FRBSF Economic Letter
2001-31; November 2, 2001
Quantitative Easing by the Bank of Japan
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Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific Basin Monetary
and Economic Studies within the FRBSF's Economic Research Department.
In the wake of continued weakness in the Japanese economy and recent
market turbulence due to the terrorist attacks in the U.S., the Bank of
Japan (BOJ) recently increased the intensity of its quantitative easing
program, which it had begun in March of this year. The BOJ initially switched
from the usual approach to expansionary monetary policy—namely, a reduction
in the target short-term interest rate—to quantitative easing because
by that time it had been pursuing a target very close to zero (0.15%).
The BOJ argued that, at an interest rate so close to zero, further nominal
interest rate target reductions were constrained to be small, as under
normal circumstances nominal interest rates are bounded at zero. As a
result, the possible stimulus obtained through further reduction in the
interest rate target was likely to be limited.
Under quantitative easing, the BOJ conducts open market operations aimed
at increasing the money supply and reducing long-term interest rates.
The recent intensification of the program has come in a number of forms.
The increase in quantitative easing involves the BOJ engaging in open
market transactions aimed at increasing its balance of current bank accounts
held at the BOJ. Balances were initially increased from 5 trillion yen
to 6 trillion yen. After September 11, 2001, balances rose as high as
12.5 trillion yen, but the BOJ gradually brought balances back down to
7 trillion yen a month later. In addition, the BOJ announced that it would
increase its outright purchase of long-term government bonds from 400
billion yen per month to 600 billion yen per month. Finally, the BOJ also
intervened against the dollar; while the BOJ has intervened repeatedly
recently against the rising yen, the latest intervention was notable because
it was unsterilized, meaning that the central bank allowed the intervention
to increase the money supply.
In this Economic Letter, I examine the prospects for these strategies
in an environment where nominal rates are close to zero. I argue that,
in this environment, a modest expansion in the growth rate of the money
supply is likely to have a limited expansionary impact unless it is accompanied
by the public's expectation of higher future inflation rates. And neither
quantitative easing nor unsterilized intervention against the yen is likely
to change inflation expectations. However, insofar as BOJ open market
purchases of long-term government debt raise the price of these assets,
they also may lower the yield. At the same time, other factors that influence
long-term nominal rates, such as inflation expectationsand risk premia,
may mitigate the downward impact of these purchases.
Quantitative easing, unsterilized intervention, and
the liquidity trap
An economy is said to be in a liquidity trap when nominal interest rates
on short-term assets have been driven to zero. Thus, nominal interest
rates can fall no farther, because currency yields zero nominal interest
and is the most desirable asset for other functions, such as engaging
in transactions.
Because nominal interest rates cannot be negative, one might conclude
that, once nominal rates are equal to zero, further monetary expansion
of any sort is impossible. For example, consider the prospects for quantitative
easing at a zero nominal rate. The BOJ prints money (or issues reserves)
and purchases short-term government securities from a bank.
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What would the effects of such a transaction be? Because of the zero
lower bound, nominal interest rates are unchanged. In addition, the bank
has additional currency and a smaller stock of government securities.
From the bank's point of view, it has swapped a near-zero interest rate
asset on its balance sheet (short-term government securities) for a zero
interest rate asset (currency or reserves). The bank may therefore consider
these two assets as being close to interchangeable. As a result, the open
market transaction has failed to change the balance sheet status of the
bank in a tangible way and, hence, may have no impact on its lending activity.
Such a scenario appears to match roughly the experience Japan has had
with quantitative easing since its inception in March 2001. Figure 1 illustrates
that the quantitative easing strategy that the BOJ began in March has
succeeded in reversing the decline in growth of M1, a narrow money aggregate.
However, broader monetary aggregates, such as the M2+CDs aggregate that
the BOJ follows most closely, have responded quite modestly.
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The source of this discrepancy is shown in Table 1, which displays the
growth experiences of the components of the broader M2+CDs aggregate.
While M1 has indeed enjoyed robust positive growth since the inception
of the quantitative easing strategy, there has been a matching decline
in the aggregate known as "quasi-money," which includes time
deposits and a number of other less liquid assets. While the central bank
can increase the stock of narrow money in the economy, the banks appear
to be treating the exercise much like a swap of near-zero and zero interest
rate assets, and they are responding with little change in their lending
activities.
The story with unsterilized foreign exchange intervention may be similar.
