Bank of Japan (BoJ) raised its policy rate by 10 basis points (bps) on March 19. It was the first hike in 17 years that ended its negative interest rate policy (NIRP) that prevailed for the last eight years. While doing so, it communicated that it considers that the large-scale monetary easing measures have fulfilled their roles. This was a reference to its NIRP, quantitative easing (QE) and the yield curve control (YCC).
One can at best take this statement with a pinch of salt. The key lessons from the Japanese experience are: (i) central banks can’t afford to leave asset price booms unchecked; (ii) they must focus on prudent regulation and supervision and ensure financial stability; and (iii) unconventional monetary policy tools (UMPTs) may be used sparingly and not treated as standard monetary policy tools.
The story of Japan’s follies began 38 years ago. During 1986-91, an asset price bubble was allowed to be built unchecked. With deregulation of interest rates in 1985, competitive rise in deposit rates caused net interest margins (NIMs) to be squeezed. They sold corporate stocks on their balance sheets to maintain profits. But with cross-holdings of the large family businesses and connected lending they were compelled to buy them back. After real estate prices soared 50 per cent higher than anywhere else in the world and stock price rose 3.8 times during 1986-91, BoJ raised policy rates five times. By August 1990, the Nikkei stock index plummeted to half its peak. By early 1992, asset prices had completely collapsed. Non-performing loans (NPLs) shot up.
The real economy went into a tailspin. GDP growth dropped from 6.8 per cent in 1988 to a contraction of 0.5 per cent in 1993. After averaging 4.4 per cent in the 1980s, it has averaged just 0.7 per cent since 1993. Japan’s inflation has averaged 0.28 per cent during this period, making a mockery of its 2 per cent inflation target. In the same period, it has run an average fiscal deficit of 5.7 per cent, causing its gross debt to GDP ratio to climb from 66.6 per cent to 260.1 per cent.
In all fairness the BoJ neither had the mandate, nor the independence to ensure a stable financial system. The mandarins in the Ministry of Finance (MoF) kept those powers through various agencies under its arm. It is currently the responsibility of Japanese Financial Services Agency (JFSA), which is designed as a super-regulator. But it is subordinated to the Cabinet Office and headed by three Ministers. Regulation in Japan remains political heavy. On top of it the Banking Act, that provides for JFSA its regulatory authority, is an archaic Act.
Negative interest rates
How did the monetary policy respond to the growth collapse? Though the BoJ, then under the control of MoF, started cutting its interest rates, it was slow. BoJ formally gained independence only in 1997. By 1999, it reduced rates to zero, entering the classic Keynesian Liquidity Trap where conventional monetary policy is ineffective. With continuous deflation during 1999-2005, real interest rates kept rising. So, BoJ unconventionally introducing QE in 2001 buying Japanese Government bonds (JGBs), and later asset-backed securities, equities and tegata (CPs).
It initially announced that it will increase banks’ current account balances with it by ¥1 trillion, to ¥5 trillion, but then raised this target nine more times to ¥35 trillion by 2004. BoJ stopped QE in 2006.
The overwhelming empirical evidence suggests that the policy had weak overall effects. It lowered yield on money substitutes by just about 10 bps and contributed little to the deflation mitigating expectations. One can lead the horse to water but can’t make it drink. Even though the monetary base expanded 70 per cent during 2001-06, broad money (M2) growth languished in 2-3 per cent p.a. range, while bank lending declined by 10 per cent. Excess liquidity infused got re-parked with BoJ as NPLs reached a high of 8.4 per cent in March 2002.
BoJ’s switch
BoJ reluctantly revived QE during 2010-13. At end-2012, Shinzo Abe started his second term promising three arrows — monetary, fiscal and structural policies — to lift Japan out of the quagmire. In January 2013, BoJ set a 2 per cent inflation target hoping to lift inflation expectations. In March, Governor Kuroda set a 2-2-2 target, aimed at doubling the base money and achieving 2 per cent inflation target in 2-years’ time. A month later he introduced Quantitative and Qualitative Easing (QEE) that doubled its QE. A year later it added ETFs to its QE buying making a qualitative shift. In late January 2016, Kuroda started NIRP by pushing the cash rate to below zero.
In September 2016, he launched the strategy of YCC, promising to peg the 10-year JGB yield to around 0 per cent, committing to buy whatever amount is offered at that target yield, hoping it will become the market yield.
BoJ’s experiment with QEE failed the same way as its earlier experiments of QE. Research work does not establish that YCC provided any additional benefits over NIRP. NIRP itself had pushed the 10-year JGB yield into negative terrain that persisted for most of 2016 and 2019. During Covid-19, BoJ further expanded its market operations and re-emphasised the YCC target. YCC has not succeeded in any place. It is best dispensed with as a UMPT even in the times of crisis.
It has for long remained in a state of denial. In its “assessment” of QEE in May 2015 it blamed its failure on decline in oil prices claiming the changes in various macro-financial indicators had been in line with its anticipation. Even in its “Comprehensive Assessment” of QQE in September 2016 was similar. BoJ clearly had no appetite for a serious re-examination of its strategy despite its abject failure.
The Exit
BoJ’s current exit from NIRP and YCC, with commitment to taper its QE has come more as a quirk from a spike in global inflation than genuine improvement in domestic conditions. Japan’s inflation has now stayed above its 2 per cent target for 22 successive months. But one cannot lose sight of the fact that in this period inflation in the US, euro area and the UK had peaked at 9.1 per cent, 10.6 per cent and 11.1 per cent, respectively, against 4 per cent in Japan.
Japan’s GDP growth has slowed in successive quarters of 2023, recording an expansion of just 1.4 per cent y-o-y and 0.1 per cent q-o-q in Q4. Japan’s IIP has contracted in the last three quarters to January 2024.
Only the labour market conditions are improving. The Shunto wage negotiations resulted in a 33-year high 5.3 per cent wage increase.
This resulted in BoJ taking a call that its price stability target of 2 per cent would be achieved in a sustainable and stable manner, despite falling inflation in recent months.
This is nothing but an arrow shot in the dark after 23 years of QE failure. The decision to end NIRP and ETF and REITS purchases was not unanimous, but there is clear indication that BoJ will be scaling down QE across other assets.
Will BoJ be able get rid of all UMPTs? BoJ will look to raise its policy rate by another 15-25 bps later this year and end QE, but a sustained improvement in the Japanese economy is unlikely unless massive structural reforms are carried out.
Fiscal and monetary arrows have been used up by Japan. It is time the Japanese Government gave more regulatory and monetary independence and re-focused itself on structural policies. BoJ’s experiment to get out of UMPTs may be not much loss to Japan as its woes lie elsewhere.
The writer is Professor at IIM Kozhikode and a former member of RBI MPC
