Introduction
Japan’s policy of “quantitative monetary easing” ended on March 2006 when the Bank of Japan (BoJ) came to a decision to withdraw from that policy. Four months later, the BoJ raised its benchmark overnight interest rates to 0.25%. This momentous decision was a small and calculated step, which was also widely anticipated. However, this switch in monetary policy undoubtedly represented a massive leap for Japan, where interest rates have been residing at zero for most of the past six years. In this paper, I will first delve into Japan’s history of liquidity targeting, and attempt to evaluate whether measures taken under liquidity targeting were effective in pulling Japan out from its deflationary spiral. I will then examine the opposing viewpoints of the BoJ and the Japanese government in order to trace how the BoJ’s decision to raise interest rates came to become a contentious political issue. Finally, I will conclude with a discussion of the road ahead for the BoJ by analyzing whether the Bank is likely to retain its independence and whether inflation targeting might become Japan’s policy framework in the near future.
An Arcane and Perverse Monetary Policy
Keynes wrote in 1920 that ‘There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.’ While these words have often been used to describe the evils of inflation; Japan, with its zero interest rate policy (ZIRP) and the BoJ’s practice of flooding the economy with excess cash, can also provide incriminating evidence of a national currency being led astray. Hence, it is no wonder that Japanese monetary policy has long been viewed as ‘arcane and perverse’ by some central bankers. To understand how one of the world’s largest economy ended up having such an unorthodox and unpopular monetary policy, it is essentially to briefly understand the history of liquidity targeting in Japan and the unfortunate circumstances leading to it.
When the stock bubble of the 1980’s burst in Japan, the economy did not sink directly into a severe recession. However, the negative shock generated by the collapse of the asset price bubble did take a toll on the Japanese economy. Year after year, the Japanese economy underperformed and grew below potential, which led to a decade of economic stagnation in the 1990s (or more commonly known as Japan’s ‘lost decade’). As companies struggled with excess debt and falling production capacity, prices starting falling in the late 1990s. Deflation eroded corporate profits, leading to wage cuts and increased unemployment, which further depressed consumption spending and economic growth. This vicious spiral continued and in February 1999, the BoJ introduced zero interest rates into Japan. The BoJ’s aim was to relate Japan’s sick economy by guiding the nominal unsecured overnight call rate (OCR) to zero percent to encourage lending, investment and consumption. This effectively placed Japan into what is commonly known as a ‘liquidity trap’, and the zero interest rates meant that the Japanese central Bank had very little tools left to influence monetary policy.
However, the effectiveness of Japan’s ZIRP was limited because besides residing in a liquidity trap, Japan was also unfortunately caught in a financial trap. Banks were worried about the volume of non-performing loans in their portfolios and were more concerned with limiting risks than extending new loans. Hence lending became impervious to changes in the cost of credit. As an indication of the vulnerability of the BoJ to changing economic conditions during that period, current governor Toshihiko Fukui analogized the BoJ to a boxer with his hands bound behind his back. However, it was clear that the BoJ had not given up fighting despite the lack of monetary policy tools at its disposal. When what began to look like string-pushing failed to jumpstart Japan’s stagnant economy, the BoJ embarked on an unprecedented monetary policy experiment in March 2001 by replacing Japanese commercial banks’ current account balance at the BoJ as the main target of monetary operations, in place of the OCR. The BoJ raised the current account target close to ten times (from one trillion yen to thirty-five trillion yen) between March 2001 and December 2004, and these increases in current account balances were achieved primarily through the purchase of long-term Japanese government bonds by the BoJ. As the new target level exceeded the level of non interest-paying required reserves, the change cut the call rate (the rate at which banks lend to one another) to close to 0%.
This method of flooding commercial banks with liquidity became known as quantitative easing and reflected recognition among Japan’s central bankers that deflation was so entrenched in the Japanese economy such that zero interest rates alone were not enough to stimulate the economy. The announcement of the quantitative easing policy was also accompanied by an ‘exit condition’, which stated that quantitative easing and zero interest rates would continue to be in place until the consumer price index (excluding fresh food) registers stably 0% or an increase year on year.
