Toshihiko Fukui: New framework for the conduct of monetary policy - toward
achieving sustainable economic growth with price stability
Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Japan Chamber
of Commerce and Industry, Tokyo,16 March 2006.
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Introduction
At the Monetary Policy Meeting (MPM) held on March 8 and 9, 2006, the Bank of Japan decided to
terminate the quantitative easing policy, which had been maintained during the five years since March
2001. The Bank shifted the operating target of money market operations from the outstanding balance
of current accounts at the Bank to a short-term interest rate, namely, the uncollateralized overnight call
rate. It also introduced a new framework for the monetary policy conduct, including clarification of its
thinking on price stability.
Today, I will focus on the background to the termination of the quantitative easing policy by looking
back on economic and financial developments during the past few years, and explain the Bank's future
monetary policy conduct.
I. Embarking on a sustainable growth path
Japan's economy continues to recover steadily. The current economic expansion started in January
2002 and has lasted for more than four years, according to the Cabinet Office's reference dates of
business cycles. The recent recovery is well balanced in terms of the balance between domestic and
external demand, and also between the corporate and household sectors. Although the recovery is not
accelerating, the foundation for economic growth is solid, and its resistance to various external shocks
has been increasing. The present phase of the recovery is the third since the bursting of the economic
bubble. Unlike the previous two phases, this time we may reasonably expect the current expansionary
phase to last longer and to be more sustainable. Japan's economy has, at last, succeeded in
emerging from its prolonged adjustment phase, which continued for more than a decade, and has
embarked on a sustainable growth path with price stability.
Several factors support this view. In addition to external factors, such as the continuing expansion of
overseas economies, on the domestic side structural reforms have made significant progress in both
the business and financial sectors. Moreover, the positive effects of the recovery are spreading to the
household sector. I will now discuss these contributing factors and then go into some detail regarding
the sustainability of the current economic recovery.
A. Progress in structural reforms
The most important factor contributing to the achievement of sustained economic recovery has been
the elimination of the burdens, or adjustment pressures, in the corporate sector and the financial
system, which have hindered the Japanese economy's movement to a sustainable growth path ever
since the bursting of the economic bubble.
As a result of stringent corporate restructuring efforts that lasted for more than a decade, the excesses
in debt, employment, and production capacity -- the so-called "three excesses" -- have for the most
part been dispelled and resolved. According to the latest Tankan (Short-Term Economic Survey of
Enterprises in Japan), the number of firms perceiving their production capacity as excessive is almost
equal to the number perceiving it as insufficient for the first time since the early 1990s. The number of
firms perceiving their holdings of labor as insufficient has already exceeded the number perceiving
them as excessive, indicating that firms perceive a tightening of the labor market. This tightness is also
evidenced by the ratio of job offers to applicants, which has exceeded 1.00. Turning to firms' debt
levels, the ratio of interest-bearing debt to sales peaked out around 1993, and is currently as low as
that seen in the mid-1980s, before the bubble era.
While taking measures to resolve the "three excesses," firms have been reviewing their business lines
based on the principle of "selection and concentration" in the face of intensified global competition.
More specifically, firms have adopted an active management approach by concentrating on strategic
areas of business and establishing business tie-ups to improve their ability to generate
high-valueadded products and services. As a result, firms have succeeded in substantially improving their
profitability. Corporate profits have increased for the three consecutive years from fiscal 2002, and are
expected to continue to increase in the current fiscal year. Firms' ratio of current profits to sales has
already exceeded the peak marked during the bubble era. Using the high level of corporate profits,
firms are actively investing in research and development and expanding production capacity in order
to boost market competitiveness. These activities are evident in increases in business fixed
investment, regardless of the type and size of firm.
