《货币银行学》课程教学资源（文献资料）TWO DECADES OF JAPANESE MONETARY POLICY

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1.IntroductionThe Japanese economy has been stagnant for more than ten years.The average growth rate from 1993to 2003 is just above 1 percent. Since 1998, the inflation rate, either measured by GDP deflator or CPL,has beennegative.Thedeflation hasbroughtthe CPIprice level by the end of2003to3%below the1997 level. During the same period, the US CPI has increased by 12%. Due to virtually zero growthand deflation, theJapanesenominal GDPhad shrunk by4% from1997to 2002, whileduring the sameperiod, nominal GDP of theUnited States has increased by25%.Many problems have been pointed to as contributing factors that explain the"lost decade"inJapan.The burst bubble and the non-performing loans problem are often blamed for the poorperformance of the early stage of the stagnation.By 2003, land and stock price indices have fallen toone-third to one-fourth of the respective peak in 1989-91.Slow policy responses to thenon-performing loan problem resulted in the banking crisis of 1997-98 and the financial sector is stillweak.The consumption tax rate increase and repeal of income tax cut in April 1997 is often regardedas a fiscal policymistake.Slow structural reform in regulated sectors is another problem for theJapaneseeconomy,whichhas notbenefited from information and communication technology(ICT)advances that propelled the US economy.But,themost likelycausefor deflation inJapanis afailureofmonetarypolicy,sinceinflationor deflation is ultimately a monetary phenomenon.The Bank of Japan was unable to stop theinflation rate from turning negative, despite its various efforts.The uncollateralized call rate (thepolicy interest rate that corresponds to the Federal Funds rate of the United States) was lowered tovirtually zero in February-March 1999. The Bank of Japan raised the call rate to 0.25% in August2000 infalse expectation of continuing economic expansion,againstprotests from thegovernmentand many economists. The interest rate was lowered to zero again in March 2001, with an additionalmeasure ofquantitative easing,setting the targetof current account (reserves)of commercial banks atthe Bank of Japan in excess of required reserves.The target amount of current account was initiallyset at 5 trillion yen, while the required reserves was about 4 trillion yen.The target amount has beenraised in several steps to a range of 30-35 trillion yen by January 2004. In addition to raising thetarget amount of current account at the Bank of Japan,theBank expanded the amount of monthlyoutright purchase of long-term government bonds from 400 billion yen to 600 billion yen in August2001,and in several stepsto1200 billion yen inOctober 2002.Inaddition,purchases of someofprivate debts, including asset-backed securities (ABS), have been introduced.By 2002, the economy and the financial institutions weakened again.Deflationaryexpectations were setting in, and consumption and investment were depressed.Aggregate demandfell short of potential output, and the widened output gap depressed prices, reinforcing deflationaryexpectations.There did not seem to be a solution to thedeflationary spiral.2

2 1. Introduction The Japanese economy has been stagnant for more than ten years. The average growth rate from 1993 to 2003 isjust above 1 percent. Since 1998, the inflation rate, either measured by GDP deflator or CPI, has been negative. The deflation has brought the CPI price level by the end of 2003 to 3% below the 1997 level. During the same period, the US CPI has increased by 12%. Due to virtually zero growth and deflation, the Japanese nominal GDP had shrunk by 4% from 1997 to 2002, while during the same period, nominal GDP of the United States has increased by 25%. Many problems have been pointed to as contributing factors that explain the “lost decade” in Japan. The burst bubble and the non-performing loans problem are often blamed for the poor performance of the early stage of the stagnation. By 2003, land and stock price indices have fallen to one-third to one-fourth of the respective peak in 1989-91. Slow policy responses to the non-performing loan problem resulted in the banking crisis of 1997-98 and the financial sector is still weak. The consumption tax rate increase and repeal of income tax cut in April 1997 is often regarded as a fiscal policy mistake. Slow structural reform in regulated sectors is another problem for the Japanese economy, which has not benefited from information and communication technology (ICT) advances that propelled the US economy. But, the most likely cause for deflation in Japan is a failure of monetary policy, since inflation