Future of Monetary Policy: Fiscal consolidation is essential for exit from unconventional monetary easing

OGURO Kazumasa
Consulting Fellow, RIETI

It is obvious that the unconventional monetary easing of the Bank of Japan (BOJ) has reached its limits. The BOJ already made an adjustment to the unconventional monetary easing in late September 2016. While maintaining the policy of keeping the short-term interest rate below zero, the BOJ decided to introduce a new monetary policy framework under which it controls the long-term interest rate in order to keep it at around zero. The new framework represents a shift in policy emphasis from a quantitative target to interest rate control.

The BOJ is now proceeding with "stealth tapering": rolling back the unconventional monetary easing without announcing it. There is the view that the long-term interest rate remains low at around 0.05% despite the stealth tapering because the market is taking stock of this move.

Although the BOJ is proceeding with stealth tapering, it is doing nothing more than slowing down the pace of the annual net purchase of Japanese government bonds (JGBs) (the amount of JGBs newly purchased by the BOJ minus the amount of redeemed JGBs, which is equivalent to an increase in the amount of JGBs held by the BOJ) from around 80 trillion to around 50 trillion yen. Therefore, the BOJ's balance sheet continues to expand. As a result, the value of assets on the BOJ's balance sheet is approximately 500 trillion yen (as of August 10, 2017), of which JGBs account for around 430 trillion yen. This is spreading a certain degree of cautiousness in the market.

To shrink the balance sheet, the BOJ will need to reduce the annual net purchase amount of long-term JGBs to less than the amount of the government's budget deficit (which equals the amount of newly issued JGBs), or around 30 trillion yen. If the BOJ purchases JGBs in excess of the amount of the budget deficit, it will become impossible in theory to wind down the unconventional monetary easing because its balance sheet will continue to expand as it absorbs JGBs held by the private sector.

Although the BOJ has reduced annual purchases of JGBs to around 50 trillion yen, this figure still exceeds the 30 trillion yen budget deficit amount, and as a result, the amount of long-term JGBs held by the private sector is declining.

Interest rates will rise if the annual purchase amount of JGBs drops below 30 trillion yen

From the above, the fact that the long-term interest rate remains low despite the BOJ's stealth tapering appears to be evidence that the so-called stock view applies in this case.

The stock view argues that the impact of quantitative easing on the long-term interest rate depends on the amount of long-term JGBs held by the central bank (stock). Underlying this view is the idea that if the amount of JGBs held by the private sector excluding the central bank declines, excess demand for JGBs arises, putting downward pressure on the long-term interest rate.

Meanwhile, the flow view argues that the monetary operation amount routinely conducted by the central bank (the amount of sales and purchase of long-term JGBs on a flow basis) affects the long-term interest rate.

If the stock view applies, the stealth tapering will start to put upward pressure on the long-term interest rate when the annual net purchase amount of JGBs by the BOJ falls below the amount of the budget deficit (around 30 trillion yen).

What complicates this matter is that the U.S. Federal Reserve Board (FRB) has decided to shrink the amount of assets that it holds, and European Central Bank (ECB) President Mario Draghi has expressed an intention to start curtailing the ECB's quantitative easing around this autumn.

In the global economy, in which money flows freely across national borders, it is extremely difficult to keep only domestic interest rates low compared with the level of interest rates abroad. As the large-scale monetary easing that has been implemented around the world is at a turning point, the long-term interest rate in Japan will come under upward pressure if the rates in the United States and other countries rise.

An attempt to keep the long-term rate in Japan low at any cost despite rising rates abroad is likely to lead to the yen's depreciation as it causes the interest rate gap with the United States and other countries to widen, thereby prompting investors to take money out of Japan in pursuit of higher returns. The yen's depreciation will eventually put upward pressure on the nominal long-term interest rate by pushing up the inflation rate through a rise in import prices. In short, in any case, the long-term interest rate will gradually rise.

When the long-term interest rate rises, Japan, which is stuck with a huge debt load, will face an increase in interest payments. Currently, the outstanding balance of JGBs as a proportion of the gross domestic product (GDP) is approximately 200%. Although the amount of debt is as high as around 1,000 trillion yen, the annual amount of interest rate payments remains relatively low at around 10 trillion yen because the weighted average of government bond yields is only around 1%. However, an interest rate rise of 3%-4% will boost the interest payment amount by a factor of three to four to 30-40 trillion yen.

To cope with this risk, it is essential to shrink the budget deficit by implementing fiscal consolidation as quickly as possible. That will increase the chance for the BOJ to achieve a successful exit from the unconventional monetary easing following the stealth tapering.

