The BOJ Should Introduce a Price Stability Target: Avoid Sending a Wrong Message During Gradual Withdrawal of Monetary Easing
Faculty Fellow, RIETI
If the Bank of Japan lowers the target range for the outstanding balance of current accounts held by financial institutions at the BOJ, or if it continues to allow the frequent undersubsriptions in its open market operations, this will send a wrong signal to the markets: namely, that the central bank has begun to tighten monetary policy. To cope with these undersubsriptions in open market operations without abandoning its unwavering commitment to combat deflation, the BOJ needs to shift the focus of monetary policy from the current quantitative measurement, i.e., the outstanding balance of BOJ current accounts, to a specific numerical target for price stability.
Lowering the quantitative target would be taken as a signal of monetary tightening
The BOJ's quantitative easing policy has reached a turning point. In order to maintain its target range of between ¥30 trillion and ¥35 trillion for the outstanding balance of current accounts, the BOJ must continue to provide liquidity by buying short-term government bonds in the bond market. In reality, however, open market operations have frequently resulted in undersubsription, with bids falling short of the BOJ's offers. Against this backdrop, some people are beginning to express concerns that the BOJ, in failing to purchase short-term bonds or provide liquidity as planned, may not be able to maintain the quantitative target range in the current accounts.
BOJ current accounts do not offer interest. Thus, in theory, financial institutions have no incentive to keep their money in their current accounts at the central bank beyond the amount of required reserves - a fraction of each bank's deposits based on the fixed reserve ratio - totaling some ¥5 trillion. The fact that these financial institutions hold current account balances in excess of the required reserve amount indicates they have no better way to invest their money and that inter-bank rates (overnight call rates) are being kept at zero.
Lately we have been hearing a great deal of debate that says, in essence: The frequent occurrence of undersubsription is evidence that Japanese financial institutions have ceased to need ample liquidity, and therefore the BOJ needs to quietly lower the liquidity target. This is tantamount to saying the policy of maintaining excess current account balances was implemented solely for the purpose of restoring the stability of the financial system, and that this policy has fulfilled its role now that the worst of Japan's of nonperforming loan problem is over and the nation's financial system has stabilized.
But this view is mistaken. It must be remembered that the current account target range of between ¥30 trillion and ¥35 trillion was determined as a monetary policy at a meeting of the BOJ Policy Board. Stabilization of the financial system is definitely not the sole purpose of this policy. Therefore, should the BOJ lower the target balance for current accounts, or, should the actual balance continuously fall below the target balance, many people may see it as a first step toward monetary tightening by the BOJ.
Consider the following scenario: First, the BOJ gradually lowers the target from between ¥30 trillion to ¥35 trillion, to ¥20 trillion to ¥10 trillion, and eventually to ¥5 trillion, which is the level of the required reserve balance. Next, the BOJ shifts its focus from the outstanding balance of current accounts to the overnight call rate, thereby returning from quantitative easing to the zero interest rate policy. Finally, the BOJ begins to guide interest rates higher.
Looking at cyclical behaviors, there is a pause in growth of the Japanese economy. There is no prospect for economic growth to exceed the potential growth rate and, albeit slightly, general prices are still falling. The problem is that the BOJ, in anticipation of future rises in interest rates, needs to tighten monetary policy at the time when the actual state of economy does not warrant tightening based on any conventional economic theory.
In the 10 months since BOJ Governor Toshihiko Fukui assumed his post in March 2003, the central bank has raised the target balance of current accounts four times, bringing it to its present range of between ¥30 trillion and ¥35 trillion. We need to remember why this was necessary. In the spring of 2003, the Japanese economy was in critical condition, with the Nikkei stock average below ¥8000. In addition, the yen was coming under substantial upward pressure amid heavy yen buying by foreign investors. Against this backdrop, the Ministry of Finance was frantically intervening in foreign exchange markets to prevent the yen's rise in the midst of the economic slump.
The raising of the target balance for current accounts was a signal that the BOJ would "unsterilize" its foreign exchange interventions. The market welcomed this as an indication of the BOJ's strong commitment to monetary easing. It also served as an important signal that the BOJ would not raise interest rates too quickly even if the economy began to improve.
Furthermore, from the spring through the fall of 2003, Governor Fukui repeatedly said, in speeches and elsewhere, that the BOJ would be patient in putting an end to the quantitative easing policy, signaling to the markets the central bank's strong determination to pull the Japanese economy out of deflation. Though he did not say so explicitly, the governor's remarks were seen as a message showing his determination not to repeat the mistake of August 2000, when the BOJ tightened the monetary policy despite continuing deflation. Undoubtedly, the unwavering stance of the BOJ has provided a sense of assurance to the markets and contributed to the rapid economic recovery from the latter half of the 2003 through the beginning of 2004.