or deflation is ultimately a monetary phenomenon. The Bank of Japan was unable to stop the inflation rate from turning negative, despite its various efforts. The uncollateralized call rate (the policy interest rate that corresponds to the Federal Funds rate of the United States) was lowered to virtually zero in February-March 1999. The Bank of Japan raised the call rate to 0.25% in August 2000 in false expectation of continuing economic expansion, against protests from the government and many economists. The interest rate was lowered to zero again in March 2001, with an additional measure of quantitative easing, setting the target of current account (reserves) of commercial banks at the Bank of Japan in excess of required reserves. The target amount of current account was initially set at 5 trillion yen, while the required reserves was about 4 trillion yen. The target amount has been raised in several steps to a range of 30-35 trillion yen by January 2004. In addition to raising the target amount of current account at the Bank of Japan, the Bank expanded the amount of monthly outright purchase of long-term government bonds from 400 billion yen to 600 billion yen in August 2001, and in several steps to 1200 billion yen in October 2002. In addition, purchases of some of private debts, including asset-backed securities (ABS), have been introduced. By 2002, the economy and the financial institutions weakened again. Deflationary expectations were setting in, and consumption and investment were depressed. Aggregate demand fell short of potential output, and the widened output gap depressed prices, reinforcing deflationary expectations. There did not seem to be a solution to the deflationary spiral

When the zero interest ratepolicy (ZIRP)was first introduced in February 1999, it wasintended to continue until"deflationary concern is dispelled."It was then lifted in August 2000.When it was re-introduced in March 2001, it was declared to continue until "the inflation rate becomesstably above zero."The condition was further elaborated in October 2003, so that the necessarycondition for the exit from ZIRPis that the CPIinflation ratebecomes zero or abovefor afewmonthsand there was no forecast by the Board members offalling back to deflation.The determination tofight deflation seems to have been strengthened.Given that deflation was not over at the time ofZIRP termination and that the ZIRPhad to be re-instated, the interest rate hike of August 2000 wasclearlyamistake.Lively debates have taken place as to what the Bank of Japan could have done to preventdeflation from occurring and getting worse, and on what the Bank of Japan could do to get out ofdeflation. Many academics and policy makers, including studies at the Federal Reserve Board, arguethattheBankofJapan actions weretoo littletoolate,atleast in retrospect,inpreventingdeflationfromemerging and fighting out of deflation.Many academic critics have been arguing fornon-conventional monetarypolicyin combating deflation:for example,purchasinglong-term bonds,equities, foreign-currency-denominated bonds, and non-performing loans.However, it has beenpointed out that the transmission channel of non-conventional monetary policy is unclear.Inflation targetinghas also beenproposed as a tool to promotean independent central bankand to help get out of deflation.Namely, a credible announcement of inflation targeting, of say I to 3percent, would make inflation expectations become higher, so that the deflationary spiral would bebroken. A combination of inflation targeting as a communication and anchoring device withnon-conventional policies was advocated by academic work in the past.!However,theBank ofJapanhas opposed inflationtargeting,witheconomists in theBank ofJapan arguing that there are no clear instruments to get out of deflation,and a mere announcementwithout instruments would not convince market participants to change their inflation expectations.But,others in the Bank have suggested that the commitment tokeep the zero interest rate policy untilthe inflation rate becomes stably above zero has similar effects to inflation targeting.The paper is organized as follows.Sections 2 and 3 will review Japanese Monetary Policyoverthelasttwodecades.Theformerconcentratesontheperiodof bubbleand burst(1985-1997)and the latter examines the issue under the newlaw of the Bank of Japan (1998-).Section 4discusseswhetherestimates ofTaylorrulescanbeusedto assess Japanesemonetarypolicy.Section5discussesthecosts ofdeflation.Section6examinesmonetarypolicyactionstopreventdeflation,and Section7surveys the literature on monetary policy to cure deflation and discusses non-conventional monetarypolicymeasures. Section 8 concludes the paper.1 See Ito (2000, 2001),Kazumasa Iwata (2002),and Kikuo Iwata (2001,2002) in the books wrtten inJapanese.3

