On the Bank of Japan's Interest Rate Policy
Online Full Debate
- Atsushi MIZUNO (Chief Fixed Income Strategist/Chief Economist, Japan Deutsche Securities Ltd., Tokyo Branch)
- Richard WERNER (Managing Director, Profit Research Center Ltd., Japan; Assistant Professor, Sophia University, Japan)
Moderator: Takahiro MIYAO (Professor, GLOCOM, Int'l University of Japan)
Also comments by Prof. Mitsuhiro Fukao at Keio University, and others
MIYAO (GLOCOM): Before our formal debate, I would like to take up a response from
Professor Mera, since it gives a very good reference point for our discussion.
MERA (Prof. Koichi Mera at USC in Los Angeles): Regarding BOJ's interest rate policy, let me make the following points:
1. There was a significant disagreement on this issue between the Administration and BOJ.
2. BOJ acted to raise the rate in spite of fierce objections from the Administration. It demonstrated its independence.
3. The stock index is not doing well since then, but we do not know what caused the decline.
4. What bothers me most is the fact that there is no dominant view on this issue. If the Chairman of BoJ believes that this is the time to raise the rate, he should be able to convince most economists and policy-makers. If the Minister of Finance or the Minister of Economic Planning Agency believes that the rate should not be raised, then he should be able to convince most other experts. To me, neither was able to convince the other camp. This is a sad situation. As a result, the decision had to be made by the organization that has the power. This kind of power game may lead to another catastrophe.
In this sense, this debate performs a very useful function. Through this kind of discussion, all assumptions, reasoning, expected consequences, and the degree of the lack of knowledge needs to be clarified.
FULL DEBATE WITH OUR PANELISTS
INTEREST RATES VS. THE QUANTITY OF CREDIT
MIYAO: Having Prof. Mera's points in mind, let us start our debate. Mr. Mizuno, you may now respond to Prof. Werner's comment on your statement in our preliminary discussion.
MIZUNO (Japan Deutsche Securities Ltd.): First of all, the purpose of my article "Implication of Termination of Zero Interest Rates Policy" is written to explain 1) the logic of the BOJ why they decided the first rate hike in 10 years; 2) how the financial markets should prepare future course of its monetary policy. In other words, the purpose of my draft does explain the impact on real economy or transmission mechanism of monetary policy.
Prof. Werner argues "monetary policy tool employed by the Bank of Japan is the quantity of total creation". I think he means this is true under zero interest rates policy. As the BOJ argues, however, BOJ was ready to provide enough liquidity in the market to maintain call O/N rates around zero percent. In other words, under the zero interest rates policy, BOJ cannot and will not control the quantity of liquidity or money supply at all. For example, governor Masaru Hayami has kept saying that liquidity and interest rates are two size of the same coin.
MIYAO: Prof. Werner, you must have something to say to Mr. Mizuno.
WERNER (Profit Research Center Ltd.): To me, the transmission of monetary policy refers to the question of just how monetary policy affects the real economy. Mr. Mizuno assumes a certain effect from interest rate policies, or call-rate targeting policies. However, I would take issue with this causation. It is the discussion of this issue that is at the heart of the debate about the Bank of Japan's policy and it would be productive for us to also engage in this debate.
With my statement that the "monetary policy tool employed by the Bank of Japan is the quantity of total credit creation" I in fact do not refer to the Bank of Japan's interest rate policy. I realize that the Bank of Japan asserts that it is ready to provide enough liquidity in the call market to maintain call O/N rates around zero. However, I am not referring to this small sub-set of total credit creation, namely the call market operations. Instead, I am referring to total net credit creation by the central bank. There are many ways in which the central bank can create credit, and indeed it is a fact that the BoJ creates the majority of money outside the call market. This means that the call market is not the most important market concerning the central bank's quantitative credit policy. From this we know that the Bank of Japan's assertion that "under the zero interest rates policy, BOJ cannot and will not control the quantity of liquidity or money supply at all" is unsubstantiated and, indeed, plain wrong. Also governor Masaru Hayami's claim that liquidity and interest rates are two size of the same coin cannot be proven. Indeed, it can be refuted easily, using data on the price of money (interest rates) and its quantity (the quantity of credit creation). It can be shown that both are not in any unique relationship. An increase in total credit does not necessarily change the interest rate, and a change in interest rates does not change the quantity of credit. Both are independently determined.