Improvements are also notable in the financial system. The nonperforming-loan (NPL) problem that
has plagued Japan's economy for so long has by and large been resolved, and the stability of the
Japanese financial system has been restored. The lending attitude of financial institutions has become
more active as a result of improvements in their profitability and capital adequacy ratios due to the
decrease in the amount of NPLs. The amount outstanding of lending by private banks, which had long
been on a downward trend, finally turned upward on a year-on-year basis in August 2005 after an
adjustment for securitization of loans and loan write-offs. Since then, the pace of increase has been
gradually accelerating. In the previous two recovery phases, weakness in the financial system
hindered the economy from moving onto a sustainable growth path. At present, however, the financial
system has recovered to a level of soundness sufficient to firmly support the achievement of sustained
economic growth.
B. Spread of improvement in the corporate sector to the household sector
In order to realize a sustainable economic recovery, it is important for a virtuous cycle to operate in the
economy, wherein the improvement in income of the corporate sector spreads to the household
sector, and this in turn feeds back to the corporate sector. Unfortunately, in past recovery phases,
such a virtuous cycle did not fully operate, as both the corporate sector and the financial system were
subject to structural adjustment pressure. In contrast, in the current recovery phase, apparent
improvement in the employment and income situation has been observed since the beginning of 2005,
and a longer and more sustainable recovery is expected in the household sector.
Firms have been increasing their numbers of employees, as the adjustment in excessive holdings of
labor has progressed. Initially, they relied mainly on part-time workers in order to restrain labor costs,
but firms have begun to gradually increase their numbers of regular employees, as the labor market
has tightened. Wages per worker have also been rising, reflecting such conditions in the labor market.
Specifically, regular payments have recently begun to increase in addition to continuing growth in
overtime payments and bonus payments. This improvement in the employment and income situation,
coupled with a rise in stock prices and an increase in dividend income, has contributed to income
growth in the household sector. With such income conditions, private consumption has been solid. It is
expected to remain so, supported by the increase in household income. This development is expected
to accelerate the virtuous cycle further as the firmness in private consumption feeds back to the
corporate sector.
As seen from what I have described, Japan's economy continues its solid recovery, but this recovery
is often said to not apply evenly across small firms and regional economies. In fact, the degree of
recovery still varies according to size of firm and region.
The economic recovery has indeed been spreading steadily, with both domestic and external demand
continuing to increase. The Tankan indicated that business conditions at not only large firms but also
small and medium-sized ones have been improving. The Bank's branches conduct research and
interviews so as to grasp the state of regional economies, and the results are presented at the meeting
of general managers of the Bank's branches. The results show that, although there still is a difference
in the degree of recovery, all regional economies are showing improvement. The Bank will continue to
pay due attention to future developments in regional economies.
II. Improvement in the environment for prices
The environment for prices has become favorable reflecting the continuing economic recovery. The
year-on-year rate of change in the consumer price index (CPI, excluding fresh food) had been
negative since 1998, but returned to 0.0 percent in October 2005 and turned positive in November.
According to the figure released on March 3, 2006, it rose further in January 2006, reaching 0.5
percent. This was partly attributable to the dissipation of temporary factors such as the reduction of
telephone charges implemented in 2005 and also to high crude oil prices, but more importantly,
fundamental factors that affect price developments clearly began to improve and started to exert
upward pressure on prices.
First, the supply-demand balance is improving gradually and improvement is expected to continue, as
the economy continues to recover at a pace slightly above its potential. Second, although unit labor
costs continue to be driven down by the productivity increase, with wages beginning to rise, the rate of
decline has been diminishing and this trend is expected to continue. And third, firms' and households'
expectations of inflation have been gradually revised upward, as indicated by various surveys.
All of this indicates that the environment for prices has changed dramatically from the past, when a
substantial output gap exerted downward pressure on prices. As the economy is expected to continue
to recover steadily with a balance being maintained between domestic and external demand and
between the corporate and household sectors, a positive trend in the year-on-year rate of change in
consumer prices is projected to be established, albeit with some fluctuations.
As I have explained, Japan's economy has achieved substantial improvement, in terms of both
economic activity and prices, and this implies that the Bank should respond to the improvement by
changing its conduct of monetary policy.
