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At its Monetary Policy Meeting held last week, the Bank of Japan undertook a comprehensive assessment of the monetary easing policies it has pursued to date and in light of the results, introduced a new framework of “Quantitative and Qualitative Monetary Easing with Yield Curve Control.”
Three years ago, the Bank of Japan set the “price stability target” at 2% in terms of the year-on-year rate of change in the consumer price index, and to achieve this, introduced a policy of “quantitative and qualitative monetary easing.” Three mechanisms were envisaged at the time: (1) raising people’s expectation of prices (expected rate of inflation) by making a clear commitment to achieving 2% inflation and employing large-scale monetary easing; (2) lowering the nominal interest rate by buying long-term government bonds in large quantities; and (3) lowering real interest rates (interest rates based on forecast prices) through these two measures to stimulate the economy and push up prices.
More than three years later, there were record high corporate earnings and the unemployment rate had dropped to 3%. The excessive appreciation of the yen had been corrected, and stock prices rose. The economy experienced a bear market for three consecutive years, and when excluding the effects of energy prices, consumer prices increased for two years and ten months straight. In terms of “persistent price declines,” deflation was eliminated in the Japanese economy. Analyses using large-scale economic models have also been able to demonstrate that the lowering of real interest rates through “quantitative and qualitative monetary easing” contributed to this turnaround.
While deflation was eliminated, the 2% target has not been achieved, because the expected rate of inflation did not rise as much as expected. The first year saw a steady improvement, with consumer prices rising as much as 1.5%. People started to reverse their deflationary mindset, and the expected inflation rate rose accordingly. However, from the second year onwards, the actual inflation rate dropped due to (1) falling price of crude oil and weak demand following the consumption tax hike from the summer of 2014; and (2) adverse conditions caused by instability in the financial markets of developing countries from summer 2015 onwards. In line with this, the expected rate of inflation went from increasing to flat, and eventually began to weaken.
Generally speaking, expected inflation is made up of two elements: (1) the “formation of forward-looking expectations” towards the Bank of Japan’s 2% target; and (2) the “formation of adaptive expectations” influenced by past inflation rates. In Japan, which has experienced prolonged deflation, the latter element holds greater weight compared with Europe or the United States. In other words Japan’s expected inflation rate is more likely to be informed by past price trends, and when actual inflation dropped due to adverse conditions, it grew weaker. This is why the 2% inflation target was not met.
How can this be addressed? If the inflation rate is being weighed down by the forming of adaptive expectations, the strength of forward-looking expectations towards the 2% rate should be bolstered in return. As a means to doing so, the Bank of Japan has made a commitment to continually expanding the monetary base “until actual the inflation rate is stable above 2%.” The BoJ has essential made a 2% overshoot commitment.
As the price stability target was always something that needed to be achieved on average in order to smooth out business fluctuations, the aspect of a rate in excess of 2% was naturally on the table. But since there is a time lag until monetary policies start to work and an inertia can act upon prices in the meantime, usually a commitment is made to pursue a policy “until the rate is expected to exceed 2%.” Making a commitment to “continue with monetary easing until seeing figures above 2%” in terms of actual results is exceedingly unusual.
Even now, the money supply has risen to 80% of nominal GDP, but if it expands in line with current policies, it will exceed 100% in a little more than a year (see figure). By promising to continue such strong monetary easing, the Bank of Japan is aiming to boost people’s confidence that a 2% rate of inflation will be achieved.
Next is the issue of negative interest. If we pursue the effects of real interest rate declines as the expected rate of inflation weakens, then lowering the nominal interest rate is essential. The negative interest policy introduced in January had a significant effect in this regard. Yields on government bonds fell significantly, and interest rates on lending and corporate bonds have also seen significant declines. On the other hand, the degree of reduction in deposit interest rates has been less pronounced. This suggests that the fall in lending rates has contracted earnings for financial institutions. In addition, the decline in investment return on insurance and pension schemes, aside from its direct impact, may have an adverse effect on the economy in terms of mindset.
For this reason, the new framework seeks to spur the formation of short and long-term interest rates that are most effective at maintaining momentum towards 2% inflation in light of financial conditions in addition to the economy and prices.
What does this mean in practice? It used to be said that “long-term interest rates cannot be controlled.” But after the Lehman Shock, the American and English central banks began policies to work on long-term interest. “Quantitative and qualitative monetary easing” is an extension of those efforts. What’s more, the experience of Japan following the introduction of negative interest is important. We learned that if negative interest and the large-scale buying up of government bonds is combined, short-term and long-term interest rates overall can be influenced considerably.
Given this, in addition to adjustment measures that place this combination at the center, such as the buying up of government bonds at quoted prices, the BoJ has decided to start implementing control short-term and long-term interest rates (yield curve control).
At the recent Monetary Policy Meeting, the Bank of Japan framed short-term and long-term interest rates largely at their currently levels and decided on a policy to (1) maintain the short-term policy interest rate at 0.1%; and (2) set a control target for ten-year rates at largely currently levels (around 0%). If the degree of fluctuation allowed by the description of “around” is too wide, the aim of the policy will not be achieved, and if it is too narrow, it will have too great an impact on market functions, so the bank will need to develop appropriate market forecasts through actual market adjustments.
If additional easing is required, “lowering short-term and long-term interest rates” will be the main measure employed. As in the past, moves to “expand asset purchases” would also be used. Depending on circumstances, steps might also be taken to “accelerate the pace of monetary base expansion.” In that case, while interest rates would drop significantly, depending on conditions in the economy and financial markets, that degree of aggressive easing may be required. It comes down to using every available measure as needed through a process of weighting the benefits against the costs.
Compared with conventional methods that established control targets for the monetary base and government bond purchase amounts, the new framework can adapt more flexibly to changing conditions. As those improvements will enable more effective purchases and a more precise accounting of cost aspects, the policies will also be more sustainable.
On this point, the market’s view is that the BoJ is “approaching the limit of bond purchases.” If that were the case, the downward effect on interest rates for each unit of bond purchases should rapidly rise as we approach that limit. But even if one takes that stance, the control of short-term and long-term interest rates is sustainable.
Of course, we don’t believe that we are close to a limit, and that is why we believe it is necessary to control long-term interest rates by continuing with the large-scale purchase of government bonds (with the aim of the same amount as before). Even if the control target is “interest,” it doesn’t differ from expanding “quantity.”
By setting real interest lower than the natural rate of interest (the interest rate neutral towards economic activity and prices), monetary policy pursues the effects of easing. The natural rate of interest in Japan has trended downward along with a declining potential growth rate. This time it was once again estimated to be “in the neighborhood of 0%.” Efforts to raise the natural interest rate by bolstering growth potential are important.
However, that is no reason at all to back off on monetary easing. The reality is that the natural interest rate is still low.
Translated by The Japan Journal, Ltd. The article first appeared in the interview column of The Nikkei newspaper on 29 September 2016 under the title, “Kinyuseisaku no sokatsukensho’ no hyoka (1): 2% koerumade kanwa keizoku” (Evaluating the “Comprehensive Assessment of Monetary Policy” (1): Continued Easing To Overshoot 2% Inflation).” The Nikkei, 29 September 2016, p. 29. (Courtesy of the author)