Rules Versus Discretion

Faculty Fellow, RIETI

The issue of rules versus discretion in monetary policy, as a matter of policy management style, is a debate that goes back decades. "Discretion," in this context, refers to a decision-making style in which the monetary authorities decide policies based on their judgment of current situations. In contrast, "rules" refers to a policy management style in which a central bank announces how it will act in the future; also called an advance commitment or promise with the market.

BOJ's shift to a new policy management style with the adoption of the zero interest rate policy

Now, let me look back at the Bank of Japan's past monetary policies. The BOJ adopted an ultra-easy monetary policy (zero interest rate policy) in February 1999, which was followed that April by the release of a very unusual statement by then BOJ Governor Masaru Hayami. The statement called on the market to see the zero interest rate policy not as a temporary, short-lived measure, but as a policy that would be around for a sizable period of time. Against the backdrop of the BOJ's decision to release this extraordinary statement was an unexpected turn of events following the introduction of the ultra-easy monetary policy; subsequent to the February announcement of the policy, overnight call rates fell to a level near zero just as intended by the BOJ, but longer-term interest rates failed to fall sufficiently.

Considering the BOJ's prior monetary policy management, market participants at the time thought that such an unusual policy as keeping interest rates virtually at zero would not last long and could be abandoned at a moment's notice. Because of this expectation, longer-term interest rates resisted a fall. Governor Hayami's statement was meant to urge changes in market expectations by conveying the message that the BOJ was stepping out of its past monetary policymaking pattern and intending to maintain the zero interest rate policy for a period far longer than might be expected by the market.

The issuance of this particular statement was undeniably a desperate attempt by the BOJ to cope with the unexpected market reaction to its zero interest rate policy. Subsequently, however, the BOJ had been signaling its intention - that is, to keep the ultra-easy monetary policy longer than the market expected - in a more skillful and assured way. For instance, the central bank announced in March 2001 that the quantitative easing policy would be maintained until the BOJ is assured that "the year-on-year increase in consumer price index (CPI) rises and remains stable above zero." By sending out a strong message that the easing policy implemented at the time did not fit the pattern of prior easing policies, the BOJ intended to shift the direction of market anticipation of monetary policies toward easing, thereby propping up the economy. These statements are tantamount to the central bank's commitment to its future policy and thus are essentially very close to rules.

But then, why did the BOJ make such promises? These promises are thought to have been nothing but a last-resort measure for the BOJ to ensure the effectiveness of its monetary policy under the zero interest rate regime. When overnight call rates fall to zero, there is no further easing in terms of interest rates. This, however, is not the end of monetary easing. A central bank can create an easing effect by promising a certain level of overnight call rates for next day, the day after, and a year from now. This is because if the market anticipates overnight call rates to remain bound at zero for one year from today, interest rates determined in the market today for instruments with one-year maturity would move closer to zero, which would have a stimulating impact on the economy.

Prior to the adoption of the zero interest rate policy, the BOJ's monetary policy management had been quite discretionary. In light of this, the above-described shift in the policy management style was an extremely bold step for the BOJ. The emergency situation of the zero interest rate regime it probably what made it possible.

However, it is not only under the zero interest rate regime that a central bank's commitment is effective. A series of recent studies on optimal monetary policy rules show that rule-based (promise-based) policy management, as a general trend, can realize higher levels of economic welfare than those achieved by discretionary policy management. Under promise-based policy management, a central bank influences market anticipation by announcing what actions it will take in the near future, which serves as a new channel for influencing the current state of the economy ("anticipation channel" of monetary policy). It is self-evident that an additional transmission channel for monetary policy to affect the real-term economy would lead to greater economic welfare. Inflation targeting, which has been drawing a great deal of attention recently, is one type of rule-based monetary policy.

Returning to the discretionary monetary policy regime means abandoning the anticipation channel

In the run-up to the lifting of the quantitative easing policy in March this year, speculation ran rife in the market as to what would be the BOJ's "next promise." At the time, the BOJ's March 2001 promise concerning the quantitative easing was about to expire and it was only natural for market participants to seek a new promise to replace the outgoing one. Market players were begging for information that would help them anticipate the BOJ's future course of action. The BOJ's response to this, however, was the announcement of its "understanding" of price stability. In doing so, it emphasized that the figures referred to were neither meant to be a target nor provided as a reference. In this regard, what market participants actually got from the BOJ was totally different from what they had expected. It seems that the BOJ is trying to return to its old regime of discretionary monetary policy.

Indeed, deciding future policy at the present time is quite restricting and the central bank would be deprived of freedom of choice in deciding policy in the future. That is, monetary policy effectiveness and promise-based policymaking contradict in certain aspects. This is a classic problem that has been pointed out for many years and exactly what the BOJ is concerned about. Rather surprisingly, a similar concern is held by some market participants and quite a few of them support the BOJ's stance. However, returning to the discretionary monetary policy regime means abandoning the anticipation channel. Given today's market structure in which changes in people's expectations are the dominant factor causing changes in interest rates, the cost of this abandonment would be significant.

June 6, 2006

June 6, 2006