III. Effects of the quantitative easing policy
The Bank displayed its resolve in continuing the quantitative easing policy for five years after
introducing it in March 2001. At the time, Japan's economy was in a recessionary phase triggered by
the collapse of the IT bubble around the globe. Financial institutions in Japan were also burdened by
massive NPLs, and there was a high level of public anxiety concerning the stability of the financial
system. In these circumstances, the economy faced a severe challenge, the potential risk of falling into
a vicious cycle, or so-called deflationary spiral, in which a fall in demand reflecting deterioration of the
economy causes a decline in prices and this in turn leads to a further fall in demand. To counter this
situation, the Bank acted decisively and introduced the quantitative easing policy, which was
unprecedented in the history of any central bank, with the aim of preventing a continuing fall in prices
and establishing a foundation for achieving sustainable economic growth. I would like to elaborate on
what the quantitative easing policy has contributed to Japan's economy over the past five years.
The quantitative easing policy consisted of two pillars: provision by the Bank of ample liquidity to raise
the outstanding balance of current accounts at the Bank above the amount of reserves financial
institutions are required to hold, namely, required reserves; and a commitment by the Bank to continue
to provide ample liquidity until the year-on-year rate of change in the CPI (excluding fresh food)
registered zero percent or higher on a sustainable basis.
Provision of ample liquidity exceeding required reserves reduced very short-term interest rates to
effectively zero percent and dispelled financial institutions' liquidity concern. After the introduction of
the quantitative easing policy, there was no occurrence of any large-scale credit crunch, such as was
observed in 1997 and 1998, and stability in financial markets was maintained despite the
materialization of various shocks, including the terrorist attacks in the United States and the Iraq war
as well as the injection of public funds into a major Japanese bank when the financial system was
fragile.
The Bank's commitment to continue the quantitative easing policy generated expectations that the
zero interest rate environment would continue for a certain period of time while consumer prices
continued to decline. This is referred to as the "duration effect," that is, the effect of the Bank's
commitment regarding the duration of the policy. As a result of this duration effect, the Bank's
commitment contributed to keeping short- to medium-term interest rates stable at low levels.
The policy effects of dispelling the liquidity concern as well as keeping interest rates low and stable
have created an accommodative environment not only in the money market and capital markets but
also in corporate finance activities. Bank lending rates, for example, have continued to decline partly
reflecting the decrease in the credit premium, and are around historically low levels, despite the
ongoing economic recovery.
As mentioned earlier, Japanese firms, after strenuous efforts, have tackled structural problems such
as the "three excesses," and are becoming increasingly active in undertaking business fixed
investment. The accommodative financial environment created by the quantitative easing policy has
been firmly supporting such developments. It could be said that the policy has contributed to improving
the rate of return on capital and to raising corporate profits, as it enabled lending rates to decline even
while the economic outlook was gradually brightening. These improvements in the corporate sector
have, with a certain lag, been exerting positive effects on the household sector, thereby supporting the
continuing economic recovery and the favorable environment for price developments.
The Bank's quantitative easing policy played a significant role in the recovery of Japan's economy and
in the improvement in price developments. However, amid recent economic and financial
circumstances, both the effect of the quantity of liquidity to dispel liquidity concern and the duration
effect through which the Bank's commitment influences interest rates are considered to have played
themselves out. As the financial system has regained stability, liquidity demand at financial institutions
has declined, reducing the need for the provision of funds at a level well over required reserves. In
addition, the duration effect of the policy commitment has been gradually diminishing with the
shortening of the expected duration of the quantitative easing policy in line with the improvement in
price developments. Ultimately, the duration effect ceases to exist when the criterion that the
year-onyear rate of change in the CPI is registering zero percent or higher on a sustainable basis is fulfilled. In
short, the effects of the quantitative easing policy on economic activity and prices had already become
essentially equivalent to those of an interest rate policy targeting a short-term interest rate of zero
percent prior to the termination of the quantitative easing policy.
IV. Background to the termination of the quantitative easing policy
In this situation, the Bank decided to terminate the quantitative easing policy at the MPM held on
March 8 and 9, 2006. The Bank decided to change the operating target of money market operations
from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call
rate, and to set the guideline for money market operations for the intermeeting period as follows: "The
Bank of Japan will encourage the uncollateralized overnight call rate to remain at effectively zero
percent."
