The bubble economy burst in the 1990s left painful consequences for Japan's economy. In the aftermath of that burst, Japanese firms had been confronting three excesses namely: excess production capacity, excess employment and excess debt. Moreover, the financial institutions were grappled with a very high non-performing loan. Consequently, Japan's potential economic growth fell considerably from around 4.0 per cent in the early 90s to around 1.0 per cent in the late 90s. Inflation rate of the economy also slipped to a negative territory in 1998 and generally remained negative over a decade and a half. This persistent decline in price level (known as deflation) led the economy to a bad equilibrium in which the overall economic activity kept dwindling. Hence fighting the deflation through adopting a mix of economic stabilisation policies became the challenge for the Japanese policy makers.
EVOLUTION OF QQE: The Bank of Japan (BoJ) has been seen to play its role in revitalising the economy since the nineties. For instance, in response to a marked slowdown in economic activity and a mounting financial instability in the early nineties, the BoJ slashed its policy interest rate 9 (nine) times to 0.5 per cent from 6.0 per cent between 1991 and 1995. Going forward, as the natural rate of interest (i.e. real interest rate neutral to economic activity) was falling below the real interest rates, the BoJ introduced the zero interest rate policy in 1999, guiding the uncollateralised overnight call rate (OCR) to as low as possible. Consequently, Japanese economy was witnessing a clear sign of recovery. But due to the subsequent lifting of zero interest rate policy (ZIRP) in 2000, the economy started declining again. Responding to the worsening macroeconomic conditions, the BoJ embarked on a quantitative easing (QE) policy, first-ever of its kind, in March 2001 setting current account balances of financial institutions with the BoJ as an operating target of monetary policy with a commitment to continue such measures until the CPI (Consumer Price Index) inflation rate registers zero per cent or above in a stable manner. In 2006, the BoJ had halted the QE measures and lifted the ZIRP.
The global financial crisis (GFC) in 2008 led to a deflation in Japan again so the BoJ came up with a comprehensive monetary easing (CME) measures in October 2010 including targeting OCR to 0 per cent to 0.1 per cent and introducing an asset purchase programme. The CME was aimed at overcoming the zero lower bound (ZLB) by influencing the term premium of long-term interest rate through longer-term lending as well as purchasing various risk assets. Although the BoJ kept providing financial accommodation through various means, significant improvement in economic activity and price level was not in sight. The unsatisfactory economic performance led the BoJ to launch a more powerful policy package in April 2013 namely Quantitative and Qualitative Easing (QQE) with a shift of the main operating target of monetary policy from interest rate to monetary base. The QQE have been more powerful than CME in that the QQE strongly encouraged a decline in the long-term interest rate through a large-scale purchase of Japanese Government Bonds (JGBs), influenced risk premium through expanding the volume of risk asset purchase such as Japanese exchange-traded funds (ETFs), Japan's real estate investment trusts (J-REITs). Moreover, the QQE with negative interest rate policy (NIRP) introduced in January 2016 essentially removed the ZLB of short-term interest rate. The policy was intended to exert downward pressure on the interest rate across the entire yield curve by particularly influencing the short end of the yield curve. The QQE measures also includes the BoJ's firm commitment of doing whatever it takes with regard to attaining a price stability target of 2.0 per cent, which, in fact, aimed at changing the inflation expectations of economic agents.
Although the QQE is very powerful, it may potentially lead to side effects going forward. For example, financial intermediation may be severely hurt because of the downward pressure on the financial institutions' profit resulting from long lasting decline in and flattening of the yield curve. Keeping these side effects in mind, the BoJ introduced the QQE with yield curve control in September 2016, which comprises two components. The first component, yield curve control, takes the form of controlling short-term and long-term interest rates at such levels deemed to be most appropriate for attaining the price stability target of 2.0 per cent. The second component, inflation-overshooting commitment, delineates a powerful commitment on the part of the BoJ to continue expanding the monetary base until the inflation rate based on the observed CPI exceeds the price stability target of 2.0 per cent and remains above that level in a stable manner. This firm commitment is expected to dispel deflationary mindsets and later re-anchor inflation expectations of economic agents at 2.0 per cent. The QQE with yield curve control implicitly allows for changing the operating target of monetary policy from monetary base to interest rate.
IMPACT OF THE QQE: Through the various monetary easing measures, the BoJ has succeeded in keeping the natural rate of interest from declining since 2010 and in reducing real interest rates to well below the natural rate of interest. The gap between natural rates and real rates reflecting the extent of monetary accommodation paved the way for stimulating economic activity. Consequently, Japan's economy as measured by real gross domestic product (GDP) has improved significantly since the onset of the CME measures. In addition to a steady improvement in output gap over the years, the corporate profits, in a tight labour market of virtually full employment, edged up substantially reaching as high as 6.0 per cent of sales in 2017. Wage growth has also witnessed a modest increase over the years. As regards price development, the annual change in CPI of all items except fresh food and energy has been buoyant since 2010, albeit with modest and sporadic slowdowns in some years. Overall, the economy appears to overcome the sustained decline in prices i.e. deflation.
While the rate of annual change in CPI has been slightly above 0 per cent, the economy is way behind the price stability target of 2.0 per cent. This development is partly attributable to subdued inflation expectations. Although the inflation expectation had increased substantially soon after the introduction of the QQE in 2013, it started landing in the following two years reflecting the fact that expectation formation in Japan is backward looking (i.e. adaptive). On the other hand, the BoJ's negative interest rate policy and yield curve control has appeared to be successful in changing the level and slope of the yield curve. As expected, the decline in Japanese Government Bonds (JGBs) has led to a reduction of lending rates and interest rates on corporate bonds. Nevertheless, to what extent a further decline in short-term and long-term interest rates will translate into a decline in lending rates depends greatly on the lending stance of financial institutions.
Saidul Islam is Deputy Director of Bangaldseh Bank.
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