For the Bank of Japan: Implication of Termination of Zero Interest Rate Policy

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

1. BOJ Scraps Zero Interest Rate Policy

Determined BoJ Ends Zero Rate Policy
The BoJ, defying intense political pressure, finally lifted its zero interest rate policy at its Monetary Policy Council (MPC) meeting on August 11. It announced that it would henceforth guide the unsecured overnight call rate to an average of around 0.25%. Some investors appeared to agree with the government that the BoJ's action was premature. However, as we can see from the BoJ's monthly economic reports and such, the bank has become increasingly positive regarding the economy and the recovery's durability. Once the economy achieves a self-sustaining expansion led by private-sector demand, it would be strange for the unsecured overnight call rate to be maintained at 0.25%. Notwithstanding the structural problems that still beset the economy, capex continues to drive the expansion thanks to unexpectedly robust Asian demand and buoyant IT-related investment. When the BoJ implemented its zero interest rate policy in February 1999, it could hardly have imagined that the economy would have been this solid just 18 months later.

BoJ feared loss of credibility
The BoJ made its decision now for several reasons. First, the government looks to transfer the temporarily nationalised Nippon Credit Bank to its purchasers as per the initial contract, resisting populist pressures to revise the contract terms. This suggests that the share price decline prompted by the Sogo bankruptcy case has ended, and the bank seems to have judged the future risk of a stock market plunge to be remote. Moreover, further postponement of a policy change despite the manifest recovery in the economy would have dealt a severe blow to the bank's credibility.

We applaud the bank's decision to move forward with a policy change for the following reasons:

1. With corporate earnings on the upswing and capex showing unexpected strength, the economic expansion looks likely to continue at least throughout this fiscal year.
2. We believe that the post-bubble bad debt problem is in its final stages. Though the slight interest rate hike represented by the BoJ's policy change may push some shaky companies into bankruptcy, rates remain at super-low levels, and there is an adequate safety net in the form of financial and bankruptcy rehabilitation laws. Thus, we do not feel that the BoJ's move will threaten the financial system.
3. The move takes away the speculation and uncertainties over prospects for the zero interest rate policy. Financial markets are likely to remain stable until investors begin looking for the next rate hike.

However, we can only truly judge the BoJ's move to have been correct if the economy does achieve a self-sustaining recovery that allows for a further rate hike, and if the financial system remains calm in the wake of the policy change.

Market dialogue needs informed markets
In a press conference after Friday's meeting, Hayami conceded that the bank's communication with the markets had not been entirely smooth, and promised to work on this aspect in the future. However, looking objectively at the market turmoil in the lead-up to the policy decision, we feel that the financial markets and media should also reflect on their own shortcomings. There was an almost wilful ignorance of the basic tenets of the revised BoJ Law, particularly regarding the bank's greater autonomy under the law, the inclination of any central bank to base monetary policy on the business cycle, and the fact that major policy decisions can only be made by majority vote of the MPC. Investors persisted in their belief that the BoJ could not halt the zero interest rate policy while share prices were sluggish; that the bank was vulnerable to political and overseas pressure; that Hayami's leadership was weak; and that the bank had little leeway in monetary policy while the bad debt problem and other serious structural problems remained in the economy. What Hayami perhaps is really saying is that the BoJ alone cannot improve its communication with the markets until investors gain a better understanding of the changes in the law.

Clumsy political interference
A representative of the government attending Friday's MPC meeting proposed at the meeting that the vote on the zero interest rate policy be suspended until the next meeting, knowing full well that the proposal would be rejected. The government had been insisting very publicly that a termination of the policy would be premature. The startlingly blatant attempts by MoF and politicians to strong-arm the BoJ into leaving rates untouched stemmed from the politically distasteful prospect of further corporate bankruptcies, a rise in unemployment and a drop in the yen, as well as the potential effects of the Sogo saga on the financial system. The government also feared that it would be left powerless to prevent a downturn in regional economies given its own colossal fiscal deficit and inability to concoct a major supplementary budget after its losses in the June Lower House election. Its futile proposal that the bank defer a vote may have been a pre-emptive move to push all responsibility for the rate hike decision onto the BoJ, thereby deflecting any future criticism away from the government and ruling parties. The political bullying of the BoJ not only threatened the bank's independence but hurt the integrity of the nation's entire economic policy in the eyes of the world.

