Against the Bank of Japan: The Right Way to End the Zero Interest Rate Policy

Mitsuhiro FUKAO (Professor, Keio University)

Unwise Policy Decision
The Bank of Japan decided to end its "zero interest rate policy" and to raise the short-term market interest rate by 0.25 percent at the Monetary Policy Meeting on August 11th. While I agree with the Bank of Japan saying that we should end the zero or abnormally low (less than one percent) positive interest rate policy as soon as possible, I disagree with the way the Bank of Japan ended it.

I do not think that the short-term rate hike from zero to 0.25 percent itself will affect the real economy very much, but it does imply that the Bank of Japan will not adopt quantitative easing policy for sometime to come. This is not very wise since we are expecting a number of downside risk factors that will worsen the economic condition. The risk factors include a sudden slowdown of the U.S. economy, the bankruptcies of effectively insolvent large companies, worsening fiscal conditions and a sharp reduction in public investment.

Paradoxically, the quickest way to move the Japanese economy from the current near zero interest situations to a normal condition where interest rate policy can function properly is to adopt an even easier monetary policy than the zero interest policy. More concretely, as has been proposed by Mr. Nakahara, a policy board member of the Bank of Japan, I argue for quantitative easing of monetary conditions with an explicit target range of CPI inflation rate.

The Bank of Japan should conduct open-market purchases of medium-term and long-term government bonds to increase the base money supply. The increasing liquidity in the economy would help reverse the trend of general price deflation as well as asset price deflation. The resulting increase in the expected rate of inflation would push up long-term interest rates. If that happens, the Bank of Japan can safely raise short-term rates.

Effectiveness of Quantitative Policy
In their formal opinion, the Bank of Japan is denying the effectiveness of quantitative easing monetary policy. But the common sense of central bankers overseas (as well as this author who worked for the Bank of Japan for 23 years until 1997) would tell you that "a central bank can stop deflation and generate inflation if it really wishes to do so." All it should do is to expand the scope of its open market operations from high-quality short-term monetary instruments to other kinds of assets and to increase the amount of open market purchases decisively. By open market operations for medium-term and long-term bonds, interest-bearing assets in the private sector tend to decrease, while the base money with zero interest increases. Thus, the average yield for privately held assets will decline, and it will pressure private banks to lend more, leading to an expansion of economic activity.

In addition, such quantitative easing of monetary conditions with steady and high growth of base money supply is expected to stimulate the economy further by facilitating increases in the expected inflation rate, the associated depreciation of the yen, and the appreciation of asset prices such as stocks and real estate. In fact, we did have depreciation of the yen and rising stock prices late last year, when the Bank of Japan drastically increased base money supply as a Y2K contingency measure and generated expectations that the Bank of Japan would adopt expansionary quantitative money supply policy.

Importance of Inflation Targeting
The question is whether the Bank of Japan can control the pace of inflation when the general price level starts to climb as a result of successful quantitative monetary policy. For this purpose, it would be necessary to start quantitative monetary policy by setting an inflation target. Setting an inflation target is not only for pushing up the expected rate of inflation, but also for allowing the Bank to raise the short-term interest rate in a timely fashion whenever the real economy picks up.

I would like to argue that the Bank of Japan should aim at the target of realizing a 1.5 percent annual increase in the CPI (excluding perishables and changes in indirect taxes) plus or minus one percent. This is because the bias for the CPI due to changes in the quality in goods and services is about one percent, and also because we need a "safety margin" to prevent the general price level from falling again. With a positive inflation rate, the Bank of Japan can easily stimulate the economy by lowering the real interest rate to a near zero level in severe cyclical downturns. In this sense I am proposing a policy of quantitative easing of monetary conditions, but not the so-called "chosei infure" inflationary monetary policy proposed by Paul Krugman.