One Year of Quantitative Monetary Easing: Can Deflation Be Conquered?

Atsushi MIZUNO
(Chief Fixed Income Strategist/Chief Economist, Japan Global Markets Research, Deutsche Securities Limited, Tokyo Branch)

Why the economy will not recover

It has now been over a year since the BoJ adopted its quantitative monetary easing policy at its policy board meeting of March 19, 2001. The move came as the bank could no longer deny the possibility of a deflationary spiral, but the process since has been largely trial-and-error since the potential effects and side effects of the decision were uncertain from the start. The year of the quantitative monetary easing has been difficult for the bank, which has also had to fend with growing political interference in monetary policymaking.

Private banks and securities firms conduct settlements with each other though current accounts at the BoJ. As part of its quantitative monetary easing, the BoJ set its current account balance, a figure indicating the volume of funds in financial markets, as the target of its daily market operations. The target, initially set at ¥5trn, was gradually raised to the present value of between ¥10trn-¥15trn.

Some have argued that the bank should intensify its quantitative monetary easing by shifting the target of its daily operations to a monetary base. In order to prevent market instability at the end of December 2001 and the end of FY2001 (March 2002), the bank maintained a massive supply of liquidity to the markets.

Moreover, individuals and private banks held vast amount of liquidity prior to the April “Payoff”, the termination of government guarantees on time deposits beyond the first ¥10m. For this reason, the volume of BoJ notes outstanding (average) jumped 14.6% YoY in March. Thus, the monetary base that month swelled 32.6% YoY, the sharpest growth since February 1974 during the first oil crisis.

However, it would be nearly impossible to maintain this pace of growth on a YoY basis. The supply of high levels of base money was effective in tempering the adverse effects of September 11 on Japanese financial markets and calming fears over the viability of the financial system in connection with the bad debt problem. However, we should also observe that there was no equivalent rise in M2+CD or broad liquidity and that bank lending continues to decline on a YoY basis. The rise in M2+CD appears gradually to be picking up speed, but this appears largely due to the shift in money away from MMF, mutual funds and the yucho postal savings fund into cash and deposits.

There are several reasons that the speedy rise in base money has not spurred an economic recovery:

(1) The financial intermediary function of the banks has diminished notably due to the burden of their huge bad debt volumes.
(2) With the so-called hollowing out of industry, capex demand at home has been sluggish.
(3) Household consumption demand has failed to revive as salary cuts have reduced expected lifetime earnings and raised concern over the safety of future pensions.
(4) The number of corporate bankruptcies is on the rise in line with bad debt disposal by the banks. This has aggravated asset deflation pressures.
(5) The government has pursued structural reform and deregulation but not sufficiently to inspire greater private-sector activity.

BoJ achieves cheaper yen, stable low JGB yields

The BoJ explains that its quantitative monetary easing has had three distinct effects. First is the reduction in unsecured overnight call rates, which have fallen even lower than under the zero interest rate policy. Second is the portfolio rebalancing effect. As a result of the ultra-low level of interest rates, private financial institutions have moved their money out of the BoJ’s non-interest-bearing current account to loans, bonds and stocks in an attempt to generate profits. Third is the impact on market expectations.

The BoJ does not appear ready to go beyond its present quantitative monetary easing into non-orthodox monetary easing measures. Officially it has established its rinban (outright JGB purchasing) operations as a means of providing liquidity smoothly to the markets.

However, if market expectations of a rinban hike cause a decline not only in unsecured overnight call rates and short-term interest rates but also in long-term bond yields, the result may be a portfolio rebalancing effect. Low stable JGB yields and the weak yen are the clearest signs that the quantitative monetary easing is having an impact. We cannot imagine that the BoJ would want to obstruct any falloff in bond yields.

We believe that the BoJ’s next step will be a hike in its rinban operations. Each time the BoJ raises its rinban volume, there are cries in the bond markets over the negative implications for fiscal discipline. We do not subscribe to this view, since the bank is not directly underwriting JGBs but purchasing them from the markets.

There is also a belief that the accumulated effects of the bank’s monetary easing measures will gradually make themselves felt. While we can safely dismiss claims that the bank’s efforts thus far have had no effect, it is also true that monetary policy is not sufficient on its own to spur an economic recovery as long as the government maintains its contractionary fiscal stance.

Monetarists argue that inflation and deflation are two sides of the same coin. This is true of a time span of decades, but we would not apply this logic to a short period of 2-3 years.

Given the weakened financial intermediary function of private banks as they struggle to clear out their bad debt, a further monetary easing is unlikely to boost bank lending and will have little positive impact on the real economy.

In implementing its quantitative monetary easing in March last year, the BoJ appears to have linked its policy too closely to structural problems in the economy and the bad debt situation. The BoJ is now being looked upon to act as deflation fighter. Unless the government and BoJ engage in constructive dialogue, deflation is not likely to be overcome.

(The original Japanese version of this paper appeared in the April 23, 2002, issue of “Economist,” published by Mainichi Shinbun-sha.)