An End to Five Years of Quantitative Easing

At a monetary policy meeting on March 8–9, the Bank of Japan decided to put an end to quantitative easing, a super-loose monetary policy unlike any other among the world’s industrial democracies. In this article I will review the circumstances that led to the adoption of quantitative easing, the aims, effectiveness, and value of the policy, and the prospects for monetary policy henceforth.

BACKGROUND TO AN EXTRAORDINARY POLICY

The monetary authorities ordinarily make use of adjustments in interest rates to influence economic activity. In the past, the Bank of Japan deployed a policy centered on changes in the official discount rate, which is the basic rate for the central bank’s loans to financial institutions. When Japan’s bubble economy deflated at the start of the 1990s, the BOJ responded by cutting the discount rate in successive steps, all the way to 0.5% in September 1995. With little room to lower this rate any further, the BOJ turned to another interest rate, the uncollateralized overnight call rate, as its main tool in the second half of the decade. This is the rate used by commercial banks for unsecured transactions to meet daily fund demand.

During the 1990s Japan’s slump grew increasingly serious, and the financial system came to be endangered by a growing mountain of nonperforming loans. In tandem with the government’s repeated applications of fiscal stimulus, the monetary authorities pushed interest rates lower and lower. Eventually, in February 1999, they adopted the so-called zero-interest-rate policy, which sought to hold the overnight call rate as close to zero as possible. Even after that, though, the BOJ came under pressure to make credit still more readily available, and since interest rates could not be pushed below zero, the idea was advanced in the autumn of 1999 that the central bank should adopt a new tool, "quantitative easing"—something no other advanced country was doing. But in August 2000 the BOJ reversed course by jacking the overnight call rate up to 0.25%. No sooner had it made this move, however, than the information-technology bubble burst, and the economy rapidly turned for the worse. The BOJ then lowered the overnight call rate to 0.15%, and in March 2001 it introduced the policy of quantitative easing.

This policy worked by mandating a large increase in the amount of funds commercial banks and other financial institutions kept on deposit in their current accounts at the BOJ, in return for BOJ purchases of bills and government bonds they were holding. Quantitative easing had the effect of holding the overnight call rate close to zero. Beyond that, though, it also had the experimental significance of raising expectations that its effect would be even greater than a zero interest rate. The current accounts at the BOJ are where banks place the minimum amount of their legally required reserve deposits, which they keep on hand to meet a possible sudden rush of withdrawals by customers. When banks have an outstanding balance in these accounts larger than their legal reserve requirements, they cease to need to raise that amount of funds by borrowing from other institutions on the call market.

In a statement released on March 19, 2001, the BOJ declared that it would not alter course until the core consumer price index (which excludes perishables, whose prices are volatile) returned to a year-on-year rate of change of zero or higher. The message was that zero interest rates and quantitative easing would be kept in place until deflation was vanquished.

EFFECTS OF QUANTITATIVE EASING

It was hoped that quantitative easing would produce four effects. (1) Stabilizing the management of funds by banks and heading off financial jitters. (2) Lowering interest rates on instruments longer than overnight. This is the so-called time-axis effect, or the suppression of interest rates on instruments ranging from three-month bills to five-year bonds based on the expectation that rates will not rise until deflation has stopped. (3) Arousing expectations of inflation. (4) Expanding bank lending to companies and giving a boost to investment and other active uses of funds. This is called the portfolio-rebalancing effect.

At the same time, a number of side effects of quantitative easing also drew comment. For instance, the time-axis effect could undermine the market’s function of determining interest rates, and the central bank’s assistance in fund management by financial institutions could harm the functioning of the call market and other money markets. Moreover, the lowering of interest rates on bank deposits to almost zero over an extended period would deprive the household sector of interest income, and it could also retard the weeding out of inefficient business firms. It was not clear, though, that these side effects could be attributed specifically to the quantitative-easing policy.

