The Bank of Japan (BOJ) launched its unprecedented quantitative and qualitative monetary easing (QQE) in April 2013 under its new governor, Haruhiko Kuroda (Cecchetti and Schoenholtz 2016). Four years later, underlying inflation and inflation expectations have remained below 2%. Achieving 2% inflation stability is likely to take longer than currently claimed by the Bank (around fiscal year 2018). Therefore, the BOJ’s mission is incomplete. In a new book, I describe the detailed frameworks and performance of the BOJ’s unconventional monetary policies from the late 1990s (Shirai 2017). This column briefly reviews the Bank’s recent practices and performance.
Unprecedented unconventional monetary easing under QQE
After the Global Crisis, the BOJ was faced with the virtually-zero lower bound and thus needed to come up with unconventional monetary easing measures. The economy faced a demand shortage, chronic mild deflation, an overvaluation of the yen caused by its safe haven status, and an undervaluation of stock prices. This led to the adoption of Comprehensive Monetary Easing (CME) in October 2010 under then-governor Masaaki Shirakawa. Under CME, the BOJ created an asset purchase programme, with the types of assets purchased including Japanese Government Bonds (JGBs) with remaining maturity up to three years, treasury discount bills, exchange-traded funds (ETFs), Japan real estate investment trusts (J-REITs), and so on. Despite these efforts, the BOJ was unable to overcome the mild deflation, overvaluation of the yen, and undervaluation of stock prices. Growing criticism emerged of the seriousness of the Bank in its efforts to overcome deflation – the Bank’s credibility was increasingly at stake.
These sluggish market trends were quickly reversed beginning in late November 2012 after the Lower House of the Diet was dissolved by the then-ruling Democratic Party of Japan. The yen began to depreciate sharply and stock prices began to rise rapidly, reflecting growing expectations that a new economic stimulus package would be introduced by Mr Shinzo Abe – leader of the then-opposition Liberal Democratic Party – after the general election. Following a landslide election victory, Mr Abe became Prime Minster in December 2012 and launched ‘Abenomics’ – a set of economic policies based on ‘three arrows’ covering unconventional monetary easing to achieve the 2% price stability target, fiscal stimulus, and structural reforms. To achieve the objectives of the first arrow, Mr Haruhiko Kuroda, who had been a long-term critic of the BOJ’s monetary policy and President of the Asian Development Bank, was subsequently appointed as governor of the Bank in March 2013. Mr Kuroda publicly expressed his confidence about achieving the 2% price stability target within two years.
Governor Kuroda introduced QQE without hesitation, aiming to overcome deflation and eliminate credibility issues. QQE represents a drastic leap from previous CME in terms of the boldness and scale of monetary accommodation. QQE targeted the monetary base mainly through massive JGB purchases with all remaining maturities up to a maximum of 40-year bonds. In October 2014, the annual pace of monetary base expansion and JGB purchase were expanded further to around 80 trillion yen ($700 billion) each. Purchases of risk assets such as ETFs and J-REITs were also an essential part of the QQE – currently expanding at an annual pace of around 6 trillion yen and 90 billion yen, respectively. The BOJ’s present total assets are around 90% of GDP and its holding of JGBs account for around 40% of outstanding JGBs issued. A negative interest rate, which is applicable to current accounts held by financial institutions with the BOJ, was added in January 2016 and yield curve control was added in September 2016.
A negative interest rate is experimented with in Japan and Europe
Since the Global Crisis, major central banks have adopted unconventional monetary easing tools – most commonly, large-scale purchases of government bonds as adopted by Federal Reserve, the BOJ, the Bank of England, and the ECB.
Of those four, only the BOJ and the ECB adopted a negative interest rate, to achieve the price stability target of around 2%. A negative interest rate was also adopted by some central banks in small European countries – including Switzerland, Denmark, and Sweden – whose currencies tended to appreciate vis-à-vis the euro due to the Eurozone Crisis and the introduction of a negative interest rate by the ECB. In the case of Denmark, a negative interest rate was necessary to maintain a fixed exchange rate against the euro under Exchange Rate Mechanism II.
On 16 January 2016, the BOJ surprised the public and the markets when it announced its decision to adopt a negative interest rate on part of excess reserves, with effect from 16 February, the possibility of which had been rejected by the Bank for many years. The BOJ’s new view was that a negative interest rate would expand aggregate demand and inflation expectations, thereby accelerating the path toward 2% inflation.
The negative interest rate policy lowered the entire yield curve and resulted in reducing longer-term yields to a significant degree. While the BOJ emphasised this was a result of its successful monetary policy, the negative interest rate policy raised a number of concerns and has potential side effects. These adverse impacts can be classified into four issues:
- a decline in the profitability of the financial sector and potential financial instability risk;
- promotion of cash substitution and a deterioration in households’ sentiments;
- a decline in liquidity and weakened functions of the JGB markets; and
- the BOJ’s operational challenges and balance sheet risk.