3 When the zero interest rate policy (ZIRP) was first introduced in February 1999, it was intended to continue until “deflationary concern is dispelled.” It was then lifted in August 2000. When it was re-introduced in March 2001, it was declared to continue until “the inflation rate becomes stably above zero.” The condition was further elaborated in October 2003, so that the necessary condition for the exit from ZIRP is that the CPI inflation rate becomes zero or above for a few months and there was no forecast by the Board members of falling back to deflation. The determination to fight deflation seems to have been strengthened. Given that deflation was not over at the time of ZIRP termination and that the ZIRP had to be re-instated, the interest rate hike of August 2000 was clearly a mistake. Lively debates have taken place as to what the Bank of Japan could have done to prevent deflation from occurring and getting worse, and on what the Bank of Japan could do to get out of deflation. Many academics and policy makers, including studies at the Federal Reserve Board, argue that the Bank ofJapan actions were too little too late, at least in retrospect, in preventing deflation from emerging and fighting out of deflation. Many academic critics have been arguing for non-conventional monetary policy in combating deflation: for example, purchasing long-term bonds, equities, foreign-currency-denominated bonds, and non-performing loans. However, it has been pointed out that the transmission channel of non-conventional monetary policy is unclear. Inflation targeting has also been proposed as a tool to promote an independent central bank and to help get out of deflation. Namely, a credible announcement of inflation targeting, of say 1 to 3 percent, would make inflation expectations become higher, so that the deflationary spiral would be broken. A combination of inflation targeting as a communication and anchoring device with non-conventional policies was advocated by academic work in the past. 1 However, the Bank of Japan has opposed inflation targeting, with economists in the Bank of Japan arguing that there are no clear instruments to get out of deflation, and a mere announcement without instruments would not convince market participants to change their inflation expectations. But, others in the Bank have suggested that the commitment to keep the zero interest rate policy until the inflation rate becomes stably above zero has similar effects to inflation targeting. The paper is organized as follows. Sections 2 and 3 will review Japanese Monetary Policy over the last two decades. The former concentrates on the period of bubble and burst (1985-1997), and the latter examines the issue under the new law of the Bank of Japan (1998- ). Section 4 discusses whether estimates of Taylor rules can be used to assess Japanese monetary policy. Section 5 discusses the costs of deflation. Section 6 examines monetary policy actions to prevent deflation, and Section 7 surveys the literature on monetary policy to cure deflation and discusses non-conventional monetary policy measures. Section 8 concludes the paper. 1 See Ito (2000, 2001), Kazumasa Iwata (2002), and Kikuo Iwata (2001, 2002) in the books written in Japanese

2.MonetaryPolicyandtheBubble2.1.Bubble and BurstSome researchers goback to the bubble period,1985-90,as a source of the Japanese stagnation in the1990s.Since the bubble occurred and burst, the Japanese economy fell into a difficult position ofhaving nonperforming loans that led to thebanking crisis.Some economists seem tobelievethatthere was a mistake in monetary policy in the 1980s, and once the burst bubble occurred, monetarypolicy became powerless in the 1990s, because the transmission channel from the interest rate policyto thereal economy was no longeroperational.Therefore,it is entirelyappropriateto start the storyof deflation from thebubbleyears.In retrospect, it is obvious that the Japanese economy was experiencing a bubble economyThe stock price index and the land price index quadrupled from 1983 to 1989.The stock prices index(Nikkei225)rosefrom10.000yenattheendof1983tonear40,000attheendof1989.Theeconomicgrowthratewasapproaching5%surpassingtheaverageof4%from1975to1989,andthetax revenues were increasing to close a fiscal gap that had plagued the economy for two decades.Atthe end of the 1980s, many economists as well as policy makers around the world were praising theJapaneseeconomyforitsexcellentperformance.Althoughafeweconomistsraisedconcerns,manyfinancial analysts and bankers were not alarmed at