kazumasa iwata : the conduct of monetary policy under the new framework excerpts of a speech by mr kazumasa iwata, deputy governor of the bank of japan, at a meeting with business leaders, akita, 8 june 2006. * * * the conduct of monetary policy the bank of japan terminated the quantitative easing policy in early march 2006, and is in the process of reducing the outstanding balance of current accounts held by financial institutions at the bank. the outstanding balance, which was at around 30 to 35 trillion yen at the time of the termination, is currently at around 12 trillion yen. some market participants take the view that the pace of reduction may be too fast, and speculate that this may reflect the bank's intention to raise the target for interest rates at an early date. market participants expect the bank to raise the target for interest rates at some point during fiscal 2006, and this expectation has been factored into current market rates. the bank, however, noted when the quantitative easing policy was terminated that it would take a few months before the outstanding balance declined to a level near the reserve requirement. the bank's money market operations have been in line with this policy statement, and the bank has not been accelerating the pace of reduction in order to raise the target for interest rates at an early date. it has been some time since money market transactions were conducted under normal market conditions, so that some rates have risen due to trading friction. nevertheless, on the whole the bank's reduction of the outstanding balance has been carried out in a stable manner. new framework of monetary policy and policy implementation the conduct of monetary policy is now based on the new framework announced in march this year and on the findings from examining the risks affecting the economic outlook that are described in the outlook for economic activity and prices ( hereafter the outlook report ). under the quantitative easing policy, monetary policy was conducted with an emphasis on the underlying trend of the core consumer price index ( cpi ). to be more specific, with the overnight call rate at virtually zero percent, the bank made a commitment to maintain the quantitative easing policy until the year - on - year rate of change in the core cpi registered zero percent or higher on a sustainable basis in order to affect market expectations of the future path of interest rates. 1 this effect is referred to as the policy duration effect. the effectiveness of the quantitative easing policy has been the focus of much debate and criticism. i believe, however,

that ultimately the policy achieved its initial aims, although this took some time. there are two reasons for this success. first, the commitment by the bank to maintain the quantitative easing policy until the core cpi registered zero percent or higher on a sustainable basis provided an anchor for stabilizing expectations concerning future price movements. second, the commitment to maintain the policy helped keep relatively long - term rates as well as shortterm rates at low levels by affecting expectations regarding the future path of interest rates. as a result, the burden of firms'debt was lightened, facilitating business restructuring. this restructuring increased the effectiveness of resource allocation, leading to improvements in productivity and corporate profitability, and ultimately pushed up the potential growth rate. in short, the combination of low market interest rates and the increased rate of return on corporate nonfinancial assets acted as the significance of modern monetary policy is more in its ability to influence market participants'expectations of future policy interest rates than in the effects of changes in the policy rate itself. mervyn king, governor of the bank of england, has referred to this phenomenon, in which the effectiveness of monetary policy is enhanced by movements in market interest rates that considerably exceed those in policy rates, as the " maradona theory of interest rates. " the name derives from argentine football legend diego maradona who, in the 1986 world cup match against england, ran 60 yards in a straight line before placing the ball in the english goal. maradona was able to run straight for the goal because the english defenders were expecting sudden darting feints. for more details, see m. king ( 2005 ), " monetary policy : practice ahead of theory, " mais lecture 2005. the basic mechanism pushing the rate of change in the core cpi above zero percent. 2 it goes without saying that the bank's ample provision of liquidity played a complementary role in stabilizing financial markets and keeping interest rates low. the quantitative easing policy was at times criticized as being extremely risky, being likened to driving with one's eyes on the rearview mirror because the bank relied on a price index, a lagging indicator, in conducting monetary policy. the bank did not rely solely on the rearview mirror, however. in october 2003, the bank provided a detailed description of its commitment to maintaining the quantitative easing policy. one of the conditions underpinning the commitment was that the bank needed to be convinced that the prospective core cpi would not once again drop below zero percent after terminating the