2.Monetary policy still not back to normal

Let us consider the prognosis for monetary policy. For reference, we will use two approaches to analyse the unsecured overnight call rate level that would be neutral to the economy. First we will use the estimated potential growth rate and expected inflation rate to calculate this rate. Then we will review the BoJ's monetary policy throughout the 1990s, from the days of a 6.0% ODR to the adoption of the zero interest rate policy.

If we assume conservatively a potential growth rate of around 1.0% and expected inflation rate of zero, an economy-neutral unsecured call rate level would come to around 0.75%-1.0%. Since we actually believe that the potential growth rate is closer to 1.5%-2.0%, we feel that an economy-neutral call rate would be at least 1.0%. As the BoJ pointed out in a statement after last week's meeting, the end of the zero interest rate policy does not signify any change in the bank's ultra-easy monetary policy. With an adequate financial system safety net in place, the post-bubble bad debt problem in its final stages, and structural reforms underway led by the private sector, a self-sustaining private-led recovery now appears a real possibility. From a long-term perspective, the conditions for a further tightening should gradually fall into place in line with the economic cycle given the ongoing structural changes both in industry, such as the development of the service economy, and in the economy as a whole, including positive developments such as the information/communications revolution and innovations in the distribution sector.

Moreover, through its zero interest rate policy, the BoJ was able to squeeze out every benefit of a financial easing in the implicit promise that it would not touch monetary policy for some time. Financial markets are now likely to be much more sensitive to economic indicators. Interest rates will remain extremely low even without the zero interest rate policy. The bank declared in its statement that the policy change was only a minor adjustment in line with the improving economy, and pointed out that monetary policy remained exceptionally loose, with the unsecured overnight call rate at a minuscule 0.25%. Thus, if economic statistics continue to show an ongoing recovery, money markets and JGB markets should relatively quickly discount a second rate hike.

Three phases of BoJ tightening cycle
The prevailing view in financial markets is that another rate hike is highly unlikely in the foreseeable future. However, we believe that the BoJ may want to bring unsecured overnight call rates back to the 0.5% level of the ODR, without changing the overall framework of its accommodative monetary policy, once it concludes that emergency measures are no longer necessary to protect the financial system. The BoJ's monetary easing from 1991-95 was basically in response to the deterioration in the real economy. However, its subsequent easing - its 25bp rate cut on September 9, 1998, and the adoption of the zero interest rate policy on February 25, 1999 - were due mainly to worries over the financial system that had spread between late 1997 and 1998. If the economy continues to move towards a self-sustaining recovery, the August 11 meeting of the Monetary Policy Council, at which the bank decided to halt the zero interest rate policy, will prove to have been a major turning point for monetary policy. Assuming that this is true, we can consider the bank's future tightening (probably multiple rate hikes) in three phases.

The first is a return to normal, since the policy was initially an emergency measured instituted to prevent the Asian currency crisis and Japanese financial system instability from dragging the nation into a deflationary spiral. The BoJ will likely explain a future tightening by pointing to the uptrend in the economy, but it will also need to make some assurances regarding the financial system. In this event, we feel the bank will seek to raise the unsecured overnight call rate to 0.5%, around the same as the ODR.

The second phase of a tightening will be the move from an accommodative monetary policy to a neutral stance. Assuming conservatively that Japan's potential GDP growth rate is around 1.0% with a negligible expected inflation rate, the unsecured overnight call rate level is neutral at around 0.75%-1.0%. We actually believe that potential growth is 1.5%-2.0%, so an economy-neutral level for short-term interest rates would have to be at least 1.0%. That is, in the second phase, the BoJ will probably seek to bring the unsecured overnight call rate to an average of around 1.0%.

In the third phase, the BoJ will finally return to an actual monetary tightening. If GDP growth exceeds 2.0% in both FY2000 and FY2001, the deflationary gap will start to narrow. However, given the great size of this gap at present, there is little fear of inflationary pressures. The BoJ feels that the consumer price index (CPI) and corporate service price index (CSPI) are dropping due to distribution and IT innovations, which should be distinguished from the kind of price decline that threatens to become a deflationary spiral. The bank believes that the bubble economy of the late 1980s was caused by its delay in hiking rates, on the grounds that consumer prices were growing more than 3.0% YoY (annualised). For this reason, the hawkish members of the bank may be extremely nervous regarding movements in major price indexes. Once the CPI and CSPI hit bottom or began a turnaround, the BoJ will immediately want to consider a pre-emptive tightening.

Atsushi Mizuno