MIYAO: There is clearly a difference in opinions on this issue. Mr. Mizuno, would you like to add anything to this issue or to make any other point?
|MIZUNO: In the preliminary discussion, Prof. Werner also mentions " the very recovery of 1999 and 2000 can be shown to come as no surprise to Bank of Japan. For the recovery was stimulated by the BOJ's very own quantitative stimulation policies, implemented in March 1998". However, the BOJ does not believe that zero interest policy was a main driving force of current recovery, even though its policy made capital market stabilized and reduce the risk of financial system instability. I hear that the BOJ was surprised that economic recovery is much faster than they believes in February 1999 when they decide zero interest rate policy. The BOJ believes that the reason behind current recovery is due to much faster recovery in Asian region and safety net for financial system stability including tax-payers money creation scheme. It seems to me that Prof. Werner overestimated the impact of monetary policy. I do not think two interest rate cuts (September 1998 and February 1999) have made a significant positive impact of economy since monetary policy has been extremely accommodative since the BOJ cut both Official discount rates and call O/N rates to 0.5% in September 1995. At the same time, I think the BOJ did not have an intention to expand monetary base to stimulate the economy. Expansion of monetary base or liquidity was just the result of zero interest rate policy.
MIYAO: Your turn again, Prof. Werner.
WERNER: Mr. Mizuno says that I overestimated the impact of monetary policy and he does not think two interest rate cuts have made a significant positive impact of economy. In fact, I also do not think two interest rate cuts have made any impact on the economy. As I have argued in many publications since 1994, interest rates cuts could not be expected to stimulate Japan's economy. As is quoted above, instead I have argued that " the very recovery of 1999 and 2000 can be shown to come as no surprise to Bank of Japan. For the recovery was stimulated by the BOJ's very own quantitative stimulation policies, implemented in March 1998" (italics added). In other words, the recovery was not due to interest rate policies, but to the BoJ's quantitative policies. As explained above, these are quite different matters.
Secondly, it is heart-warming to see how faithfully Mr. Mizuno seems to believe the public statements made by public-relations officers of the Bank of Japan. I, for my part, have been forced to become a little less quick to believe every word of the BoJ. Of course, the Bank of Japan claims to have been surprised by the strength of the recovery. This claim, however, does not constitute proof that the Bank of Japan was actually surprised. Similarly, the Bank of Japan expressed surprise at the prolonged recession of the 1990s, despite the fact that its very policies created and prolonged the recession. Finally, the creation of the bubble in the 1980s also allegedly took the Bank of Japan by surprise, despite the fact that its excessively large window guidance quantitative policies clearly created the bubble. We are faced with the option of (a) believing in the public statements of the Bank of Japan, which means that we must also believe that the Bank of Japan is incompetent to the extreme, or (b) not believing in its publicity statements.
ZERO INTEREST RATE AND DEFLATIONARY PRESSURE
I am afraid that the debate has gone to the extreme. Let me change our pace by asking Mr. Mizuno a couple of questions myself on behalf of Prof. Fukao, who has contributed an excellent essay to our Platform, and see if we can involve Prof. Fukao in our debate.
Mr. Mizuno, how would you respond to the following statement?
The Japanese economy is yet to recover. In fact it is still suffering from asset deflation and the wholesale price level is likely to fall further in the future. In this kind of situation, even the zero interest rate policy is not good enough, since the real interest rate is too high, due to the deflationary pressure.
|MIZUNO: My response would be as follows. In any country, price indices such as GDP deflator are not reliable indicator due to structural changes. Normally, consumer price index (CPI) overestimates actual inflationary pressure. BOJ's Shigenori Shiratsuka publishes a series of working papers. He estimates measurement error of CPI and he say that Y-o-Y CPI growth rate overestimates around 0.9% to actual inflation rates. Many economists calculate real interest rates using some inflation index and argue that BOJ's monetary policy is too tight. I think this kind of approach is too simple to argue whether BOJ's monetary policy is appropriate or not. BOJ recently argue there are two type of deflationary pressure. One is linked to what is called "deflationary pressure" and the other is due to IT revolution and more efficient distribution system. Then, BOJ said that the first type of deflationary pressure has passed away.
MIYAO: I would disagree with your very last statement, but I rather have Prof. Fukao himself talk to you directly. Here is Prof. Fukao.
FUKAO (Prof. Mitsuhiro Fukao at Keio University): As Mr. Mizuno points out, since there is an upward bias in CPI, current slightly negative CPI inflation rate actually means a deflation of more than 1 percent per year. Moreover, GDP deflator is falling almost 2 percent per year and deflation is accelerating. Therefore, I cannot understand why one can say that deflationary pressure has disappeared.
