FRBSF Economic Letter
2006-28; October 20, 2006
Did Quantitative Easing by the
Bank of Japan "Work"?
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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 Studies within the FRBSF's Economic Research Department.
On March 19, 2001, the Bank of Japan (BOJ) embarked
on an unprecedented monetary policy experiment, commonly referred
to as "quantitative easing," in an attempt to stimulate
the nation's stagnant economy. Under this policy, the BOJ increased
its target for "current account balances" of commercial
banks at the BOJ far in excess of their required reserve levels.
This had the expected impact of reducing the already low overnight
call rate (which is roughly equivalent to the Federal Reserve's
monetary policy instrument, the federal funds rate) effectively
to zero. In addition, the BOJ committed to maintain the policy
until the core consumer price index registered "stably" a
0% or a positive increase year on year. The policy was lifted
five years later, in March 2006. At the launch of the program,
many were skeptical that it would have any impact on the real
economy, as overnight interest rates were already close to zero,
so flooding Japanese commercial banks with excess reserves would
only amount to a swap of two assets with close to zero yields.
Now that the program has been lifted, several
studies have attempted to assess its impact through a number
of channels. These include a direct effect of increases in current
account balances, an impact on the expectations of market participants,
increased central bank purchases of long-term Japanese government
bonds (JGBs) that would reduce long-term interest rates, and
an encouragement of greater risk-tolerance in the Japanese financial
The success, or lack thereof, of the quantitative
easing program is of interest not only as an important experience
in Japanese economic history, but more generally as an unprecedented
experiment in monetary policy under very low nominal interest
rates. In this Economic Letter, I review the evidence
that has emerged to date concerning the impact of the quantitative
Direct impact of current account balance increases
The primary policy innovation of quantitative
easing was that the outstanding balance of current accounts held
by Japanese commercial banks at the BOJ replaced the overnight
call interest rate as the main target for monetary operations.
The BOJ initially increased the current account balance approximately ¥1
trillion, to a target of ¥5 trillion. As this new target level
exceeded required reserves, which did not pay interest, the change
reduced the call rate from its 0.15% level to close to 0%.
The BOJ raised its current account target nine
more times between March 2001 and December 2004, when the target
reached ¥35 trillion, its final upper limit of the target range.
The increases in current account balances were achieved primarily
through monthly purchases of JGBs in open market operations.
The BOJ was generally successful in keeping its monthly current
account balances within its announced target ranges (see Figure
1), though there were short deviations, most notably in 2005,
largely due to an insufficient supply of JGBs (there were also
some earlier episodes, for example in 2002, where movements above
the target range were quickly followed by upward adjustments
in the range, but these were not considered problematic from
a policy standpoint).
Most economic models fail to predict that simple
increases in banks' current account balances could have an impact
on real activity in an environment when interest rates are close
to zero. However, there appears to have been a perception that
the BOJ was concerned that abruptly running down the current
account balances of commercial banks could have adverse consequences
for the financial system. If markets did have this perception,
then a buildup of the stock of reserves alone could push markets'
expectations of future interest rates downward.
Oda and Ueda (2005) do find a small but statistically
significant impact of increases in the current account on medium-
to long-term JGB yields. They find that a ¥10 trillion increase
in the current account balance target would be expected to reduce
three-year JGB yields by 19 basis points and five-year JGBs by
17 basis points. However, they interpret these changes as extending
the market's perception of the duration of the quantitative easing
program, that is, the length of time that interest rates would
be maintained at their zero levels. In contrast, Kobayashi et
al. (2006) fail to find evidence of extra-normal returns on Japanese
bank stock equities on dates where announcements of increases
in the current account targets were not accompanied by increases
in the ceiling on long-term JGB purchases.
Impact of policy maintenance commitment
A second channel through which quantitative easing
could have real effects is its impact on expectations. As the
quantitative easing policy drove short-term rates to zero, markets
may have believed in the BOJ's commitment to maintaining the
policy until the inflation criteria were met, that is, they may
have believed that short-term interest rates would remain at
zero until these criteria were achieved, even in the face of
economic conditions that might have led to interest rate increases
in the absence of any commitment. As inflation may respond to
this recovery only with a lag, the impact of the policy commitment
may have led to expectations of lower interest rates going forward.
However, it is relevant to ask why the public
should believe in the BOJ's commitment to meet its inflation
criteria even though tightening might be desirable in the wake
of a fledgling economic recovery. One answer may be that the
BOJ perceives that its policy independence would be curtailed
if it reneged on a commitment. This argument is analogous to
that suggesting that formally adopting an inflation target that
matches a central bank's existing policy preferences could also
have real effects.
Some studies have found evidence that the program
affected markets' expectations concerning future interest rates.
Baba et al. (2005) use a macroeconomic model to estimate the
impact of the policy commitment on the "yield curve," the
discrepancy in the yields of long- and short-term interest rates.