In this respect, the latest version of the Economic and Fiscal Projections for Medium to Long Term Analysis, which was announced by the Cabinet Office at a meeting of the Council on Economic and Fiscal Policy in late July, provides useful information. According to the analysis, even if the consumption tax rate is raised to 10% in October 2019 and unrealistically high growth is achieved as assumed in the Economic Revitalization Case, the primary budget balance (tax revenues minus policy expenditures excluding the government bond-servicing cost) of the national and local governments as a whole will show a deficit of 8.2 trillion yen. In the Baseline Case, the primary budget deficit of the national and local governments in fiscal 2020 is assumed to be 10.7 trillion yen, which is equivalent to the amount of revenues earned from the 4% portion of the consumption tax.

In light of the severe fiscal situation, it is desirable to make sure the consumption tax rate is raised in October 2019 as scheduled while carrying out fundamental social security reforms. Prime Minister Shinzo Abe announced a plan to allocate the revenues from the increased portion of the consumption tax to expenditure on education and child care support, but given the election to the House of Councillors scheduled for the summer of 2019, this does not necessarily mean that the government will actually go ahead with the consumption tax rate hike as scheduled. If it is difficult to raise the consumption tax rate by two percentage points at a time, I would suggest an alternative option of raising it by one point in each of the four consecutive years from fiscal 2018.

Inflation will depress tax revenue and boost expenditure

Some people argue that causing high inflation will help to achieve fiscal consolidation without taking the standard approach to fiscal consolidation. However, this argument is wrong.

One example of the fiscal impact of high inflation is the situation that was witnessed at the time of the runaway inflation in 1974. To bring it under control, the government and the BOJ implemented a package of measures to restrain total demand, including curbing public works and raising the official discount rate. Although the inflation subsided as a result, the Japanese economy recorded negative growth in 1974 for the first time in the postwar era.

How was the fiscal situation affected by the runaway inflation? The impact can be grasped through comparison between the budgets (the general accounting budgets of the national government) for fiscal 1973 and fiscal 1975 (see Table). First, although the consumer price index (CPI) rose by as much as 38% between 1972 and 1974, tax revenues grew only by around 3% between fiscal 1973 and 1975. On the other hand, while expenditure on public works was kept at the same level as in the previous year in nominal terms, expenditure related to social security increased by as much as around 86%, resulting in a rise of about 49% in overall expenditure (the initial general account budget of the national government), higher than the inflation rate.

Table: Outline of the National Budgets at the Time of the Runaway Inflation in the 1970s
FY1973 FY1975 Growth rate (%)
Total expenditures (initial budget, billion yen) 14,284.0 21,288.8 49
Social security-related expenditures (billion yen) 2,114.5 3,926.9 86
Tax revenues (settled account, billion yen) 13,365.6 13,752.7 3
Primary budget balance (billion yen) −1,081.3 −4,178.1 286
Primary budget balance (as a proportion of GDP, %) −0.9 −2.7
JGB interest payments (billion yen) 442.2 780.0 76
Outstanding balance of JGBs (as a proportion of GDP; %) 6.5 9.8
CPI (consumer price index) growth rate (1974/1972) 38
Source: Ministry of Finance, Cabinet Office

Consequently, the primary budget deficit in the general account budget of the national government as a proportion of GDP rose from 0.9% to 2.7%, while the outstanding balance of JGBs as a proportion of GDP increased from 6.5% to 9.8%. In the meantime, the government bond-servicing cost grew by 76%. A steeper rise could be avoided only because the outstanding balance of JGBs as a proportion of GDP was low at 6.5%. In other words, there is no silver bullet theory that justifies the argument that fiscal consolidation can be implemented without causing pains.

In order to shrink the BOJ's balance sheet by increasing the chance for a successful exit from the unconventional monetary easing following the stealth tapering while avoiding the risk of an increase in the debt-servicing cost due to inflation, it is important to proceed with fiscal consolidation and reduce the new issue amount of JGBs. If progress is made in implementation of these measures, it will be possible to curb upward pressure on the long-term interest rate despite a decrease in the amount of long-term JGBs purchased by the BOJ.

At a time when it is becoming clear that the unconventional monetary easing policy has reached its limits, it is desirable to carry out fiscal consolidation in preparation for winding down the monetary easing while bearing in mind various risks and developments in the United States and Europe.

>> Original text in Japanese

* Translated by RIETI.

October 17, 2017 Weekly Economist (Mainichi Shimbun Publishing Inc.)

December 4, 2017