the apparent high value of stocks and landcompared to theircash-flowearning.Land and stockpricemovements from1970to2003areshowninFigure1.Insert Figure 1 about hereThe inflation rate had gradually come down from 12 percent in 1974 to below 4 percent in 1978. Theinflation rate suddenly went up to about 8percent in 1979 dueto the second oil crisis.However,theCPIinflation rate was quicklybrought down to below3percent in 1982.The inflation ratefluctuatedat the low rangeof 0-3%for therest of the1980s.The inflation performanceof Japanfrom1976to1987, despite a lack of legal independence of the Bank of Japan, was often praised in the literatureFigure2 shows the CPI inflation rate (excluding fresh food),that is adjusted for the consumption taxintroduction in 1989,and theconsumption tax rate increase in 1997.InsertFigure2about hereIt is remarkable that during the bubble period, the CPI inflation rate remained low. While asset priceswere doubling and tripling in a few years, the CPI inflation rate remained quite reasonable,prompting2See Ito(1992)forcomprehensiveexplanationoftheJapaneseeconomyupto19913See,for example,Cargill,Hutchison,andIto (1997),for theview thattheBank of Japanmight havehaddefactoindependenceandexercised itwisely4

4 2. Monetary Policy and the Bubble 2.1. Bubble and Burst Some researchers go back to the bubble period, 1985-90, as a source of the Japanese stagnation in the 1990s. Since the bubble occurred and burst, the Japanese economy fell into a difficult position of having nonperforming loans that led to the banking crisis. Some economists seem to believe that there was a mistake in monetary policy in the 1980s, and once the burst bubble occurred, monetary policy became powerless in the 1990s, because the transmission channel from the interest rate policy to the real economy was no longer operational. Therefore, it is entirely appropriate to start the story of deflation from the bubble years. In retrospect, it is obvious that the Japanese economy was experiencing a bubble economy: The stock price index and the land price index quadrupled from 1983 to 1989. The stock prices index (Nikkei 225) rose from 10,000 yen at the end of 1983 to near 40,000 at the end of 1989. The economic growth rate was approaching 5% surpassing the average of 4% from 1975 to 1989, and the tax revenues were increasing to close a fiscal gap that had plagued the economy for two decades. At the end of the 1980s, many economists as well as policy makers around the world were praising the Japanese economy for its excellent performance. 2 Although a few economists raised concerns, many financial analysts and bankers were not alarmed at the apparent high value of stocks and land compared to their cash-flow earning. Land and stock price movements from 1970 to 2003 are shown in Figure 1. Insert Figure 1 about here The inflation rate had gradually come down from 12 percent in 1974 to below 4 percent in 1978. The inflation rate suddenly went up to about 8 percent in 1979 due to the second oil crisis. However, the CPI inflation rate was quickly brought down to below 3 percent in 1982. The inflation rate fluctuated at the low range of 0-3% for the rest of the 1980s. The inflation performance of Japan from 1976 to 1987, despite a lack of legal independence of the Bank of Japan, was often praised in the literature. 3 Figure 2 shows the CPI inflation rate (excluding fresh food), that is adjusted for the consumption tax introduction in 1989, and the consumption tax rate increase in 1997. Insert Figure 2 about here It is remarkable that during the bubble period, the CPI inflation rate remained low. While asset prices were doubling and tripling in a few years, the CPI inflation rate remained quite reasonable, prompting 2 See Ito (1992) for comprehensive explanation of the Japanese economy up to 1991. 3 See, for example, Cargill, Hutchison, and Ito (1997), for the view that the Bank of Japan might have had de facto independence and exercised it wisely

a difficult choice to the Bank of Japan. Indeed, the Bank of Japan did not start tightening until 1989Although the Bank of Japan would not target asset prices,the burstbubble would make monetarypolicy more difficult—all with the benefit of hindsight.The yen appreciated from 260 yen/dollar inFebruary1985to150yen/dollar in the summerof 1986,of which somepartwas a movementtowardan equilibrium and some part was overshooting.The sharp yen appreciation caused a recession (dueto a slump of exports) and imported disinflation. Interest rates were lowered from 1996 to 1997 inpart to help stimulate the economy that was depressed by sharp yen appreciation.Low interest rateswere necessary to prevent the yen from appreciating