MIYAO: In addition to CPI, we need take asset prices into consideration. Focusing on asset deflation, one might make the following statement:
Due to declining land prices and stagnant stock prices, there are so many firms with near-insolvent balance sheet positions in the Japanese economy. In this sense, we are yet to come out of economic emergency. The termination of the zero interest rate policy was a mistake, since rising long-term rates will hurt those near-insolvent firms and the whole economy by making asset deflation even worse in the future. So, what is needed is even a more aggressive money supply policy, while keeping zero interest rate, in order to reflate the economy, which will lead to a more normal situation where interest rate policy will regain its effectiveness.
Mr. Mizuno, what do you think of this kind of statement?
MIZUNO: I do not have any strong view that BOJ's decision to end zero interest rates on August 11 is too hasty or not from pure fundamental's point of views. From financial market point of view, however, it is not appropriate to postpone rate hike after BOJ senior officials made a lot of speech and comment to make the market discount the end of zero interest rate policy would come soon, In terms of economic impact of termination of zero interest rates policy, I do not think there are any significant direct impact. Ten-year JGB yields still have stayed below 2.0%. I do not think termination of zero interest rates and correction of Japanese bond markets (JGB) will overkill the economy. It is especially so in this economic recovery which is driven by IT-related capital expenditure. This type of private capital expenditure is less sensitive to interest rates.
Regarding reflation policy, I do not think it would stimulate the economy even BOJ moves to what is called "reflation policy" by expanding monetary base. Some people argue that BOJ should monetize public debt (direct purchase of JGBs). I think, however, those aggressive monetary policy will not work since demand for capital is not strong since clean-up process of balance sheet by both banks and non-financial corporate have been continued. I also think BOJ provides enough liquidity in money markets through its daily operation. M1, narrow based money supply, grew 6.5% Y-o-Y in August 2000, which means that BOJ's monetary policy is still accommodative even after the end of zero interest rate policy.
MIYAO: I will have Prof. Fukao say a final word.
FUKAO: What is necessary, I believe, is to generate mild inflation expectations in the
mind of household and business sectors. Without this, it is not possible to expect a broad based recovery of the economy. The so-called IT-sector is not big enough to pull the stagnant Japanese economy.
I am against the direct purchase of JGBs by the BOJ. However, BOJ can increase open market purchase of JGBs so as to boost the economy.
MIYAO: I think in this debate we have made it clear where we stand and how our opinions differ. The debate on this issue has just begun in public, so let's continue this discussion even if we must end our formal debate on the web now. In closing, I would like to thank you, Mr. Mizuno, Prof. Werner, Prof. Fukao and Prof. Mera, for your invaluable contributions to this debate.
COMMENTS FROM OUR AUDIENCE
SCHULZ (Martin Schulz, Senior Economist at the Fujitsu Research Institute in Tokyo): Thank you very much for the interesting debate.
It is somewhat unfortunate that the debate started out with the difficult art of fixing numbers for appropriate interest rate levels. This is because the absolute level of interest rates is, from a policy perspective, much less important than the policy stance or signaling of the central bank.
However, if we are using the level of interest rates as a starting point for the evaluation of policy stance, as Werner is doing from a monetarist perspective and Mizuno is doing within a more up-to-date inflation targeting context, it should be done right.
If calculating the current price of central bank money, or interest rate, it is mistaken to use the neutral price because this is the price of a neutral situation. As long as the discussants do not suspect the current situation as neutral, they would have to include the gap between a neutral or potential situation into their calculations. Doing so, their results would turn into the opposite, as Professor Fukao stresses (see the proof at the very end of this comment). Especially Werner, with his optimism and a corresponding wide gap between bright potential and miserable present, should have concluded that the current policy is restrictive.
Unfortunately, this mistake of the pre-debate spread into the full debate. While Werner went off the mark by trying to separate volumes and prices somehow, Mizuno undermined his position by stating that Japan is at the fringes of deflation, as Professor Fukao pointed out.
Separating prices and volumes on markets, as Werner tries, is impossible, of course. Only the traded quantities as expressions of supply and demand can define the price. What Werner probably meant, was that the supplied central bank money became ineffective by not multiplying during its way through the transmission mechanism into real demand. That means that money went into lockers and under the mattress instead of circulation. This is the classic description of a Keynesian liquidity trap where monetary policy becomes inefficient because people do not use the supplied money. The cure in such a situation is the monetarist medicine of Professor Fukao. As long as the public trusts the central bank, the announcement of a mild inflationary goal would induce them to spend their money for something "real," like real estate.