People skeptical of the effect of quantitative easing have given a cold response. Some said that unsterilized interventions - when implemented under the zero interest rate - are just as ineffective as sterilized interventions. Others said that the BOJ, even if it expands the monetary base and has banks maintain excess reserves, would have no channel to create a real impact on economic activity unless the money supply increased. As it turns out, however, the massive liquidity, which far exceeds the required reserve balance, seems to have prompted risk-taking moves both in securities and real investment. Most importantly, it convinced the market that the zero interest rate would continue for a substantial period of time.
Three options in coping with undersubsription
What then can be done to cope with the frequent undersubsriptions in the BOJ's open market operations? If the situation is left unattended, it will wrongly signal the markets that the BOJ has begun to tighten monetary policy. To prevent this, the BOJ has three monetary policy options.
First, the BOJ may try to maintain, at all costs, the target range of between ¥30 trillion and ¥35 trillion in the outstanding balance of current accounts in order to continue signaling its commitment to monetary easing. To do this, the central bank needs to consider increasing its purchases of long-term government bonds and other types of debt securities. Second, the BOJ, while keeping the target range of between ¥30 trillion and ¥35 trillion intact, may decide to offer interest on the reserves kept in current accounts to make the target more easily achievable. Third, the BOJ can introduce an explicit price stability target in place of the current quantitative target as a new signal of monetary easing.
Under the first option, one thing the BOJ can do is to increase purchases of long-term government bonds from the current ¥1.2 trillion per month, a level that has been maintained since October 2001. Also, the BOJ might choose to purchase other types of debt securities with higher risks, such as corporate bonds, real estate investment trusts (REITs), or exchange-traded funds (ETFs). These measures would enable the BOJ to maintain long-term interest rates at a relatively low level and push up the overall prices of risk-bearing debt securities. Thus, in terms of stimulating the economy, this option would have the greatest impact.
However, even in the spring of 2003, when the nation's economy was in the doldrums, the BOJ did not dare to resort to measures such as diversifying the types of securities used in market operations or increasing its purchases of long-term government bonds. Therefore, it is almost unimaginable that the BOJ would opt for these measures now that there is only a pause in the economic recovery and deflation is receding.
The signal will be lost if the BOJ offers interest on reserves in current accounts
The second option of offering interest on current account balances would be unusual, but not totally out of the question. This measure would increase incentives for banks to deposit surplus funds into their current accounts at the BOJ, thereby making it easier for the BOJ to maintain the target balance. This would allow the BOJ to maintain the target range of between ¥30 trillion and ¥35 trillion until deflation clearly ends and the BOJ feels comfortable tightening monetary policy. However, it is uncertain whether maintaining the target range by offering interest would continue to be taken as signaling the continuation of quantitative easing.
Under the third option, the BOJ's commitment of its determination to end deflation could be shifted from the current quantitative target to a "price level target," whereby the central bank would demonstrate a stronger commitment in its fight against deflation. The ongoing quantitative easing signals the BOJ's commitment to delay monetary tightening. But this does not constitute a concrete commitment by the BOJ as to the level of inflation at which the central bank would consider prices to have stabilized.
The strongest commitment the BOJ can make with respect to pulling the Japanese economy out of deflation is to define price stability by presenting specific figures and specifying a deadline for achieving that target. For instance, the BOJ could define the target inflation rate at 1%-3% and state that it will achieve the target by the end of fiscal 2006. Then, even if the outstanding balance of BOJ current accounts falls below the current level, the market would not take it as a signal of monetary tightening.
The BOJ's self-imposed conditions for an "exit" from the current quantitative easing framework are: 1) the inflation rate measured by changes in the core CPI remains zero or above for a few months; and 2) the majority of the BOJ's Policy Board members believes that the Japanese economy will not fall back into deflation. However, the question remains whether the BOJ is really prepared to start tightening simply because the inflation rate is positive for several months, that is, even if the inflation rate is only slightly positive. Or, even if the BOJ's mid-term inflation target is positive, would it be very close to zero? As such, there are a number of questions regarding the BOJ's policy management after exiting the quantitative easing framework.
Unless it provides a clear new framework for monetary policy after exiting the current framework, the BOJ's failure to maintain the target balance of current accounts as a result of undersubsription in market operations will be taken as a signal of tightening. The introduction of a price stability target is the card to play to solve this problem.
* Translated by RIETI.
March 29, 2005 Nihon Keizai Shimbun
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