The Role of Expectations in Monetary Policy: Evolution of Theories and the Bank of Japan’s Experience – episode 1

Haruhiko Kuroda, Governor of the Bank of Japan

Speech at the University of Oxford., June 8, 2017


I am very honored to have the opportunity to give a speech at Oxford University today. At the same time, it is also an extremely emotional experience from a personal point of view. I was a graduate student at Oxford University from 1969 to 1971 and was able to enjoy Oxford, the university, and its colleges in my younger days. I was dispatched here by Japan’s Ministry of Finance, planning to study public finance.

However, since Lady Ursula Kathleen Hicks, a prominent scholar in public finance, had already retired, I decided to study monetary economics under Professor Richard Good Smethurst. In those days, Emeritus Professor John Richard Hicks provided a series of seminars on monetary economics for graduate students, and I participated in it. The lectures and seminars at Oxford gave me the opportunity to study monetary economics and monetary policy in  earnest, but I certainly could not have imagined at the time that about half a century later I would give a speech here about monetary policy as Governor of the Bank of Japan.

In my speech today, titled ” The Role of Expectations in Monetary Policy: Evolution of  Theories and the Bank of Japan’s Experience,” I would like to talk about the evolution of  theoretical ideas about monetary policy and the conduct of monetary policy by the Bank of Japan in recent years. In April 2013, the Bank of Japan introduced quantitative and qualitative monetary easing (QQE), which considerably differs from the policy framework employed until then and which has since been further enhanced and strengthened. These policies conducted by the Bank of Japan, together with policy initiatives by central banks in Europe and the United States in recent years, are frequently classified as unconventional monetary policies. However, the roots of the ideas underlying these policies can be traced back to work by economists in the United Kingdom nearly a century ago. In today’s speech, I would like to provide an overview of the debate in economics since the first half of the 20th century, discuss the implications for monetary policy today, and consider remaining issues.

I.Intellectual Origins: Monetary Policy Discussions by Economists in the United Kingdom in the First Half of the 20th Century.

Monetary Policy Discussions by Economists in the United Kingdom in the First Half of the 20th Century Monetary policy discussions by economists in the United Kingdom in the first half of the 20th century provide extremely useful insights into monetary policy today. I am particularly surprised by the fact that those insights from almost a century ago are relevant to the unconventional monetary policies in advanced economies in recent years.

A British economist in the first half of the 20th century that everyone first and foremost thinks of probably is John Maynard Keynes (Chart 1). Keynes, the founder of macroeconomics, highlighted the role of central bank monetary policy in guiding long-term interest rates during a recession through the purchase and sale of long-term government bonds and other measures. As is well known, in 1933, Keynes sent an open letter to U.S. President Roosevelt, urging a reduction of long-term interest rates through purchases of long-term government bonds.

JM Keynes -1At the same time, Keynes, in his seminal book, The General Theory of Employment, Interest, and Money published in 1936, accurately pointed out that when long-term interest rates decline to certain levels, this can give rise to a “liquidity trap” — a situation in which long-term interest rates do not fall further and the monetary authority loses effective control over interest rates because people expect interest rates to rise in the future and hold cash instead of investing in long-term bonds. What is surprising is that Keynes had predicted the possibility of a liquidity trap long before such a situation had ever arisen. In fact, although a liquidity trap had never actually arisen when the General Theory was written, he stated that “this limiting case might become practically important in future.”

Note: Liquidity Trap is a scenario in which the central bank adds money into the market with the goal of stimulating the economy, but fails to lower the interest rates. In times of recession, an economy can be faced with the problem of short-term interest rates reaching or nearing zero. This makes the monetary policy ineffective, and an external catalyst is besought to stimulate the economy. The central bank does so by purchasing financial assets of longer maturity from commercial banks with the intent of lowering the long-term interest rate. A liquidity trap takes place when these actions fail to lower the long-term interest rate.

As you all know, Keynes not only discussed the liquidity trap but also keenly examined many other issues of macroeconomics from an academic standpoint and had a tremendous influence on macroeconomic policies afterward. However, regarding the topic of my speech today–expectations and monetary policy — another scholar providing extremely useful insights is Ralph George Hawtrey, a close friend and intellectual sparring partner of Keynes. As a government economist known for numerous publications written while acting as Director of Financial Enquiries at the U.K.Treasury for a few decades, Hawtrey devised his own economic theories rooted in practice and highlighted the role of monetary factors in the business cycle.

From an extremely early stage, he identified the importance of conducting monetary policy in a forward-looking manner (Chart 2). In his book Monetary Reconstruction published in 1923, he stated that “it is not the past rise in prices but the future rise that has to be counteracted. ” He also pointed out that “[t]he problem is a psychological one” and that “a very relevant factor in the psychological problem is the traders’ expectations as to the intentions of the authority which fixes rates. ” In other words, Hawtrey highlighted that private entities decide their actions based on expectations for the future, identifying — at this extremely early stage in the study of economics — that the central bank’s policy stance toward future price stability is an important factor working on the expectations of such economic entities.

RG Hawtrey

Hawtrey also provides us with instructive insights about why interest rate control by the central bank produces significant policy effects (Chart 3). In his 1938 book A Century of Bank Rate, he argues that “[t]he pressure applied to traders by a moderate rise in the short-term rate of interest, say, 1 percent, is undeniably very slight. Yet apparently the Bank of England always counted on a rise of 1 percent or even of 0.5 percent having a noticeable effect.” He continues by stating that, when the Bank of England raises the official discount rate by 1 percent, “a trader would reason that this was intended to have a restrictive effect on markets, and that, if the effect was not brought about, the rate would simply go higher and higher till it was.” Hawtrey thus probably was the first to clearly point out that the reason why a minor change in the policy interest rate creates a major policy effect is people’s expectations regardingthe future monetary policy stance of the central bank.

RG Hawtrey - 1

I vividly remember hearing about this last point from Professor John Richard Hicks during my days at Oxford. However, while Hawtrey called this policy effect resulting from people anticipating the intentions of the central bank the “psychological effect,” Hicks argued that the effect was based on extremely rational behavior of economic entities (Chart 4). From a theoretical perspective, Hicks found this to be a stronger argument with regard to the transmission mechanism of monetary policy than Hawtrey’s argument. Hicks called this the central bank’s” announcement effect,” saying that the central bank’s policy “should almost immediately result in a shift in expectations,” and that “[w]hat I learn from Hawtrey’s analysis is that the ‘classical’ Bank Rate system was strong, or could be strong, in its announcement effects.” This identification of the announcement effect by Hicks is based on the so-called expectations theory with regard to long-term interest rates. He therefore can be said to have pointed out at an early stage the importance of what today is called “forward guidance.”

JR Hicks

This brief outline indicates that, nearly a century ago, British economists such as Keynes,  Hawtrey, and Hicks had already introduced or anticipated key concepts related to the  unconventional monetary policies implemented today, such as the liquidity trap, forward-looking monetary policy, and forward guidance. Although their arguments were largely conceptual, they were later formalized by scholars such as Friedman and Lucas as well as the New Keynesians, and the essence of their arguments lives on in contemporary economics in a refined form. Central bank policy makers like myself have been influenced both directly and indirectly by the contributions of these British economists. Of particular importance is the point that a strong determination by the central bank to stabilize prices will work on people’s  expectations and increase the effectiveness of monetary policy. This is also the essence of  the monetary easing that the Bank of Japan is currently pursuing. Based on these background considerations, I would now like to explain the Bank of Japan’s policy conduct in recent years.

to be continued

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