The Effectiveness of Liquidity Targeting
Japan’s ZIRP, together with a policy of almost limitless monetary abundance were seen as emergency measures to save the economy from a deflationary spiral and to rescue the banking system, which was heavily saddled with bad loans from the brink of a breakdown. One of the main aims of quantitative easing was to achieve real effects by raising inflation expectations in the market. For example, the injection of monetary base at zero interest rates aimed to indicate to Japanese consumers that the BoJ was committed to maintaining the ZIRP until the inflation criteria were met. Hence, with large amounts of liquidity flooding the economy, Japanese consumers who believe in the imminent end of deflation would be tempted to spend now, instead of waiting for prices to actually start rising. This change in consumer psychology would stimulate spending and the resultant upward pressure on prices would allow Japan to break out from its liquidity trap.
Secondly, the injection of money in the economy was also intended to stimulate bank lending and rescue Japan from its financial trap. With positive expected future inflation and nominal interest rates being held at zero, real interest rates would be pushed into the negative zone. Hence, currency would earn a negative rate of return and banks would respond by expanding their lending volume to reduce the cost of holding currency on their balance sheets. However, whether quantitative easing did encourage credit extension by Japanese banks remains unclear. While there is no evidence of a spike in overall lending since the introduction of the program, it is also difficult to know whether the pace of credit creation would have been even more sluggish in the absence of the program. However, some have argued that quantitative easing helped to boost credit creation by supporting the weaker players in Japan’s financial system. For example, the program of quantitative easing reduced the variance of certificate of deposit rates across banks and left weaker Japanese banks (with lower credit ratings) relatively less disadvantaged in raising capital than they would have been in the absence of the program. The encouragement of greater risk tolerance in the Japanese financial system may have been one of the intentions of the program of quantitative easing; however, the lending of support to weaker banks may have also led to the unintended outcome of a delay in the implementation of structural reforms in Japan’s financial system.
Both objectives identified above hinges on the requisite condition that banks and the public expect future inflation to rise. Hence, the absence of an explicit target inflation rate may be seen as a weakness of the BOJ approach in influencing public and corporate expectations. As a result, there have been calls for Japan to adopt an explicit inflation-targeting regime i.e. by affirming its continuation of the policy of monetary expansion until a target inflation rate is achieved. Furthermore, the announcement of the explicit goal of the BoJ’s policy would also increase the ex-post accountability of the independent central bank for its own actions. But some have also argued that an announcement of an inflation target would be insufficient to guarantee the success of BOJ’s approach. For example, without any instrument to guarantee the exit from deflation, credibility would be lost by announcing inflation targeting. Furthermore, the BoJ’s other concern has been that positive inflation expectations, once generated, might be difficult to contain.
While whether liquidity targeting was effective in boosting the economy remains debatable, the monetary easing measures taken under quantitative easing have undoubtedly helped to block the different channels through which external shocks may induce liquidity concerns, hence securing financial market stability, and preventing the economy from sinking further into a deflationary spiral. For example, external volatilities such as the September 11 attacks and the military action in Iraq did not lead to credit contraction in Japan, which may potentially damage the economy. Hence, the provision of liquidity worked as a safety valve for any sudden liquidity squeeze that might further jeopardise systemic stability in the Japanese economy.
Orthodoxing Monetary Policy
The BoJ’s decision to end quantitative easing on 9 Mar 2006 meant that it switched its policy instrument from the targeting of current account balances with the BoJ to the interest rates. However, zero interest rates had to remain for several months while the BoJ gradually withdrew liquidity from the economy in order to avoid any disruption to the financial system. Finally, in July 2006, the Bank ended the ZIRP in more than six years by raising the OCR to 0.25%. Following its first rate hike, the BoJ implemented another 25 basis point increase in Feb 2007 to bring nominal interest rates to close to 0.5%, which from then on, has been kept on hold until now in the face of subdued inflation.