The year-on-year rate of change in the CPI has been registering zero percent or above for the four
consecutive months since October 2005, and a positive trend in the rate of change in the CPI is
projected to be established. Economic developments underlying the CPI also indicate that Japan's
economy is likely to experience a sustained period of expansion with domestic and external demand
well in balance. Based on these developments in economic activity and prices, the Bank judged that
the commitment that it would continue the quantitative easing policy until the year-on-year rate of
change in the CPI registers zero percent or higher on a sustainable basis had been fulfilled, and that it
was therefore appropriate to terminate the unprecedented quantitative easing policy.
It must be stressed that the termination of the quantitative easing policy does not signify a tightening of
monetary policy. As I have explained, the policy effects of the quantitative easing policy have already
become essentially equivalent to those of an interest rate policy targeting a short-term interest rate of
zero percent. Since the Bank will encourage the uncollateralized overnight call rate to remain at
effectively zero percent based on the new guideline for money market operations, there will be no
abrupt change in monetary policy in terms of the stimulative effects of the quantitative easing policy on
economic activity and prices. The effects of short-term interest rates being at effectively zero percent
have increased gradually with the upturn in economic activity and prices, and they are expected to
become stronger while the current guideline is maintained. Although the level of interest rates
depends on developments in economic activity and prices as well as in financial markets, if it is judged
that inflationary pressures are restrained as the economy follows a balanced and sustainable growth
path, then the accommodative monetary environment ensuing from very low interest rates will
probably be maintained for some time. The Bank will continue to offer firm support to the economy by
maintaining accommodative monetary conditions.
Some might question why the Bank should terminate the quantitative easing policy if the policy effects
are equivalent to those of an interest rate policy targeting a short-term interest rate of zero percent.
However, the Bank made a clear commitment when it introduced the quantitative easing policy that it
would continue the policy until the year-on-year rate of change in the CPI registered zero percent or
higher on a sustainable basis, and market participants have been conducting transactions on this
premise. The duration effect of the policy commitment could not have been achieved without market
participants' confidence in the commitment. In this regard, the termination of the quantitative easing
policy once the Bank judged the commitment to have been fulfilled contributes to enhancing monetary
policy transparency and in turn the effectiveness of monetary policy in the long term. Putting this
another way, if the Bank had continued to conduct monetary policy in line with an operating target that
had already essentially lost its effectiveness, this could well have caused not only increased
uncertainty in financial markets but also damage to the transparency of monetary policy.
V. Conduct of money market operations for the immediate future
In conducting money market operations in the immediate future, the Bank will reduce the outstanding
balance of current accounts toward a level in line with required reserves according to the new
guideline for money market operations. It should be borne in mind, however, that as financial
institutions have managed liquidity against the backdrop of large amounts of current account balances
and extensive funds-supplying operations by the Bank for a prolonged period under the quantitative
easing policy, the functioning of the money market has been somewhat impaired. As a result, financial
institutions may have difficulties carrying out smooth fund management. Given these circumstances,
the Bank's reduction of the current account balance will be implemented taking full account of
conditions in the money market. How long it will take for the Bank to reduce the current account
balance depends on the situation in the money market, but it is reasonable to expect the reduction to
be carried out over a period of a few months. With respect to the complementary lending facility, which
allows financial institutions to borrow short-term funds from the Bank at their request up to the amount
of the collateral they pledged in advance, the Bank decided to keep the loan rate unchanged at 0.1
percent, its level prior to the termination of the quantitative easing policy. This means that the
uncollateralized overnight call rate, which will be effectively zero percent in accordance with the new
guideline for money market operations, will basically not exceed this ceiling of 0.1 percent even if it
surges temporarily. Reduction of the outstanding balance of current accounts at the Bank will be
managed through short-term money market operations. With respect to outright purchases of
longterm Japanese government bonds, these will continue at the current amounts and frequency for some
time, with due regard for the future condition of the Bank's balance sheet.