ANSWER BY R. WERNER TO COMMENT BY M. SCHULZ:
Schulz argues that I should have concluded that current policy is restrictive, because there is a gap between Japan's bright potential and the 'miserable
present'. It is a fact that can be easily demonstrated statistically that
monetary policy leads the real economy by between 3 and 5 quarters. Thus, a
miserable present does not preclude a current policy that is stimulatory, as
indeed presently the case. The proof: presently, the quantity of commercial
bank and central bank credit creation is growing at the highest growth rate
since the peak of the bubble. Moreover, its acceleration (2nd derivative) has
risen to the highest in over 20 years.
Of course, I am measuring the true stance of the BoJ's monetary policy by the
quantity of credit creation, not some interest rate, such as the call rate.
is easy to prove that the call rate (or the long bond yield or other rates
that matter) are neither leading indicators of economic activity, nor are
correlated in the fashion predicted by the simplistic model that seems to be
employed in the argument above.
Schulz argues that "Werner went off the mark by trying to separate volumes
prices somehow", and "Separating prices and volumes on markets, as Werner
tries, is impossible,of course. Only the traded quantities as expressions of
supply and demand can define the price. What Werner probably meant, was that
the supplied central bank money became ineffective by not multiplying during
its way through the transmission mechanism into real demand. That means that
money went into lockers and under the mattress instead of circulation."
interpretation of my statement is erroneous. I did not mean to say that the
injection of central bank money into the economy has become ineffective. It
never been more effective. Thanks to the BoJ's massive injection of money in
early 1998 (the biggest injections in over 25 years), not only was the yen
weakened to Y147/$, but also the economy was kickstarted and the recovery of
1999 created, which took most economists by surprise (I was forecasting it,
because I had monitored the quantity of credit creation closely, not the
Schulz also errs in his unproven assertion that "Separating prices and
on markets, as Werner tries, is impossible,of course". He appears to be
thinking of a simplistic model of money/credit supply and demand, where
adjust to equilibriate demand. The assumptions on which such theoretical
outcome is based crucially includes the assumption of perfect information.
very debate illustrates the extraordinary lack of perfect information
concerning financial matters. Schulz does not seem aware of the large body of
imperfect information literature, which has proven that with imperfect
information markets do not clear. This means that they are rationed, and
rationed markets are determined by the quantity, while prices become
circumstantial and are not directly correlated to any particular quantity. To
put it simply and apply to this case: The BoJ could choose to keep the call
rate at zero, and at the same time inject very little money into the overall
economy (notice that I refer to total liquidity injections, which are to a
large extent outside the call market anyway). Alternatively, the BoJ could
the call rate at zero, and inject a lot of money. In both cases it is the
quantity that determines economic activity. High and rising interest rates in
the US since 1993 have not slowed the economy, because the quantity of credit
creation increased. And likewise, through much of the 1990s falling rates did
not help Japan, because the Bank of Japan did not inject enough money.
Schulz is encouraged to plot the quantity of credit against interest rates
(whether nominal or real). He will note no stable correlation.
Expectations have nothing to do with this, since new credit creation will
stimulate the economy, even if all agents remain pessimistic. They will be
surprised, as happens all the time, by the recovery.
We must now be more optistic, because the Bank of Japan's monetary policy
stance is very stimulatory, as we notice immediately, if we measure the total
quantity of credit creation that is circulating in the economy. There is
any time period when interest rates have been a good indicator of where the
economy is going. Many economists did indeed forecast in 1991, when the BoJ
lowered rates, that the Japanese economy would pick up, and bank and real
estate stocks would rise. At that time, I measured the quantity of credit
creation, noticed its collapse, and thus forecast that Japan's economy would
move into the biggest recession since the Great Depression and banks would go
bankrupt. Many 'Japan experts' refused to publish this paper, arguing that no
such thing was going to happen. It was published in October 1991 at the
Institute of Economics and Statistics, Oxford University.
I agree, however, with Mr. Mizuno that this is not too important as long as BOJ's policy remains at around 0% and the economy is picking up. It is much more important how the central bank communicates its stance and analysis to the markets, and this is where Professor Mera has a strong point. Although I do not think, that monetary and fiscal authorities should agree all the time (this is why they are setup as two separate institutions, one controlled by public vote, the other independent), a continued struggle can lead to a deadlock and downward spiral, as the history of European (or Dollarized developing countries) restrictive monetary and expansive fiscal policies will easily teach anybody.
