Haruhiko Kuroda, Governor of the Bank of Japan
Speech at the University of Oxford, June 8, 2017
2.Deflation in Japan: Declines in Potential Growth Rate and Inflation Expectations.
Since the 1990s, economic volatility has sharply decreased in many advanced economies. Former Federal Reserve Chairman Ben Bernanke referred to this as the “Great Moderation” and argued that a major reason was the dramatic improvement in the ability of central banks in those economies, including the United Kingdom, to stabilize inflation expectations through the introduction of measures such as inflation targeting.
Meanwhile, Japan’s economy found itself in a completely different situation. Japan experienced a major asset bubble from the late 1980s to the early 1990s and, following the collapse of the asset bubble, suffered a sharp economic slowdown and serious financial instability. Moreover, firms had to deal with the so-called three excesses — excess production capacity, excess employment, and excess debt — while financial institutions had to grapple with the nonperforming loan problem. While the negative legacy of the asset bubble had been more or less dealt with by the mid-2000s, Japan’s potential growth rate, which had been around 4 percent in the early 1990s, dropped to about 1 percent by the late 1990s (Chart 5). On the price front, the annual rate of change in consumer prices fell into negative territory in 1998 and generally remained negative over the following decade and a half. Against this background, inflation expectations also seem to have declined, although they were not accurately captured in a timely manner.
On the monetary policy side, the policy interest rate, which was 6 percent in the early 1990s, had been lowered to 0.5 percent by 1995. At this point, conventional monetary easing measures through cuts in the short-term policy interest rate had been more or less exhausted. Paul Krugman dubbed this situation “Japan’s trap”and stated that Japan had actually fallen into a liquidity trap, which had long been regarded as just a theoretical possibility written in the back pages of macroeconomic textbooks. In order to get out of this trap, the Bank of Japan introduced a zero interest rate policy in 1999, followed, in 2001, by quantitative easing, in which the outstanding balance of current accounts that financial institutions hold at the Bank of Japan was set as the operating target for money market operations. Thus, the Bank of Japan pioneered the introduction of unconventional monetary policies, but unfortunately Japan was unable to overcome deflation.
Why did Japan’s economy fail to get out of the liquidity trap even though the Bank of Japan had taken unprecedented monetary policy steps? With the benefit of hindsight, we now know that Japan faced a simultaneous decline in the natural rate of interest and in inflation expectations. Under these circumstances, as nominal short-term interest rates faced the zero lower bound, it was difficult to lower real interest rates to level well below the natural rate of interest and achieve sufficient monetary easing. As a result, the downturn in growth during this period caused a decline in prices, further reducing growth through the rise in real interest rates, so that weak economic growth and deflation reinforced each other over a long period.
Then, in 2008, the global financial crisis led to another sharp contraction in Japan’s economy (Chart 6). Even though Japan’s financial institutions had already resolved the nonperforming loan problem by that time and had only limited exposure to subprime-related products, Japan experienced a precipitous decline in real GDP that was more severe than that in Europe and the United States, which was the epicenter of the crisis. There are a number of reasons for this, but what certainly played a role is that at the time the policy interest rate in Japan was only 0.5 percent, so that — unlike in Europe and the United States, where rate cuts of 3 – 4 percentage points were possible — there was little room for a monetary policy response through cuts in the short-term policy interest rate. This episode highlights the importance of bringing about an increase in the so-called neutral interest rate — that is, the nominal interest rate level that is neutral to economic activity — by anchoring inflation expectations at about 2 percent and of securing the ability of monetary policy to respond.
I took office as Governor of the Bank of Japan in March 2013 and immediately introduced a monetary policy regime — quantitative and qualitative monetary easing (QQE) — that is quite different from past regimes. QQE consists of two pillars: (1) directly working on people’s expectations through a price stability target of 2 percent and a strong and clear commitment to doing whatever it takes to achieve this, and (2) directly encouraging a decline in long-term interest rates through large-scale purchases of long-term Japanese government bonds (JGBs). If inflation expectations rise as a result of the former and nominal long-term interest rates fall as a result of the latter, this will push real interest rates to levels below the natural rate of interest even in the face of the zero lower bound.
The policy in which a central bank lowers interest rates and deposit ratios to make credit more easily available. This makes borrowing easier for businesses, which stimulates investment and expansion of operations. The immediate result of monetary easing is generally a boost in stock prices. In the medium term, it promotes economic growth. However, if this policy remains for too long, it can lead to a situation in which there is a glut of currency or too many dollars chasing too few goods and services, leading to inflation. For this reason, most central banks alternate between policies of monetary easing and monetary tightening to encourage growth while keeping inflation under control.
In additional steps, the Bank of Japan in January 2016 introduced a negative interest rate policy in order to address the strong headwinds caused by turbulence in global financial markets. The negative interest rate policy aims at exerting further downward pressure on interest rates across the entire yield curve by pushing down the short end of the yield curve, in combination with large-scale purchases of JGBs. Thereafter, in September 2016, the Bank conducted a comprehensive assessment on developments in economic activity and prices as well as policy effects since the introduction of QQE; based on the findings, the Bank introduced yield curve control, which focuses on long-term interest rates in addition to short-term interest rates as the operating target. However, the basic approach of lowering nominal interest rates across the entire yield curve and lowering real interest rates by raising inflation expectations has remained unchanged.
In modern central banking, QQE is classified as unconventional monetary policy, but from a somewhat longer-term perspective, it can be said to be a contemporary application of Hawtrey’s theory on the importance of guiding expectations and Keynes’ theory that monetary easing can be conducted through the purchase of long-term government bonds. An old East Asian proverb –“visiting old, learn new”– says that one can derive new understanding from learning the lessons of the past, and I think this is particularly apt with regard to the intellectual journey leading up to QQE.
In practice, QQE has produced its intended effects. Inflation expectations climbed notably after the introduction of QQE. This demonstrates that a strong determination by the central bank pushes up people’s forward-looking inflation expectations. In addition, the large-scale purchases of JGBsas part of QQE have exerted downward pressure on nominal interest rates across the entire yield curve. As a result, the Bank of Japan has succeeded in reducing real interest rates to levels well below the natural rate of interest for the first time in its two-decade long battle with the zero lower bound on the short-term policy interest rate (Chart 7).
These monetary easing effects have stimulated economic activity both in the corporate and household sectors, and the output gap has improved substantially. Corporate profits are at record highs. The unemployment rate has fallen to less than 3 percent, meaning that Japan has almost achieved full employment (Chart 8). Wages are rising moderately with the tightening of labor market conditions. An especially noteworthy change is that the practice of regular increases in base pay, which had disappeared during the prolonged deflation since the second half of the 1990s, has returned and has now been observed for the fourth consecutive year. A virtuous cycle between rising inflation and wage increases has been operating. In other words, Japan is no longer experiencing deflation in the sense of a sustained decline in prices.
to be continued