VI. Introduction of a new framework for the conduct of monetary policy
Following the latest MPM, the Bank announced the introduction of a new framework for the conduct of
monetary policy, with a view to ensuring the transparency of its policy conduct given the shift from the
quantitative easing policy to an interest rate policy.
Under the quantitative easing policy, the Bank conducted monetary policy in line with a commitment
based on the CPI. The commitment was unprecedented in that it linked the conduct of monetary policy
directly to a specific economic indicator, namely, the CPI. With the aim of generating monetary easing
effects in a situation where there was no room to further reduce short-term interest rates, the Bank
introduced this unprecedented policy to affect the formation of interest rates, in spite of acknowledging
the concomitant sacrifice in the flexibility with which it would be able to conduct monetary policy. Such
a policy measure had never previously been adopted by any central bank, and it may safely be seen
as a monetary policy innovation designed by the Bank of Japan. As I explained earlier, the Bank's
commitment regarding the duration of the policy had significant positive effects that operated by
keeping short- to medium-term interest rates stable at low levels and maintaining an accommodative
environment for corporate financing. However, at the same time, the policy to some extent undermined
the pricing function of financial markets.
With the prospects for sustainable economic growth with long-term price stability, monetary policy in
general should be conducted in a forward-looking manner -- in other words, it should be implemented
taking future developments in economic activity and prices fully into consideration -- and it should be
both flexible and timely. In the current situation where the economy is emerging from a prolonged
period of structural adjustment and moving toward a path of sustainable growth, a new framework
should be introduced to ensure that monetary policy is conducted both appropriately and with
sufficient transparency. Given the Bank's thinking about the conduct of monetary policy, market
participants, for their part, should have their own views on interest rate developments and thereby
make decisions on financial transactions, by forecasting the future course of monetary policy based on
their assessment of economic activity and prices. Such a process will facilitate the proper functioning
of pricing mechanisms in financial markets and in turn generate economic dynamism through the
efficient allocation of funds.
Three elements underlie the new framework for the conduct of monetary policy.
First, the Bank has clarified its thinking on price stability, which is a stated objective of monetary policy.
Specifically, the Bank has made public its basic thinking on price stability, and, as regards the conduct
of monetary policy, it has disclosed a level of the inflation rate that its Policy Board members currently
understand as price stability from a medium- to long-term viewpoint.
Second, the Bank has explained the two perspectives from which it examines economic activity and
prices in determining how to conduct monetary policy.
Third, the Bank has decided that, after deliberations from these two perspectives, it will outline its
thinking on the conduct of monetary policy for the immediate future, and, as a rule, disclose it
periodically in the Outlook for Economic Activity and Prices (hereafter the Outlook Report).
Now I will elaborate on these three elements.
A. Clarifying the Bank's thinking on price stability
The Bank of Japan Law stipulates the objective of monetary policy as "contributing to the sound
development of the national economy" "through the pursuit of price stability." In accomplishing this
stated objective, it is thus very important for the Bank to clearly indicate to the public its thinking on
price stability.
Price stability can be defined as a state where various economic agents including households and
firms are able to make decisions regarding economic activities such as consumption and investment
without being concerned about fluctuation in the general price level. When considering what
constitutes price stability for the purposes of conducting monetary policy, central banks should take full
account of the distinctive features of their countries' economic structures and how these influence the
public's view of prices. In the case of Japan, one noteworthy feature regards the average rate of
inflation, which, over the last a few decades, has been lower than in major overseas economies.
Specifically, average inflation rates for major countries from 1985 to 2005, measured by the CPI, are
as follows: 3.2 percent for the United States, 2.9 percent for the United Kingdom, 1.8 percent for
Germany, and 0.6 percent for Japan. As the Japanese economy has had a protracted experience of
low inflation since the 1990s, the rate of inflation at which households and firms perceive price stability
seems to be low, and economic decisions are likely to be made on the premise of a similarly
lowinflation environment. These features should be taken duly into consideration when conducting
monetary policy.