Figure 1 shows the movements in the BOJ current account balances, which rose in response to the central bank’s hikes in its target levels. The monetary authorities had a target of about ¥5 trillion when quantitative easing began in March 2001, and they raised it to about ¥10 trillion the next year. They then lifted it to the ¥15 trillion–¥20 trillion range in March 2003 and the ¥30 trillion–¥35 trillion range in 2004. When we note that legally required reserve deposits during this period were on the order of ¥5 trillion, we can appreciate that a huge supply of extra funds, one undermining the functioning of the call market, was generated.

The policy seems indeed to have had effect 1, the relieving of financial jitters, and to some extent it also produced effect 2, the time-axis effect. Professor Ueda Kazuo at the University of Tokyo, who formerly served on the BOJ’s Policy Board, has recently published a book on the zero-interest-rate regime, Zero kinri to no tatakai (The Struggle with Zero Interest Rates). He reports that the BOJ had high expectations for the time-axis effect and that this effect was in fact produced, as verified by an empirical analysis. But it appears that the central bank’s policy did not lead to expectations of inflation (effect 3) or stimulate portfolio rebalancing (effect 4). Growth of the broadly defined money supply remained at the low 2%–3% level in and after 2001, and bank lending actually contracted a bit despite the quantitative easing. What increased was banks’ holdings of government bonds. Given the tiny interest payments on deposits under the ultralow interest rates, banks could enhance their returns by holding government bonds. As far as can be ascertained from figure 2, which charts the quantitative money targets and economic activity, the increases in current account balances were associated with decreases in bank lending, and the money supply grew hardly at all.

According to an estimate by Mitsubishi Research Institute, the decline of interest rates dealt a cumulative loss of ¥280 trillion in interest income to Japan’s households between 1991, when rates began to fall, and 2005. On the other hand, companies benefited from a cumulative reduction in interest payments of ¥260 trillion, and financial institutions saw a ¥98 trillion increase in their interest income. In short, the ultralow rates brought about a transfer of income from households to companies and banks. But we should not immediately assume that this transfer amounted to shabby treatment of the household sector. After all, the ultralow rates averted a financial crisis, facilitated the disposal of bad debts, and quite possibly saved the people of Japan from suffering a much worse fate. In any event, we should undoubtedly conclude that quantitative easing and the other elements of the super-loose monetary policy played a useful role in the course of the economy’s return to recovery.

ANNOUNCING THE SHIFT

In announcing the new policy on March 9, the BOJ made four main points: (1) The operating target of money market operations will be shifted from the outstanding balance of current accounts back to the uncollateralized overnight call rate. (2) The outstanding balance of current accounts will be scaled back to the level of required reserves (about ¥6 trillion). (3) Monetary policy will initially aim at an overnight call rate of around zero, but this requirement will be gradually relaxed in line with economic and price developments. (4) Medium-to-long-term price stability for the Japanese economy means year-on-year change in the consumer price index within the approximate range of 0% to 2%, with about 1% representing the median figure.

In a press interview, Governor Fukui Toshihiko said that the BOJ had determined to terminate quantitative easing because the conditions for doing so, which were enunciated back when this emergency policy was introduced, had been satisfactorily met. Nonetheless, the zero-interest-rate policy needs to be left in place for the time being, he said, because it will take some time to ascertain that there has been a change in behavior among money market players, who have grown used to the conditions created by quantitative easing. At present, he added, no single answer can be supplied to the question of whether interest rates will continue to be held close to zero after the outstanding balance of current accounts has fallen to the level of ¥6 trillion.

The opinion in some quarters of the government was that the BOJ ought to proceed cautiously before deciding to bring quantitative easing to an end. Touching on this concern, Fukui remarked that there was no disagreement among the Policy Board’s members on how the economy’s current condition was to be read and that there is a need to maintain compatibility between the transparency and mobility of policy operations. Out of consideration to the government, he continued, the bank had decided to keep up its purchases of long-term government bonds on a monthly level of ¥1.2 trillion. At the same time, though, he indicated that the bank would eventually scale back these bond purchases.