They find an impact of the policy commitment of about 5 basis
points on five-year JGB yields and about 2 basis points on ten-year
JGBs beginning in 2003. Okina and Shiratsuka (2004) estimate
that, during the quantitative easing period, the expected duration
of zero interest rates increased from six months to roughly a
Impact of long-term JGB purchases
In addition to raising the ceiling on commercial
bank current account balances, under the quantitative easing
program the BOJ tripled the ceiling on monthly purchases of long-term
JGB purchases from ¥400 billion to ¥1.2 trillion. As
yields on these long-term bonds were nonzero, there was a perception
if long- and short-term JGBs were imperfect substitutes, then
these purchases could reduce long-term JGB yields and, thereby,
reduce long-term interest rates and stimulate long-term investment.
In addition, if increased JGB purchases flatten the yield curve,
Auerbach and Obstfeld (2005) argue that such purchases could
have expansionary effects by reducing the deficit financing costs
of the Japanese government.
The empirical evidence of real effects of increased
BOJ purchases of long-term JGBs is also mixed. Oda and Ueda (2005)
fail to find any significant effects on medium- and long-term
bond yields, while Kobayashi et al. (2006) find that Japanese
banks experienced positive excess returns on event dates where
both current account balance targets and ceilings on purchases
of long-term JGBs were increased. This contrasts sharply with
the failure to find any excess returns on dates where the current
account balance target was increased in isolation.
Financial system "soft spots"
A number of authors have also argued that the
quantitative easing program specifically targeted weaker areas
of the Japanese financial system to maintain the pace of credit
creation. In 2001, Japanese banks were still in the process of
reducing their large stock of nonperforming loans. In the month
prior to the launch of quantitative easing, 19 Japanese banks
experienced downgrades in their credit ratings.
Speeches by BOJ policymakers, as well as the
minutes of the policy meeting where quantitative easing was launched,
support this contention. Minutes of the Policy Board meeting
reveal that some members were particularly motivated to embark
on the quantitative easing policy as a vehicle to maintain the
rate of credit creation by Japanese commercial banks. However,
many have pointed to the actual declines in bank lending that
occurred after the launch of the program to argue that it was
unsuccessful in encouraging credit extension by Japanese commercial
banks. Still, it is hard to know whether the pace of credit creation
would have been even slower in the absence of the program.
While there is little evidence that quantitative
easing stimulated overall lending activity, there does appear
to be some evidence that quantitative easing disproportionately
supported the weakest Japanese banks. Baba et al. (2005) demonstrate
that the launch of the program reduced the variance of certificate
of deposit rates across banks, even more than would be expected
by the observed decline in the variance of bank credit ratings
over their sample period. This left weaker Japanese banks relatively
less disadvantaged in raising capital than they would have been
in the absence of the program. Similarly, Kobayashi et al. (2006)
find that increases in quantitative easing policies were associated
with greater excess equity returns on weaker Japanese banks,
again suggesting that the program disproportionately favored
weaker Japanese banks.
The results of studies of the impact of the quantitative
easing period are just now making their way into the literature,
but several patterns already have emerged. First, the primary
evidence for the real effects of quantitative easing appears
to be associated with empirical evidence that the introduction
of or advances in the program have been associated with some
measurable declines in longer-term interest rates. These have
been associated with both changes in agents' expectations of
future interest rate levels and with purchases of "nonstandard" assets,
such as longer-term JGBs. As these policies often occurred simultaneously,
it is difficult to discriminate between the two. Second, there
appears to be evidence that the program aided weaker Japanese
banks and generally encouraged greater risk-tolerance in the
Japanese financial system.
While these outcomes appear to be consistent
with the intentions of the program, the magnitudes of these impacts
are still very uncertain. Moreover, in strengthening the performance
of the weakest Japanese banks, quantitative easing may have had
the undesired impact of delaying structural reform.
Mark M. Spiegel
Auerbach, Alan J., and Maurice Obstfeld. 2005. "The
Case for Open Market Purchases in a Liquidity Trap." American
Economic Review 95(1) (March), pp. 110-137.
Baba, Naohiko, Motoharu Nakashima, Yosuke Shigemi,
Kazuo Ueda, and Hiroshi Ugai. 2005. "Japan's Deflation,
Problems in the Financial System, and Monetary Policy." Monetary
and Economic Studies 23(1), pp. 47-111.
Kobayashi, Takeshi, Mark M. Spiegel, and Nobuyoshi
Yamori. 2006. "Quantitative Easing and Japanese Bank Equity
Values." Forthcoming, Journal of the Japanese and International
Oda, Nobuyuki, and Kazuo Ueda. 2005. "The
Effects of the Bank of Japan's Zero Interest Rate Commitment
and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance
Approach." Bank of Japan Working Paper Series, No. 05-E-6.
Okina, Kunio, and Shigneori Shiratsuka. 2004. "Policy
Commitment and Expectation Formation: Japan's Experience Under
Zero Interest Rates." North American Journal of Economics
and Finance 15(1) (March), pp. 75-100.
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