At the latest MPM, taking into account the points I have described, there was a discussion of the level
of inflation that each Policy Board member, in conducting monetary policy, currently understands as
price stability from a medium- to long-term viewpoint. Such a level is referred to as a member's
"understanding of medium- to long-term price stability." There was a range of views among the Policy
Board members, which seemed to reflect differences between their views on the Japanese economic
structure, as well as differences in their assessments of the costs of inflation and deflation. They
concurred, however, that, in the current situation, the level in Japan was somewhat lower than in major
overseas economies. They also agreed that, by making use of the rate of year-on-year change in the
CPI to describe the understanding, an approximate range between zero and 2 percent was generally
consistent with the distribution of each member's understanding of medium- to long-term price
stability. Most Policy Board members' median figures fell on both sides of 1 percent. Given that the
"understanding of medium- to long-term price stability" may change gradually, reflecting changes in
the economic structure such as further progress in globalization and innovations in information and
communication technologies, as a rule, Policy Board members will review it annually.
B. Examining economic activity and prices from two perspectives
Having clarified its thinking on price stability, the Bank's next step was to decide how to examine
economic activity and prices in light of such thinking, and then to devise ways to incorporate such
analysis into its conduct of monetary policy. Although it is very important to clarify the Bank's thinking
on price stability, this in itself is not sufficient to develop an actual policy guideline for conducting
monetary policy. The most significant issue facing any central bank, regardless of whether it has
adopted inflation targeting or not, is how to provide information that will make it easier for the public to
predict the future course of monetary policy and so enhance its effectiveness. For instance, suppose a
central bank conducts policy based on certain mechanical rules. Although such rules would in
themselves enhance the transparency of the policy, they would be incapable of coping flexibly with the
various economic shocks hitting the economy. They would therefore fail to meet the original purpose
of enhancing transparency, which is to improve the effectiveness of monetary policy. To date, the
Bank has released its assessment of the current state and outlook for economic activity and prices
through the Monthly Report of Recent Economic and Financial Developments and the Outlook Report.
Henceforth, the Bank has decided to supplement this assessment with additional examinations of
economic activity and prices from the following two perspectives, which are of particular relevance to
the conduct of monetary policy, and then to release them.
The first perspective involves examining, as regards economic activity and prices one to two years in
the future, whether the outlook deemed most likely by the Bank follows a path of sustainable growth
under price stability.
It should be added that, in order to implement the appropriate policy for achieving sustainable growth
and price stability, it is not sufficient merely to assess the economic and price situation according to
the first perspective. Needless to say, any forecast entails uncertainty. It is for this reason that the
Bank's Outlook Report contains detailed descriptions with regard to upward and downward risks
affecting the scenario deemed most likely by the Bank. Among risk factors, there are those that will
have a significant impact on economic activity and prices should they materialize, even though the
likelihood of materialization is low. Such risks include that of falling into a deflationary spiral, or
conversely, the risk of sparking inflation or generating an asset price bubble. In conducting monetary
policy, the Bank needs to do its utmost to prevent the materialization of such potential risks.
The economic projection described in the Outlook Report covers a period of about one and a half to
two years. There could, however, be risk factors that might affect economic activity and price
development in the medium to long term, beyond the Outlook Report's projection period. Experience
inside and outside Japan shows that wide swings in asset prices and significant changes in the
financial environment, including those affecting the intermediation function of financial institutions, may
impact on economic activity and price development with a considerable lag. In addition, when the
public's longer-term expectations of inflation change, this can have a significant impact on the existing
relationship between economic activity and prices.
The second perspective, therefore, involves examining, over a longer horizon, the various risks that
are most relevant to conducting monetary policy aimed at realizing sustainable growth under price
stability. Major central banks seem to share the opinion that to conduct monetary policy putting too
much emphasis on achieving price stability in the short term results in large swings in economic
activity, and this in turn impedes long-term price stability and the sound development of the economy.
C. Conduct of monetary policy for the immediate future
Lastly, as the third element of the new framework for the conduct of monetary policy, the Bank will
outline its current view on monetary policy in light of its deliberations from the two perspectives I have
described, and disclose it periodically, as a rule in the Outlook Report. On the current occasion, the
Bank decided to relea