FRBSF Economic Letter
2004-33; November 19, 2004
Easing Out of the Bank of Japan's Monetary Easing Policy
Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific Basin
Studies within the FRBSF's Economic Research Department.
Based on the latest
data and forecasts from Japan, it would be premature to declare
the end of that country's deflationary period. The Bank of Japan
(BOJ) forecasts that consumer prices will continue to fall through
the 2004 fiscal year, which ends in March 2005, albeit only at
a 0.1% to 0.2% annual pace. Still, it is clear that the threat
of deflation in Japan has been reduced. Most recently, the Bank
of Japan has forecast positive inflation of 0.1% for the 2005 fiscal
year, which runs from March 2005 through March 2006, although BOJ
Governor Fukui was quick to point out that the precise timing of
the end of deflation was still unclear.
Part of the credit for reducing the threat of deflation
must go to the BOJ, which has been conducting expansionary monetary
policy in the form of maintaining short-term interest rates at
close to their minimum attainable zero values since 1999. More
recently, the BOJ has also been flooding commercial banks with
excess liquidity to promote private lending, leaving commercial
banks with large stocks of excess reserves, and therefore little
risk of a liquidity shortage. Together, these policies are commonly
referred to as the BOJ's "quantitative easing" policy.
As BOJ Governor Fukui (2004a) recently noted, the
quantitative easing policy would likely become more stimulative
if it were maintained as Japan's economic recovery solidifies,
given that the increased opportunities for profitable investment
would normally push interest rates upward in the absence of a response
by the central bank. Maintaining a zero interest rate in the face
of such upward pressure would therefore require even more aggressively
expansionary monetary policy. In the limit, continued stimulus
after a recovery has taken hold could cease to be sound countercyclical
policy and instead become a source of inflationary pressure.
Upward movements in 10-year Japanese government
bond yields between February and June this year suggest that the
Japanese public expects a move towards positive inflation, or a
tightening of Japanese monetary policy, or some combination of
the two (Figure 1). Although recent weak news has brought the 10-year
yield back down to spring 2004 levels, it is still about 20 to
30 basis points above its 2004 low.
Japan's impending success in ending deflation therefore
raises the question of the best "exit strategy" from
the current accommodative monetary policy to one that is consistent
with Japan's incipient economic recovery. Recent speeches by Japanese
government officials, as well as releases of the minutes of recent
central bank monetary policy meetings, reveal that the BOJ is currently
wrestling with this issue. BOJ Governor Fukui (2004b) recently
identified two policy actions associated with ending the expansionary
policy: First, nominal short-term interest rates will be raised
from their current zero levels; second, there will have to be a
reduction in the stock of excess reserves currently held by commercial
banks in their BOJ current accounts. In this Economic Letter, I
discuss the policy issues surrounding the exit from the BOJ's quantitative
An explicit CPI target?
Considerations of the appropriate strategy for
exiting from the BOJ's quantitative easing policy raise at least
two controversial questions. First, should the BOJ follow an explicit
rule concerning exactly when to begin to exit the quantitative
easing policy? Second, should such a rule be explicitly communicated
to the public?
The BOJ has announced that it will maintain its
quantitative easing policy until "…the year-on-year change
in the CPI registers zero percent or higher on a sustainable basis" (Fukui
2004a). Governor Fukui noted that this policy rule provided clarity
about the BOJ's decision process for terminating quantitative easing,
and therefore served to solidify market participants' expectations
of low Japanese interest rates going forward.
At the same time, this policy rule leaves the central
bank with some discretion over the timing, as people may hold different
beliefs about the set of conditions that would satisfy evidence
that changes in the core CPI were non-negative on a "sustainable" basis.
As such, while the BOJ announcement enhances the transparency of
its policy, there remains some degree of opacity, both in the communication
of the rule to the public and in the rule itself.
It is apparent that the policymakers at the BOJ
understand this. The minutes of the June 25 Monetary Policy Committee
meeting reveal that the Committee discussed whether the BOJ should
present an explicit higher numerical target for the CPI to better
stabilize expectations (BOJ 2004). One member advocated the idea,
while another agreed that a higher numerical target was "worth
considering." The latter stressed that the intent of such
an announcement would be to clarify the BOJ's commitment to the
public concerning the conditions for raising rates, rather than
strengthen them. In the end, the Committee decided not to pursue
such a strategy. One member argued that setting a higher condition
would impair "…the Bank's flexibility in the conduct of monetary
The tradeoff between transparency and flexibility
in monetary policy has been noted in the economics literature for
some time. While explicit policy rules may make monetary policy
more transparent, and thereby serve to anchor agents' expectations,
rules that are too rigid may hinder policy flexibility, particularly
in the event of unforeseen developments. For example, in arguing
against the adoption of an explicit inflation targeting rule for
the United States, Governor Kohn (2003) argued that "…the
U.S. economy has benefited from the flexibility that the Federal
Reserve has derived by eschewing a formal inflation target. By
flexibility I mean not frequent changes in long-term objectives
but rather the freedom to deviate from long-term price stability,
perhaps for a while."