Following the lifting of the quantitative-easing policy, long-term interest rates on the bond market began a gradual ascent. Few people expect this climb to pick up speed, however, partly because the BOJ, like the Federal Reserve Board in the United States, is taking care to keep its lines of communication with the market open. The stock market reacted favorably to the end of quantitative easing; the majority view was that since the decision dispelled the uncertainty about what the monetary authorities might do, it was likely to boost investors’ confidence and support a price upswing. Somewhat after its policy switch, the BOJ conducted its March tankan survey of short-term business sentiment, and it found that optimism is continuing to improve. Of note was an upward revision in capital investment plans. While there is room for argument over whether the upbeat mood can be read as an effect of quantitative easing, nobody can deny that the real economy’s return to health has taken hold.

In an article carried in the March 31 issue of the Nihon Keizai Shimbun, BOJ Executive Director Shirakawa Masaaki identified three elements of the bank’s new monetary policy framework. The first is a clarification of the bank’s view of "price stability." The objective is to stabilize prices over the medium-to-long term, he said, and not to try to eliminate short-term price fluctuations, since that might only lead to wide swings in economic activity. In Japan’s case, a year-on-year CPI increase in the 0%–2% range—somewhat below the inflation targets other countries have set—is seen as appropriate for achieving price stability.

At the present time, Shirakawa said, the BOJ was not willing to get more specific by using a single figure as an inflation target. This was a controversial subject among the Policy Board members, with some advocating that the bank adopt a hard target and others arguing that it just announce guideposts. Eventually it was agreed to put off setting a target in view of the possibility that the price-formation mechanism could change. After all, he noted, "Japan’s economy is in the process of returning to a sustainable growth path after a long period of adjustment, and progress is under way in economic globalization and in information and telecommunications technology."*

The second element of the new monetary framework is the enunciation of two perspectives to be used as a basis for policy actions. One is whether the outlook for economic activity and prices one or two years in the future is within the boundaries of a sustained growth path, and the other is whether price stability over a longer period may be endangered by risks, such as the formation of an asset bubble. The framework’s third element is regular announcements by the BOJ of its current thinking on monetary policy. The hope is that these statements will enhance the transparency of monetary policy and deepen the market’s understanding of the central bank’s views. In these days of rising uncertainty, regular updates on the views of the BOJ should serve to increase the effectiveness of monetary policy and maintain market confidence. These, then, are the three elements of the new framework, and the question is how the bank will be providing for them in the future.

ISSUES AND PROSPECTS FOR THE FUTURE

In this age of mounting calls for transparency in monetary policy, it has become normal around the world for the measures adopted by central banks to influence the expectations of and forecasts by economic actors. Related to this, the independence of central banks is on the rise. The direct effects of monetary policy and the impact of the policy on the overall economy are amplified by the influence they exert on expectations. One of the available monetary tools is inflation targeting, but it presents various technical problems involving the selection of statistical indicators, the difficulty of forecasting inflation rates, the time lag between policy adoption and target achievement, and the question of whether rises in asset prices should be considered an inflation target. In its new framework the BOJ has opted for the announcement of not a specific target but an inflation range (0%–2%), but this could take on a life of its own as a quasi target. The key will be how flexibly market participants look upon the new framework.

In an article titled "After the Flood—Monetary Policy in Japan" in its March 11 issue, the Economist discusses the ambiguity inherent in the new framework based on the choice of an inflation range rather than a target. While noting that the BOJ has at least clarified its own thinking on the subject and will not, in any event, permit any abrupt change in the current ultralow level of short-term interest rates, the article observes that the debate on the bank’s policies is bound to continue. Evidently it will take some time before Japan can get back to an ordinary monetary policy centered on adjustment of interest rates.

In the United States, meanwhile, Ben Bernanke has taken over as the new chairman of the FRB. In the pages of Macroeconomics, a textbook he coauthored with Andrew Abel, can be found a comparison of discretionary monetary policy and inflation targeting. While inflation targeting is currently in fashion, the authors point out that it will not be effective if the central bank does not have credibility. The question for the BOJ today is whether it can win credibility for the new framework it has erected.

Translated from an original article in Japanese written for Japan Echo.

© 2006 Japan Echo Inc.