too much.Monetary policy was finally tightened in 1989. The official discount rate (ODR) rose from2.5%,whereithadbeen since1987,to3.25%inMay1989.TheODRroseto3.75%inOctoberand4.25%in December.Despite this rapid hike of the interest rate,the CPI inflation rate rosefrom1% atthe beginning of 1989to3% toward the end of the same year.The official discount rate was raised to6.00% in August 1990 (a 350 basis point hike in 15 months).Stock prices peaked at the levelof 39.000 in Nikkei 225 index at the end of 1989.In tandemwith the interest rate hike, regulatory tightening was applied to stop increases in land prices: includinglimiting the increase in bank lending to real estate-related projects and companies in the spring of1990., and raising taxes on realized capital gains from land investment.Stock prices finally turneddown from the first trading day of 1990.The stock price index declined by one-third from the end of1989, the peak,to the end of 1990.Stock prices continued to decline and the index lost 60% of thepeak level by the summer of 1992. Land prices started to decline in 1991.The bubble had burst.Onemay question whethermonetarypolicy was toolax for too longduring thebubbleexperience, that is the second half of the 1980s.What if monetary policy was tightened in 1988?Maybethatmight have prevented the inflation rate fromrisingtoo quicklyto the 3% level atthe end of1989.The Bank of Japan was most likely behind the curve.However, it probably would not have hadameasurable impacton the bubbleprocess of stock prices and land prices.Even if the interest ratehad been hiked earlier,it is unlikely that the expected return of purchasing an asset would not havebeen affected very much when the asset is in a bubble process.5Those who emphasize the damage of burst bubble in the1990s may argue that the mistake ofmonetary policy in the second half of the 1980s was that it allowed the bubble to get bigger and bigger.There is no clear cut answer to the question of how monetary policy should respond to asset price4 See,for example,Okina, Shirakawa, and Shiratsuka (2001)for such a view.They seem toblameinternational policy coordination,suchas thePlaza Accord of September1995and theLouvreAccord ofFebruary1997 for the Bank of Japan not acting in a timelymanner.5SeeItoand Iwaisako(1996)for an interpretationof theJapanesebubblein the1980s as anapplication of stochastic bubbles.They differentiated the simulated effects of a temporary change inthe interest rate and the simulated permanent change in the interest rate upon asset prices. They arguethat unless the low interest rate in the late 198Os had been perceived to be permanent, the largeincrease in assetprices could nothavebeen explained.5

5 a difficult choice to the Bank of Japan. Indeed, the Bank of Japan did not start tightening until 1989. Although the Bank of Japan would not target asset prices, the burst bubble would make monetary policy more difficult—all with the benefit of hindsight. The yen appreciated from 260 yen/dollar in February 1985 to 150 yen/dollar in the summer of 1986, of which some part was a movement toward an equilibrium and some part was overshooting. The sharp yen appreciation caused a recession (due to a slump of exports) and imported disinflation. Interest rates were lowered from 1996 to 1997 in part to help stimulate the economy that was depressed by sharp yen appreciation. 4 Low interest rates were necessary to prevent the yen from appreciating too much. Monetary policy was finally tightened in 1989. The official discount rate (ODR) rose from 2.5%, where it had been since 1987, to 3.25% in May 1989. The ODR rose to 3.75% in October and 4.25% in December. Despite this rapid hike of the interest rate, the CPI inflation rate rose from 1% at the beginning of 1989 to 3% toward the end of the same year. The official discount rate was raised to 6.00% in August 1990 (a 350 basis point hike in 15 months). Stock prices peaked at the level of 39,000 in Nikkei 225 index at the end of 1989. In tandem with the interest rate hike, regulatory tightening was applied to stop increases in land prices: including limiting the increase in bank lending to real estate-related projects and companies in the spring of 1990, and raising taxes on realized capital gains from land investment. Stock prices finally turned down from the first trading day of 1990. The stock price index declined by one-third from the end of 1989, the peak, to the end of 1990. Stock prices continued to decline and the index lost 60% of the peak level by the summer of 1992. Land prices started to decline in 1991. The bubble had burst. One may question whether monetary policy was too lax for too long during the bubble experience, that is the second half of the 1980s. What if monetary policy was tightened in 1988? Maybe that might have prevented the inflation rate from rising too quickly to the 3% level at the end of 1989. The Bank of Japan was most likely behind the curve. However, it probably would not have had a measurable impact on the bubble process of stock prices and land prices. Even if the interest rate had been hiked earlier, it is unlikely that the expected return of purchasing an asset would not have been affected very much when the asset is in a bubble process. 