Increasing short-term interest
Another issue concerns the proper pace of raising
short-term interest rates from their current zero levels. For example,
suppose policymakers knew exactly what long-term interest rate
would be consistent with neutral monetary policy. Should policymakers
pursue a "gradualist" approach, which moves the interest
rate in small steps towards this goal, or a "discrete" approach,
which jumps to this higher rate of interest very quickly.
Arguments for gradualism in monetary policy have
been made on the basis that such policies serve to anchor agents'
expectations (for example, Woodford 1999). By moving slowly in
small steps, advocates claim, the central bank can better convey
the future interest rate path to the public. However others, such
as Rudebusch (2001) argue that anchoring public expectations requires
only that central bankers credibly convey the future interest rate
path and, in particular, does not imply any constraint on the form
of that path. Indeed, Rudebusch argues that the expectation of
a constant interest rate path, which would be the one that would
emerge in the absence of gradualist policy, may be the simplest
and therefore the easiest interest rate path to convey.
In the case of Japan it appears that the paramount
concern would be to maintain expectations of positive inflation
going forward, rather than anchoring the level of expected interest
rates. By moving toward a neutral stance only slowly, policy would
remain accommodative on the way up; and to the extent that it is
accommodative, it allows the economy to absorb a negative shock
that might otherwise lead to deflation. A gradualist policy, therefore,
serves to ensure positive inflation expectations.
Reducing commercial bank excess
The BOJ has also purchased large amounts of government
securities, leaving Japanese commercial banks holding large stocks
of excess reserves. Current bank balances lie between 30 and 35
trillion yen, far in excess of the banks' required reserves, which
total about 6 trillion yen. As Fukui noted (2004b), one of the
components of the BOJ exit strategy will concern drawing down these
excess reserve levels. In order to repurchase these reserves, the
BOJ would typically sell securities, such as Japanese government
bonds, to the commercial banks. This transaction need not have
an impact on the overall Japanese money supply, as the BOJ could
offset it by purchasing an equal amount of securities on the open
However, the motivation for the excess liquidity
policy was the perception that banks with excess liquidity would
be willing to maintain a higher ratio of loans to deposits than
they might otherwise, because they are less likely to face liquidity
problems due to an unforeseen adverse shock. As such, if the excess
liquidity policy is having a stimulating effect on bank lending,
its removal could have some damping effects.
Nevertheless, the BOJ has made it clear that it
does not intend to initiate the end of the quantitative easing
policy until the Japanese economy is on a sustainable positive
inflation path. Along such a path, the commercial banks would be
likely to choose to draw down their excess reserves on their own. As
long as there is modest deflation, the returns to banks from holding
excess reserves is slightly positive, net of the additional operational
costs associated with holding the excess. However, once
deflation is ended and interest rates again become non-zero, Japanese
banks will face a positive opportunity cost of maintaining excess
reserves at the central bank. They can respond to this change in
two ways. They can increase their lending activity, which would
raise their required reserves, or they could purchase government
securities from the central bank. The likely outcome is a mix of
these two strategies which would lead to a decline in the stock
of excess reserves.
The monetary policy challenges raised by the beginning
of the end of the Japanese deflation era are less difficult than
those previously faced, but they are challenging nonetheless. Moving
from an extremely accommodative monetary policy stance to one that
is proper for more conventional circumstances at a time when expectations
concerning positive inflation have yet to be firmly established
raises the concern that an adverse shock may lead to a reversion
back to deflationary expectations.
Because the BOJ is aware of the risks involved,
it has taken great efforts to convey to the public a policy rule
under which quantitative easing will not be ended until there is
evidence that the Japanese economy has safely emerged from deflation.
Nevertheless, the approaching end of quantitative easing demonstrates
the tension between transparency and flexibility in monetary policy.
As discussed above, some have criticized the BOJ's stated policy,
arguing that ambiguities could still arise under the stated rule
that could be eliminated through the adoption of a formal policy
rule. However, the BOJ has chosen a compromise solution, under
which the criteria for moving away from the quantitative easing
policy is relatively transparent, but retains some degree of flexibility
to allow policymakers to respond to unforeseen circumstances.
Mark M. Spiegel
Vice President, International Research,
Director, Center for Pacific Basin Studies
[URLs accessed November 2004.]
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Fukui, Toshihiko. 2004a. "Achieving
Sustainable Economic Growth and Overcoming Deflation."
Summary of a speech at the Yomiuri International Economic Society,
Tokyo, May 13. Bank of Japan.
Fukui, Toshihiko. 2004b. Untitled.
Summary of a speech at a meeting in Osaka on September 2. Bank of
Kohn, Donald L. 2003. "Remarks."
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Rudebusch, Glenn D. 2001. "How
Sluggish Is the Fed?" FRBSF Economic Letter 2001-05
(March 2). http://www.frbsf.org/publications/economics/letter/2001/el2001-05.html
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