Those effects appear to have exceeded the benefits, which were limited largely to a temporary increase in residential investment, an expansion of the J-REIT market, and issuance of long-term corporate bonds by some firms.
Negative interest rate and the financial sector
First, the negative interest rate policy squeezed the spreads between lending and deposit interest rates further, contributing to a further decline in banking sector profitability. Commercial banks found it difficult to charge a negative deposit interest rate to both retail and large depositors for fear of rapid deposit withdrawals in the overcrowded banking sector. This adverse impact is particularly severe in Japan, as the loan-to-deposit ratio has remained below 70% because deposit growth has consistently exceeded credit growth. Figure 1 shows the loan-to-deposit ratio of major banks in five countries that adopted a negative interest rate. Only Japan’s ratio was far below 100%, while the ratios of other countries remained above 100%. This suggests that some commercial banks in Europe may be able to offset a decline in the lending-deposit rate spreads with an increase in credit volume. This is not the case in Japan, however, due to limited demand for credit.
Moreover, commercial banks in Japan suffered from limited profitability from maturity transformation since the yield curve flattened substantially. They also received a smaller amount of interest income from JGB holdings due to lower coupon rates. For the time being, they could continue to enjoy unrealised valuation gains from JGB holdings or capital gains from selling them. Nevertheless, they found it difficult to reinvest JGB redemptions in an extremely low interest rate environment. Commercial banks raised concerns about the risk of undermining financial intermediation in case of current monetary policy continuing for a long time.
Figure 1. Loan-to-deposit ratio of major banks (%)
Source: S&P Capital IQ.
As for institutional investors, an excessive decline in yields on long-term and super-long-term JGBs (with remaining maturity of over ten years) made it difficult for insurance companies and pension funds to maintain sufficient returns from these assets. Lower yields also increased future pension benefit obligations through a lower applied discount rate. Although the negative interest rate policy had not yet had a substantial adverse impact as a whole on these industries, institutional investors had begun to express concerns over the future viability of their business models. In fact, some insurance companies stopped providing savings-type insurance plans due to limited returns, while others raised premiums for new clients.
Negative interest rate and households
Second, household behaviour and sentiment appears to have been adversely affected by the negative interest rate policy. There was a rapid increase in notes in circulation until around September 2016 due to a certain degree of conversion from deposits into cash holdings in home safety boxes (growth on notes in circulation exceeded 5% until September while growth on individual deposits dropped to around 1.2% in 2016 from 2.5% in 2014–2015). The ratio of notes in circulation was about 20% of GDP in 2016, which is quite high compared with other European countries that had adopted a negative interest rate (Figure 2). There is a clear contrast with Sweden, where the ratio continues to drop even after adoption of a negative interest rate. Japan remains a relatively cash-based society compared with Sweden, an economy that is highly digitised and where cash is hardly used, so that a negative interest rate is likely to have a greater impact on the substitution of cash for deposits in Japan than in Sweden.
An increase in cash holdings reflects households’ renewed recognition of a very low retail deposit rate. According to the BOJ’s “Opinion survey on the general public’s views and behaviour”, the diffusion index (DI) for the interest rate level – the difference between the ratio of respondents with ‘too high’ and those with ‘too low’ – dropped significantly from around –40 percentage points in December 2015 to –58 in March 2016, and remained between –53 and –55 in June, September, and December 2016. Given that households’ deposits and cash are about three times as large as their loans, households appear to have experienced an adverse effect in terms of the net impact of the negative interest rate.
Figure 2. Notes in circulation as a percentage of GDP (%)
Negative interest rate, market liquidity, and the Bank of Japan's operational issues
Third, massive purchases of JGBs under QQE have deteriorated the liquidity and functioning of the JGB markets. The negative interest rate policy exacerbated these conditions further as a greater number of traditional market participants refrained from actively transacting in the market to avoid the negative interest rate. The scarcity of JGBs also led to a shrinkage of related monetary market activities.
Fourth, the negative interest rate policy generated a more challenging environment for the BOJ’s asset purchase programme. The banking sector is dominant in the financial system with ample deposits from retail and large customers, so securities markets are small. These banks hold large amounts of JGBs to fill the gap between deposits and loans extended to the private sector. They therefore have to examine whether their holdings of JGBs should be sold to the BOJ and the proceeds placed in their current accounts with the Bank or, alternatively, whether they should be held until maturity to earn the coupon rate. A positive interest rate provided the incentive for these banks to sell their JGBs to the BOJ; a negative interest rate had the opposite effect. Moreover, a decline in yields and resultant higher JGB prices raised the cost of the asset purchase program, thereby amplifying the BOJ’s balance sheet risk.
Yield curve control: Motivation and effectiveness
In September 2016, the BOJ made a major change to its monetary easing framework by adopting yield curve control. The most fundamental change was the official abandonment of the monetary base target. Instead, the BOJ adopted two pinpoint interest rate targets: the ten-year JGB yield peg, and a negative interest rate. Although this was a clear shift from a volume-centred QQE framework, the BOJ appeared to be stressing continuity by indicating its projection that a similar annual pace of JGB purchases (around 80 trillion yen) would continue toward end-2017 – to avoid negative market reactions.