It is no surprise that the BoJ’s decision to end its policy of liquidity targeting has been met with skepticism and opposition, both from within and outside Japan. The increase in the OCR target was the momentous switch that marked the change in Japan’s monetary policy and was also the most contentious issue being hotly disputed. Some felt that with the lack of hard evidence of inflation being at hand, Japan could sink back into deflation if it raises interest-rates excessively. For example, OECD Chief Economist Jean-Phillippe Cotis expressed his view that the only solution for the Japanese authorities is to have interest rates as low as possible to come out of deflation. To understand the controversy surrounding Japan’s switch in monetary policy, I will approach the issue from different perspectives by considering the players involved in this dispute and the events underlining the controversy.
The Players
The Bank of Japan
With conditions in Japan improving, BoJ Governor Toshihiko Fukui has made no secret of his desire to wean Japan off its addiction to cheap money and to end the anomalous interest rate era. Fukui has repeatedly cited the dangers of prolonging an ultra-loose monetary policy and emphasized the need to carry out small and phased interest rate hikes in order to achieve sustained economic growth in the medium and long term. Fukui is anxious to avoid a repetition of the Bank’s mistake in the 1980s, where an easy monetary policy created an asset bubble, and he has vowed to raise rates “without delay” should investment become rampant. Data leading up to the decision to raise rates in July 2006 pointed to the increasingly robust health of the economy. For example, bank lending in 2006 rose consecutively up to June at a pace unprecedented in the last decade, suggesting that the chronic overcapacity that had haunted the country’s deflationary phase is now ceasing. Furthermore, the Tankan business-sentiment survey also indicated that Japan’s largest companies plan to increase investment at the quickest pace in 16 years. Hence, an interest-rate hike by the BoJ was widely anticipated.
While it is generally agreed that credit tightening is necessary to stem the flow of cheap money which can lead to potentially detrimental runaway investment, contention has arose over whether Japan is truly out of the deflation trap. For example, in September 2006, statisticians in Japan carried out their five-yearly overhaul of the inflation figures (using 2005 instead of 2000 as the base year), and they discovered that Japan had not escaped deflation definitely until July 2006 when the core annual inflation rate reached 0.2% for only the second consecutive month. This reshuffling of inflation figures contrasted sharply with the BoJ’s belief that Japan had already escaped deflation in late 2005, and that consumer prices were already rising at a heady annual rate of 0.6%. Hence, the rate hike in July may seem premature on hindsight. Furthermore, part of the upward price momentum which Japan faced could have been brought about by the sharp upturn in the price of oil in 2004 and 2005. In light of all these inconsistencies, how then, can the BoJ justify its second rate hike early this year? It is important here to note that Fukui and other officials from the BoJ focus on the overall price trend instead of monthly data. This practice partly developed from Fukui’s experience in the banking system collapse after the bursting of the asset bubble. To prevent a reprise of that meltdown, Fukui has insisted that the Bank adopt a more forward-looking approach, instead of having to react hastily to any news emanating from the market. Hence, armed with the belief that Japan’s recovering economy would push against its supply constraints over the next few years, Fukui was adamant in his stance that gradual rate hikes are required to keep upward inflation pressures in check.
Furthermore, Fukui was also concerned about the unhealthy boom in the yen carry trade, where investors procure the yen at low costs in Japan to invest in higher yielding assets overseas. Japan’s OCR of 0.5% is still immensely low compared to the Federal Reserve’s key rate of 5.25% and the European Central Bank’s main rate of 3.75%. Given the large differentials in Japan’s rates compared to other asset classes, Fukui’s current adoption of ‘gradual’ tightening is unable to impact the profitability of yen-carry traders much. However, Fukui believes that the dangers of keeping such a loose monetary policy for so long outweigh any short-term gains, and the sooner “normalcy” is achieved the better. This also means that the OCR will not remain at 0.5% forever and future rate hikes are to be expected in Japan.