Clearly, the argument of BOJ, that below 0% no policy option is left, is not convincing, as Professor Fukao pointed out. After carefully listening to statements and speeches of BOJ officials, the real idea behind the policy becomes clear, however, as Professor Mera suspects. The BOJ thinks that the economy is in a structural crisis which has to be cured by market forces, and not by central bank money. It therefore remains restrictive. The MOF, on the other hand, thinks that the economy is in a structural crisis and has therefore to be helped to revive. Both might be right, the problem with their positions is, unfortunately, that their macro-tools won't work if they are right.
For fiscal policies most people would agree in the meantime: if there is a structural crisis, the fiscal authorities might not be the best ones to pick the winners and help the economy to turn around. During the structural crises of the 70s, at least the central banks have learned this lesson well, and they were allowed to become independent on the insight and the claim that expansionary monetary policy was the wrong tool all over the world to solve a structural crises and that it wont be used anymore.
However, the same is true for restrictive monetary policy, as monetarists have taught us, and as the BOJ is currently demonstrating again. With restrictive monetary policy and uncoordinated expansionary fiscal policy, only future perspectives and startups will be punished, while the already state-dependent, declining sectors will receive their money from their governmental sources. To break this, the BOJ would have to break the MOF, and with it public finances, which would induce heavy inflation, or, paradoxically, the opposite of what was intended.
It is therefore most important, as the participants point out, that policy becomes transparent and that the communication with the markets works well. (In the end, institutions cannot control modern economies anymore, they can only provide to careful steering of expectations). But I am not so convinced, as Mr. Mizuno is, that the BOJ has succeeded in this respect. If it would have addressed the structural problems earlier, and not only in words, as during the clean-up and refinancing of poor banking, it could also have steered a more neutral course with its general instrument (the call rate or money supply).
Here is the proof for calculating policy rates:
Mizuno and Werner are correctly using their guesses of potential GDP as a basis to calculate an appropriate, neutral call rate. Mizuno states that with potential GDP at 1-2%, and inflation at zero, a neutral call rate would be about 1%. The problem with this calculation is, that the central bank, being only one market participant, is not in the position of setting the "neutral" rate. It has to set its rate depending on demand conditions, or the differential between a "neutral" inflation rate and the expected inflation rate, and the differential between potential GDP and current or expected GDP.
If the central bank sets its policy instrument or supply price (in our case the call rate) at the potential level, as both recommend, while demand is still much below, it would depress the economy by failing to meet the demand-side abilities. Money would not be demanded at that price.
So, if the optimistic scenarios of Mizuno or Werner, 2-4% real potential growth are true (or should have a chance to become true), and current (forecasted) real growth is about 1%, the BOJ would have to reduce the call rate, and not increase it.
The same is true for the evaluation of policy stance. The better the potentials of the economy, and worse its current and expected situation, the more becomes the monetary policy supply side involved into the solution of the problem. Arguing from his position, the optimistic Werner with his 4% to 4.5% estimates of potential growth should therefore have concluded that the BOJ is currently extremely restrictive (and not expansionary) because it is not trying to close the gap.
This argument becomes worse, if inflation is estimated properly as well. "Neutral" inflation, allowing for miscalculations of productivity growth is usually estimated at about 2%. The calculated rate of 0% of Mizuno is therefore not a neutral rate, but a signal for deflation and demand-side problems. Reacting on the gap of neutral (2%) and expected, or, reacting on demand side troubles, would therefore require to lower, and not to increase the supply-side price, otherwise the good, in our case central bank money,
will not be sold, as can be seen in the current situation.
NAMBARA (Mr. Akira Nambara at Dentsu): I strongly support Mr. Fukao's views about the current Japanese economy. Fear of deflation will not certainly be wiped out until our balance sheet problems are solved. But "zero interest rate policy" should have been abolished in April last year when Nikkei average recovered the level of 15,500. I did appreciate BOJ's courage to adopt zero interest rate policy as an emergency measure. Although zero interest of deposit is not abnormal at all (no risk no return), zero interest rate for borrowing such as call rate is definitely abnormal. BOJ took such abnormal policy to persuade the market that BOJ was not tightening.
Even if BOJ buys the long-term government bonds from the banks, it will end up that BOJ will enjoy the interest revenue and banks will get zero interest of deposit with BOJ unless business or consumers borrow money from banks.
What BOJ should learn from Greenspan is that he kept minus real interest rate between 1991 and 1994 until the HEADWINDS of B/C PROBLEM was solved.