Monetary Policy Transmission through the Interest Rate and Exchange Rate Channel
Not Making an Impact Big Enough to Raise the Inflation Rate to 2%

Faculty Fellow, RIETI

Three years have passed since the Bank of Japan (BOJ) introduced its quantitative and qualitative monetary easing (QQE) policy. Its spillover effects on the real economy—prices, consumption, production, capital investment, and so forth—have not been satisfactory.

In announcing the launch of QQE in April 2013, the BOJ said that the new monetary policy is expected "not only to work through such transmission channels as longer-term interest rates and asset prices (e.g., stocks, housing, and other real estate) but also to drastically change the expectations of markets and economic entities."

However, its impact in terms of improving the real economy has been limited, even after taking into account the effects of falls in crude oil prices. Which of the assumed QQE transmission channels were clogged and where?

Generally, there are three channels for monetary easing to transmit its effects. One channel transmits the effect of monetary easing by way of lower real interest rates and a depreciation of the real exchange rates of the home currency (a weaker yen in the case of Japan) to boost capital and housing investment and increase net exports. The other two channels, collectively called the "credit channel," induce banks and other lenders to provide more credit by way of higher asset prices.

One conduit of the credit channel works through borrowers, with a rise in asset prices raising the borrowing capacity of companies and households by increasing the value of their land and other assets as collateral.

The other conduit works through lenders, with a rise in asset prices making lenders more willing to lend by increasing the value of financial assets, equity capital, and liquidity holdings held by banks as lenders.

Low sensitivity to interest rate changes

In the case of the BOJ's QQE, which of the above three transmission channels worked properly and which did not?

As to the first, traditional textbook channel, simply increasing the monetary base (cash in circulation and commercial banks' deposits with the central bank) is hardly effective under the current situation where short-term interest rates have been zero-bound, leaving little room to further reduce them (liquidity trap). Thus, the BOJ has been trying to utilize this channel by giving some twists.

First, the BOJ reinforced its commitment to future policy, declaring its intention to "continue with QQE, aiming to achieve the price stability target of 2%, as long as it is necessary for maintaining that target in a stable manner." This is an attempt to drive down nominal long-term interest rates by raising market expectations for the continuation of the zero-interest rate policy.

Second, the BOJ increased the credibility of the commitment by purchasing a massive amount of Japanese government bonds (JGBs) and other risk assets. This is meant to generate the anticipation that the BOJ will not—at least in the foreseeable future—sell its massive JGB and corporate bond holdings in short succession to tighten the monetary policy.

In parallel with these measures, the BOJ drove down nominal long-term interest rates and the nominal yen exchange rates by boosting demand for long-term JGBs and foreign currencies through a portfolio rebalancing effect, which induces private-sector banks to rebalance their portfolios of investment securities. Furthermore, by generating the anticipation that all of these measures will lift the economy along with low interest rates continuing, the BOJ attempted to raise inflationary expectations and drive down real long-term interest rates. These schemes worked out fairly well with one exception, namely, inflationary expectations.

Declines in real interest rates and the weakening of the yen (depreciation in real exchange rates) failed to stimulate aggregate demand to the extent to drastically raise inflationary expectations. Some temporary factors, such as a consumption tax rate hike to 8% and sharp falls in crude oil prices, were at work, but the failure is also attributable to structural changes in the Japanese economy.

Past episodes of sharp yen appreciation prompted many Japanese companies to boost foreign direct investment and increase the proportion of overseas production, making exports less responsive to the yen's depreciation. Changes in the nature of corporate investment are another big factor. For today's companies, investment in research and development (R&D) and intangible assets such as software and brands (goodwill) is just as important a source of growth as investment in facilities and equipment. Partly because of the need to prepare for such non-capital investment, companies are inclined to accumulate internal reserves, making capital investment less sensitive to changes in interest rates.

Next, what about the two conduits of the credit channel? By lowering long-term interest rates, the QQE reduced the cost of financing for investment in stocks, housing, and other real estate, thereby helping boost stock and land prices.

Thus, we can say that the two conduits of the credit channel have had a positive impact on housing and capital investment in qualitative terms. However, when it comes to quantitative assessment, careful consideration is needed as the magnitude of the impact depends on the characteristics of the financial system and the types of lending.

Significant presence of the bank lending channel in Japan

For instance, in a joint research with Hitotsubashi University Associate Professor Daisuke Miyakawa, which was published in 2014, we analyzed the credit channel of monetary policy transmission with a particular focus on its working through banks' balance sheets, and found that the bank lending channel, or the second conduit of the credit channel, is economically significant in size in Japan. A comparison with the United States shows that the presence of the banking sector in the financial system is relatively large in Japan. Due partly to differences in the financing mechanism for housing, Japan is characteristic in that the credit channel via banks' balance sheets is relatively large in quantitative terms, while that via borrowers' balance sheets is presumably limited to small and medium-sized enterprises (SMEs).

Meanwhile, when we look at the movement of Japanese stock prices over the seven business days following the announcement of the introduction of the QQE, an index of Japanese bank stocks outperformed the Nikkei Stock Average index by more than two percentage points in the growth rate, indicating that there was ample room for the bank balance-sheet channel to work properly. However, as demand for funds for capital investment was not so strong, the impact of lending-boosting effects was limited to loans to the real estate, leasing, and healthcare and welfare industries.

In a nutshell, the QQE has been effective to some extent in propping up or increasing investment in such areas as housing and real estate mainly by way of lower interest rates and the yen's depreciation in real terms and through the bank balance-sheet channel, but its impact on aggregate demand and prices was not large enough to "drastically change the expectations of markets and economic entities."

Against this backdrop, the BOJ unveiled at the end of January its plan to push the QQE further by introducing a negative interest rate in order to cope with uncertainty over the future course of the Chinese economy and turbulence in financial markets across the world. Following this announcement and partly because BOJ Governor Haruhiko Kuroda referred to the possibility of pushing the interest rate further into the negative territory, long-term interest rates have moved significantly lower. Thus, it is expected that the real interest rate channel will strengthen and have a positive impact on housing investment.

At the same time, however, lower interest rates will gradually start weighing down on banks' profits in the forms of lower returns on their bond holdings and shrinking lending margins. Indeed, the index of bank stocks underperformed the Nikkei Stock Average index by more than 10 percentage points in the growth rate over the seven days following the announcement of the introduction of the QQE combined with a negative interest rate . Although banks' liquidity is firmly secured by the QQE, the deterioration of their earnings resulting from the BOJ's negative interest rate policy in the long run may have a negative impact on lending through the bank balance-sheet channel. The impact through this particular channel is known to be particularly strong on small and medium-sized banks and their customers, namely, SMEs. Thus, it is necessary to closely monitor banks' lending behavior vis-à-vis SMEs.

>> Original text in Japanese

* Translated by RIETI.

April 19, 2016 Weekly Economist (Mainichi Shimbun Publishing Inc.)

May 12, 2016