Consider an unsterilized intervention where the BOJ purchases dollar assets
with newly printed money. If Japanese and domestic assets are perfect
substitutes, the situation is basically the same as a domestic open market
operation. For example, suppose that a Japanese bank swapped a foreign
asset in its portfolio for the Japanese currency. This would leave the
foreign bank with a change in asset composition (it now has fewer foreign
assets and more domestic assets), but if these assets are perfect substitutes,
there would be no substantive change in its balance sheet. As in the domestic
quantitative easing, the operation may have no impact on the bank's lending
pattern.
Exceptions
Under the proper conditions, quantitative easing may still have real
effects. Consider the impact of the open market transaction discussed
above in the context of the real, rather than the nominal, rate of interest.
The real rate of interest is defined as the nominal rate of interest minus
expected inflation, and it reflects the true expected return on an asset.
If the money injection raises expected future interest rates, it can
lead to a negative real interest rate. Unlike the zero lower bound on
nominal rates, there is no such barrier on real rates. In particular,
when expected future inflation is positive, currency earns a negative
rate of return. This implies that it is now costly for banks to hold currency
on their balance sheets. In this environment, banks would respond to a
monetary injection by attempting to remove zero nominal return assets
from their balance sheets. This would be achieved by expanding their lending
activities.
But can inflationary expectations be affected by the monetary injection
itself? As discussed above, it is possible that the expanded money stock
could stay on the books of the banks, resulting in no expansion of the
economy, and confirming the banks' expectations of a continued zero nominal
rate. To break the liquidity trap, then, it would appear to be necessary
for the central bank to convince the public that such a zero nominal rate
will not persist. It is unclear whether incremental increases in the money
growth rate can have that effect.
This is the primary reason why a number of prominent economists and Japanese
public officials are arguing for the BOJ to adopt an explicit inflation-targeting
regime. They argue that if the central bank announced that it would continue
its policy of monetary expansion until it achieved its inflation target,
it could influence public expectations and thereby influence the real
rate of interest. However, some argue that the announcement of an inflation
target alone does not guarantee its achievement, particularly in the absence
of current inflation (see Spiegel 2001).
Leaving aside other arguments for or against explicit inflation targets,
it is unclear whether explicit inflation targets are necessary to reduce
the real interest rate. Solely in terms of influencing public opinion,
the BOJ may achieve the goal of escaping the liquidity trap by announcing
that it will continue to pursue expansionary monetary policy until deflation
is eradicated. If the announcement were credible, the public would be
uncertain about the future inflation rate, but it would hold a positive
expected rate, which would be sufficient to yield a negative real interest
rate at zero nominal rates.
It appears that the BOJ is moving towards such a stance. BOJ Governor
Hayami recently stated that the central bank would "...do its best
to tame deflationary pressures" (Nihon Keizai Shimbun 2001). Such
a statement appears to suggest a willingness to continue expansionary
monetary policy until deflation is eradicated without moving towards the
adoption of an explicit inflation-targeting regime.
If assets are imperfectly substitutable, other possibilities arise. For
example, under imperfect asset substitutability, the public would respond
to a BOJ purchase of long-term assets by increasing their relative price.
This increase in the price of the long-term asset implies a reduction
in the long-term interest rate. Since long-term interest rates are positive,
the liquidity trap issues discussed above do not arise.
Similarly, under imperfect asset substitutability, a purchase of foreign
assets would leave Japanese assets relatively less scarce, driving down
their price, and hence the relative value of the yen. This decrease in
the value of the yen raises the price of goods in yen and, therefore,
reduces the real interest rate through increased inflation expectations.
Conclusion
The data provide little evidence that the new steps taken by the BOJ
are having far greater effects than previous efforts. There has been little
downward pressure on long-term nominal rates in Japan since the inception
of the quantitative easing program. Indeed, the yield on 10-year Japanese
government securities has generally risen from the 1.15% levels that prevailed
in mid-March 2001 when the policy was adopted to 1.355%. While it is impossible
to know what the long-term rate would have been in the absence of the
BOJ purchases, it appears that the purchases have had little impact on
long-term rates.
The yen/dollar exchange rate has also continued to appreciate, suggesting
that unsterilized foreign exchange intervention has not been effective.
However, in light of recent turmoil in the United States, it is also possible
that the exchange rate appreciation would have been more dramatic in the
absence of the BOJ's intervention.
Mark Spiegel
Research Advisor
References
Nihon Keizai Shimbun. 2001. "BOJ Governor Gives Nod to Koizumi's
Reform Agenda" (August 31).
Spiegel, Mark M. 2000. "Inflation Targeting for the Bank of Japan?"
FRBSF Economic Letter 00-11 (April 7). http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-11.html
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