over- and undershooting of the inflation rate and the
longterm interest rate, notably during the transition period.
Recently, former Federal Reserve Governor Laurence Meyer (2005) has presented a
threestep strategy for the future of Japan's monetary policy. He identifies three phases: namely,
the quantitative easing policy, the zero interest rate policy, and the interest rate policy. In
between, there are two transitional phases: One is dismantling the bank reserve target to the
required reserve level (about 6 trillion yen), or the shrinkage of zero interest rates to the
uncollateralized overnight call rate. Another is raising short-term interest rates to the neutral
level to achieve price stability over the longer term. I personally find it desirable to provide an
appropriate anchor of price stability in numerical form when we embark on a new policy
regime such as the return to the zero interest rate policy.
It seems necessary to retain the transparent commitment on policy duration in order to
prevent abrupt changes of long-term interest rates in the transition process to reach a new
equilibrium, with the risk of entailing inflation (overshooting) or deflation (undershooting)
being preempted.6
Dynamic price stability target policy and the timeless perspective policy
The dynamic price stability target policy is "strategically coherent" (to borrow a phrase from
Professor Bennett McCallum [2005]) to attain final price stability, but it is not a "timeless
perspective policy" that puts emphasis on the time consistency of monetary policy.7 The price
level target policy recommends achieving the prescribed path of price levels with a constant
rate of inflation, regardless of the initial conditions. Yet it seems difficult to accept temporary
overshooting of the inflation rate and long-term interest rates in the transition path returning
to the desired price level path from persistent deflation, in particular under the circumstances
of the large-scale accumulation of government debt and the persistent budget deficit in
Japan.
However, we recognize the importance of "history dependence" in conducting monetary
policy. In this context, I would like to stress that maintaining the same reserve target level at
the current stage implies an increased degree of monetary easing, since the excess supply
of bank reserves is intensified and the maturity of short-term monetary operation instruments
is lengthened, with the result of extension of zero interest rates in the market. Moreover,
according to several surveys, the expected inflation rates turn out to be positive in recent
periods. This implies that the short-term real interest rate is negative despite the zero bound
on the nominal interest rates. If the core message of "history dependence" implies that the
monetary policy effect becomes more expansionary at the point close to the exit, the Bank of
Japan's current policy is in line with the spirit inherent in the price level target policy.
The role of fiscal policy
Let me conclude my remarks by referring to the role of fiscal policy to extricate Japan from
deflation. We observe that the government announced the fiscal policy target to achieve a
primary budget deficit of zero in about ten years, and the automatic stabilizer effect
dominated fiscal policy management after 2001 under the Koizumi administration.
The coordination between monetary and fiscal policy becomes more important, if the
economy were to fall into deflationary equilibrium (or the Friedmanian equilibrium), where the
size of deflation rate is equal to the natural interest rate. On fiscal policy, we can identify the
two different types; namely, the Ricardian and the non-Ricardian. If the present value of
government debt in the future becomes zero regardless of changes in the path of prices, it is
classified as a Ricardian policy.
6
This implies that we should have some safety margin on the final numerical objective (aside from the bias
inherent in the price index), given the likely negative macroeconomic shock to the lower natural interest rate of
Japan's economy over the future which is conducive to the zero bound on the nominal interest rate.
7
This issue may be related to issues such as the discretion versus rule-based policymaking, or the risk
management approach under uncertainty versus rule-based policymaking. It seems sensible to adopt the risk
management approach under the Knightian uncertainty (Greenspan [2004]). Chairman Greenspan is critical of
the "too inflexible" management of rule-based monetary policy. Yet "activist" rule-based policymaking seems
to possess sufficient flexibility in uncertain circumstances. For instance, the Bayesian decision process under
the risk management approach involves a learning process. Learnability plays an important role in
ruleoriented monetary policy to secure stability of the equilibrium. Rule-based monetary policy has flexibility to
implement a systematic revision of a contingent plan and prescribes the updating process in a "timeless
manner," while discretionary policy revises a contingency plan period by period. In any case, there may arise
no conflict or inconsistency between the risk management approach and the provision of the price stability
anchor to market participants.
As long as the fiscal rule aiming at reducing the primary budget deficit over the medium term
implies a moderate increase in the nominal government bond supply, then fiscal policy that is
passive (or Ricardian) under the normal equilibrium with a positive rate of changes in prices
becomes active (or non-Ricardian) under the deflationary equilibrium. Thus, there is a good
reason to expect that the gradual consolidation of the fiscal balance facilitates the economy's
exit from deflation, coupled with a monetary easing policy based on the price stability anchor.