Now that the Rubicon has been crossed, there is no turning back without compromise of the BoJ’s credibility. The BoJ has a delicate job ahead as the Japanese economy is still convalescing and prudent steering of monetary policy is needed to guide the economy onto a stable growth path. Yet, being overly cautious may lead to the risk of an asset bubble forming. By raising the OCR, the BoJ is sending a strong signal to the markets of its confidence in the sustainability of the growth of Japan’s economy. Hence, how the Bank steers monetary policy from now on and whether Japan’s economy can continue its growth path will determine people’s judgment of whether the BoJ has done the right thing in exiting from the ZIRP. It is also possible that Japan’s economic health in the wake of the interest rate hikes may have a bearing on the degree of independence the BoJ enjoys from the government, as we shall examine in our following paragraph.
The Japanese Government
The BoJ first gained its independence from the Ministry of Finance after a major revision to the Bank of Japan Law in April 1998. This revision effectively gave BoJ officials autonomy from the government, but also puts more responsibility and accountability upon central-bank management. Hence, recent mounting political pressure from Prime Minister Shinzo Abe’s ruling LDP to discourage future credit tightening can be seen as a violation of the Bank’s autonomy. However, we need to add an extra qualification. If the BoJ is perceived to be behaving irresponsibly towards the public (i.e. by killing off the nascent recovery in the Japanese economy through raising interest rates), does the government have a legal and moral obligation to step in and interfere? Furthermore, we should recognize the differences in the role of an independent central bank during inflationary and deflationary periods. The virtue of an independent central bank in an inflationary environment lies in its ability to reject government demands to monetize its fiscal debt. However, in the face of protracted deflation, excessive printing of money is unlikely to be the real problem and a more cooperative stance from the central bank may be desired.
Event 1 – Raising of OCR in 2000
Analysis of two events (past and future) underlying the controversy over rate hikes in the Japanese economy may prove illuminating to our examination of the dichotomy of independence and responsibility in the rivalry between the BoJ and the Japanese government. The first event I will be looking at is the fiasco of August 2000, where the BoJ raised the OCR by 25 basis points, only to reinstate the zero interest-rate policy a few months, after discovering the Japanese economy was not robust enough to absorb the rate hike. However, the damage had already been done, as the CPI dropped 0.7% in 2000 and 2001 and deflation reached a nadir in 2003. Before the OCR was raised, the government had attempted to exercise its right to request for the postponement of a board vote on the pending decision to raise interest rates. However, the BoJ rejected the decision (in what was widely perceived as a politically-motivated move to assert central bank independence), citing substantial improvement in Japan’s economic conditions as justifications for a rate hike and went ahead with its decision. Hence, with memories of that severe miscalculation by the BoJ still fresh in their minds, Japanese politicians today are anxious to avoid a repeat of the 2000 blunder by discouraging any increase in interest rates at a period which they deem to be premature.
There are two issues we can consider here. Firstly, would a small interest rate hike, six years on, still put a severe brake on economic growth? It is important to realize that the Japanese economy has moved on since the 1990s. Factors such as a weaker yen compared with six years ago, stronger corporate balance sheets, a buoyant labour market and rising consumer prices are in favour of a rate rise. In the words of Merrill Lynch Chief Economist, Jesper Koll, the rate rise in July 2006 was “absolutely” the right move at the right time. Despite stronger fundamentals, we must realize that the Japanese economy is still very much in a process of rationalization and structural reformation. There is no guarantee that the fragile rebound of the Japanese economy would not be prematurely crushed in the face of interest rate hikes. Furthermore, Japan might not have totally shaken off deflation unlike what some policymakers believe, as domestic consumption may not be as strong as what the figures depict them to be. Besides the issue of the choice of base year as previously discussed, we should also note that the core CPI in Japan excludes prices of fresh food, but not energy prices. Hence, exclusion of energy, another commodity with volatile price movements (which has showed a spectacular increase in the past few years) may reveal a much lower, or even negative inflation rate during the last few months of 2006.