In my view, the purpose of pegging the ten-year yield at around 0% was to prevent longer-term yields from falling excessively low, thus mitigating adverse impacts on financial institutions, especially institutional investors. In other words, yield curve control was the BOJ’s policy response to a sharp fall in the ten-year yield and an acknowledgement that the side effects and adverse impacts were brought about by the negative interest rate.
This framework helped to depreciate the exchange rate of the yen substantially and to raise stock prices after the US presidential election last November. On the other hand, it has generated uncertainty regarding the direction of the BOJ’s monetary easing stance due to ambiguity over its commitment to achieving the ten-year yield peg. If the ten-year yield is pegged as close to 0% as possible, the BOJ may end up purchasing more than 80 trillion yen with the frequent use of fixed-rate JGB purchase operations adopted for this purpose. This would make it difficult for the Bank to shift away from the volume-centred QQE. So far, the BOJ’s purchase operations suggest its unwillingness to increase the total amount of JGB purchases as well as its unwillingness to frequently utilise fixed-rate purchase operations. Bond market participants are thus sceptical of the BOJ’s ability to continue yield curve control for a long time.
How long the current performance in the foreign exchange and stock markets will continue is unknown, and will also depend on the new policies to be implemented by the new Trump-led US government. Since 2013, correction of an overvalued yen (with undervaluation of stock prices) has helped to raise corporate profits in manufacturing, tax revenue, and the value of foreign assets owned by investors. During this period, however, export volume has hardly grown; and export value rose due to a shift toward value-added goods. Intra-industry trade has grown rapidly; the yen’s depreciation has reduced the prices of exports but increased those of imports so that the net positive impact has not been as large as in the more distant past. It is also not clear whether the yen’s depreciation beyond economic fundamentals (reflecting underlying current account surpluses and inflation differentials) will help raise aggregate demand, the output gap, underlying inflation, and inflation expectations in a sustainable manner. Households and non-manufacturing firms may suffer from higher import prices.
So far, credit demand and real consumption have not shown a strong uptick. The rate of change in the consumer price index is turning positive, mainly due to a base effect (phasing out of the downward pressure on prices from a drop in commodity prices). Upward pressure on prices from aggregate demand has been limited.
Factors that hinder the effectiveness of unconventional monetary easing and the next move
Four inter-related structural factors contribute to the limited impact of unconventional monetary easing on aggregate demand and inflation:
- limited demand for credit relative to ample liquidity (as shown by the low loan-deposit ratio);
- low expectation of income growth;
- unfavourable demographics and concerns about the sustainability of the social security system; and
- households’ upward bias in perceived inflation and long-term inflation expectations.
The fourth factor requires explanation. Households tend to form high perceived-inflation and inflation expectations, even when CPI-based inflation indicates deflation. This reflects long-standing stagnant income growth and perceived tighter budgets. In particular, households are very sensitive to an increase in food prices. When food prices rise rapidly, households' present perceived inflation rises and their tolerance for price rises drops. Based on this price perception and limited tolerance of price hikes, firms appear to have found it difficult to continuously raise sale prices.
The BOJ’s experiences suggest that there is asymmetry in the implementation of a flexible inflation-targeting framework between raising inflation and lowering inflation. Raising inflation in an economy with past stable or mild deflation like Japan is a challenging task, since households are accustomed to a situation of no significant overall price changes, yet they feel that prices have increased and will rise further. This suggests that achieving 2% inflation sustainably could only happen in the distant future since it must accompany sustainable income growth and higher expectations of future income growth.
Therefore, it is time for the BOJ to come up with more objective projections on the timing of achieving its 2% price stability target, and to examine its next move accordingly. In my view, the monetary easing framework should be made more sustainable so that adequate monetary accommodation can be maintained for a longer period. The BOJ may find it increasingly difficult to continue the asset purchase programme, because its amount of JGB purchases has been much greater than net issuance of JGBs and the main investors are domestic financial institutions that desparately need JGBs for the reasons mentioned above. Moreover, maintaining long-term interest rates at such low levels for a long time may not make sense in terms of the smooth functioning of financial intermediation, corporate sector restructuring, severe distortion in the JGB market, and the BOJ’s balance sheet risk.
My suggestion is to raise the ten-year yield target level to around 0.5% or introduce a target range of around 0%–0.5% as a first step in 2017. A logically consistent combination would be to gradually reduce the annual pace of JGB purchase from around 80 trillion yen to 60–70 trillion yen. Then the amount could be reduced at a moderate pace to net issuance of JGBs. The ECB’s decision, announced last December, to cut monthly asset purchases from April 2017 would make monetary easing more sustainable. Unconventional monetary policies are approaching a turning point.
Cecchetti, S and K Schoenholtz (2016), “The Bank of Japan at the policy frontier”, VoxEU.org, 7 December.
Shirai, S (2017) Mission incomplete: Reflating Japan’s economy, Asian Development Bank Institute.