The doubtful judgment over the decision to raise rates leads to the second issue of whether we can consider the blunder of 2000 a mistake ex-ante. No doubt, it was a mistake ex-post, as the economy sank into recession a few months after the decision to terminate ZIRP. However, whether the decision was a mistake ex-ante is not so clear, as the economy did show signs of recovery in early 2000 and a small interest rate hike of 25 basis points was thought to be small enough not to cause major disturbance to consumption and investment. On the other hand, there were forecasts that predicted slower growth in the U.S. and Japan due to the bursting of the ICT bubble. Furthermore, the rate hike was undertaken when the CPI still showed negative inflation, with no clear signs of deflation ending. Hence, it can also be argued that the decision to withdraw from the ZIRP was a mistake ex-ante. In today’s context, although the Japanese economy is definitely much more robust than before, there is still no clear sign that Japan has totally escaped the deflation trap, as discussed in the previous paragraph. Furthermore, the threat of a housing slump in the U.S. may potentially retard global growth and set back Japan’s economic recovery. Hence, it is pertinent that the BoJ’s officials pay heed to such signs in steering its future monetary policy in order to avoid committing another similar error.
Event 2 – Upper-house Elections in July 2007
The second motive underlying the contentious issue of interest rate hikes is the approach of upper-house elections in Japan in July 2007. PM Abe’s government has adopted a focus on policies to spur growth and to curb the expansion of the world’s largest public debt. Hence, fears of a rate hike choking off the current economic expansion and casting a pall over the LDP’s elections prospects provide more than enough justification for the government to oppose further rate hikes from the BoJ. Furthermore, a rate hike would raise the real cost of financing the government’s huge fiscal deficit, which may set back its fiscal rehabilitation plans. Hence, government officials have continuously voiced opposition to rate increases with the most vocal opposition of credit tightening, LDP Secretary General Hidenao Nakagawa, even going as far as to suggest curbing the BoJ’s independence and weakening the Bank’s decision-making power.
Hence, we see that the government also has its own vested interests in the contention over interest rate hikes. However, such overt bullying from the government will undoubtedly compromise the international credibility of the BoJ as an independent custodian of Japanese monetary policy. Furthermore, the government’s strong opposition to monetary tightening may make further decisions by the BoJ to keep rates on hold look like signs of weaknesses (i.e. caving in to political pressures) even if this might be what the Bank regards as the optimal policy for the economy at that point in time. Hence, under the current circumstances, the conflicting issues of independence and responsibility can only be best resolved through greater coordination and cooperation between the BoJ and the government. Reaching a consensual agreement through a negotiation process in this period should not be seen as compromising the independence of the central bank. In the words of Ben Bernanke, ‘greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.’
The Road Ahead – Would the BoJ’s Independence be Curbed?
Despite opposition from the political arena, there is little doubt that the BoJ under Fukui is staying very focused on normalizing interest rates. Strong economic data driven by a robust corporate sector may sway the BoJ to raise rates again before the Upper House elections in July. However, besides hinging on Japan’s economic performance, the ease with which the BoJ may be able to raise rates again depends on whether the degree of independence the Bank currently enjoys may be curbed by the government. Presently, the BoJ is still not regarded as a fully independent bank, as under Article 4 of the Bank of Japan Law, a certain degree of dependence is still enshrined in the revised law itself.
Despite the government’s heavy-handed campaign against a rate hike, I do not believe that the strength of the BoJ’s independence would be weakened in the future. Firstly, the fact that the government had argued for the revision of the law and legalized it in 1998 may make any public retraction of ruling now appear like an embarrassing policy flip-flop. Of course, it would be wrong to equate legal central bank independence with de facto independence. However, it is undeniable that central bank independence instituted through legislation adds robustness to it. As political scientist John Carey once described, “the act of writing rules down can contribute to their binding force.” Furthermore, the incentive and ability of the government to curb the BoJ’s independence can also be called into question. For example, I have identified how steering future monetary policy is a delicate task in Japan. Given the heavy and difficult responsibilities associated with monetary policymaking in Japan, it may not be in the best interests of the government to fight for a place in the monetary policy hot seat. For example, in the August 2000 fiasco, it was easy for the government to criticize the BoJ for its policy blunder. However, things might turn out very different if the government were to assume direct responsibility for Japan’s economic woes arising from monetary policy slip-ups.
Besides the question of motivation, the government may also be limited in its ability to clip the BoJ’s wings. The revision to the law in 1998 allowed the BoJ to retain significant informational advantage over the government and the transparency requirement also meant that the BoJ can justify its policies and share its views directly with the public through policy statements and publications instead of going through the government. Hence, the availability of power resources at the hands of the BoJ will perpetuate its independence and government officials, instead of trying to curb the Bank’s independence, may fare better in advancing their political agendas by trying to forge stronger and more direct relationships with bank officials. Lastly, central bank independence is now globally recognized as a desirable hallmark of quality economic policymaking. Given Japan’s political and economic standing in the international dimension, it has a strong incentive to maintain its international legitimacy as well as to attract financial investors, who have shown a preference to gravitate towards countries with independent central banks.
Would the BoJ Become an Inflation-Targeting Regime?
Krugman was probably the first economist to suggest inflation targeting for Japan when he argued that the way to make monetary policy effective was for the BoJ to ‘credibly promise to be irresponsible’, i.e. to promise a high rate of inflation to influence inflation expectations. Subsequent advocates have argued for inflation targeting in Japan based on the grounds of accountability and transparency, instrumental independence and its effectiveness on inflation expectations. Accountability and transparency of the BoJ does seem to be what Japan needs now, given the conflict between the Bank and Japan’s ruling government. The Bank’s current mandate of price stability is at best, vague, and makes the assessment of whether the Bank has acted appropriately a subjective matter. Having a numerical target (point or range) for inflation would provide more clarification and may lead to greater accountability and greater transparency in the workings of the BoJ. Furthermore, the granting of instrumental independence to the BoJ to pursue its inflation target would mean fewer conflicts between the Bank and the government over specific policy measures.
Hence, I would propose a model for inflation targeting in Japan largely similar to the one defined by Bernanke, which involves instrumental independence (i.e. the BoJ should have the sole responsibility for the setting of interest rates) and goal dependence (the inflation target is jointly set by the central bank and the government). Goal dependence, as practiced in New Zealand and the United Kingdom, should not be seen as violating central bank independence. On the contrary, involvement of the Japanese government in setting the inflation target is a good way of achieving coordination between fiscal and monetary policy. Furthermore, having the government and the BoJ share a common commitment to a policy consistent with the inflation target would lend more credibility to inflation targeting.
Generally, the BoJ has rejected calls for inflation targeting due to a lack of a suitable price index, a lack of instruments under the ZIRP (which would render the mere announcement of an inflation target non-credible) and the fact that no country had adopted inflation targeting to return to inflation from a state of deflation before. However, if the current recovery of the Japanese economy continues, and if the Japanese economy manages to successfully and convincingly overcome deflation, many of these reasons for rejecting inflation-targeting would no longer stand. Hence, given the need to facilitate accountability in the post-ZIRP era and the empirical success of inflation targeting in countries where it has been implemented, the BoJ and the Japanese government should give inflation targeting some serious thought.
Conclusion
In summing up, this paper has delved into a case study of the unique Japanese Great Stagnation, where traditional monetary transmission failed to work and a controversial and unconventional policy of quantitative easing and zero interest rates had to be put in place. After more than a decade of prolonged slump, signs of the economic malaise coming to an end are showing, and in response, the BoJ has eagerly turned off the tap and raised rates to bring monetary policy back on the road to normalcy. However, the political chorus of objections that has erupted in response to the BoJ’s rate hikes has raised questions about the Bank’s de facto independence from the government. But it is unlikely that the thinly-veiled threats to the BoJ’s independence would translate into any actual weakening of the Bank’s independence in time to come. Instead, the need to define a new monetary regime in the wake of the ZIRP era, and the need for a credible replacement framework which is consistent with the government’s fiscal reform plans would necessitate constructive debate between the BoJ and the government to come to an accord on the post-ZIRP monetary regime. Among the options available, an inflation-targeting regime with the target jointly set by the government and the BoJ would be a practical choice.
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