5 Those who emphasize the damage of burst bubble in the 1990s may argue that the mistake of monetary policy in the second half of the 1980s was that it allowed the bubble to get bigger and bigger. There is no clear cut answer to the question of how monetary policy should respond to asset price 4 See, for example, Okina, Shirakawa, and Shiratsuka (2001) for such a view. They seem to blame international policy coordination, such as the Plaza Accord of September 1995 and the Louvre Accord of February 1997 for the Bank of Japan not acting in a timely manner. 5 See Ito and Iwaisako (1996) for an interpretation of the Japanese bubble in the 1980s as an application of stochastic bubbles. They differentiated the simulated effects of a temporary change in the interest rate and the simulated permanent change in the interest rate upon asset prices. They argue that unless the low interest rate in the late 1980s had been perceived to be permanent, the large increase in asset prices could not have been explained

inflation with a stable CPI inflation rate as will be seen in the general discussion in Section 2.3.However,thedilemmaof themonetarypolicyatthetimewasthat CPIinflation wasindicating low inflation,mainly due to a sharp yen appreciation,from 260 yen/dollar in February1985to150 yen/dollar in the summer of 1986, and to 120 yen/dollar in December 1987.When the CPIinflation rate is about 0.5%while the stock and land prices are increasing at30% annually,whatshould monetary policy do?The low inflation rate,which is below typical inflation targets of around2%,might suggest there is roomfor monetaryeasing,while stopping the assetpriceinflation requirestightermonetarypolicy.There seems tobedilemma formonetarypolicyThere is a fundamental law in (linear model) economics that there should be at least two policyinstruments to pursue two policy objectives.No perfect solution for the interestratepolicy can beobtained to pursue both CPI price stability and asset price stabilityAssessment of monetary policy in Japan in 1987 and 1986 is difficult.Could one justify themonetary policy that lowered the discountrate to2.5% in February1987and maintainedit at2.5%,then therecord low,until May 1989?One may argue that the Bank of Japan should have applied tight monetarypolicy in 1987 in order to curb asset price inflation. But, it would have been difficult to justify the actiongiven thelow CPI inflation rate,the slow economic recoveryfrom the yen-appreciationrecession of1986,and the aftermath of Black Monday in October 1987.We are not confident that preventing asset priceinflation was an overriding priority of the central bank in 1987.On the other hand, the tradeoff haddisappeared in 1988 when both CPI price forecasts and asset price movements now indicated that at leastmodest tightening would have been justifiable.The BOJ was probably behind the curve in 19882.2.Bubble Overkill?In the beginning of the assetprice declinepublic opinion was favorable toward monetary andregulatory policy to stop the bubble.Housing was considered to have become too expensive toordinary citizens, so stopping the housing price from skyrocketing was considered to be a good thingDespite the burst of the bubble, robust consumption and investment continued in 1991.The GDPgrowth rate remained higher than 3% in 1990 and 1991.The Japanese economy slowed down considerably in 1992. Stock prices plummeted in thesummerof1992,tothelevelof15.000 inNikke225index,losingmorethan60%ofthepeakvalueintwo and half years.The quarter-to-quarter GDP growth rate became negative in the spring-summerof1992.Lending to the real estate sectorfrom banks slowed down after1991 due toregulation,butthere was a loophole. Lending via nonblank financial institutions (such as leasing companies)continued and total lending to the real estate, construction,and nonbank sectors remained high untilthe mid-199Os.Nonperforming loans,due to nonpayment of interestby real estatecompanies.6

6 inflation with a stable CPI inflation rate as will be seen in the general discussion in Section 2.3. However, the dilemma of the monetary policy at the time was that CPI inflation was indicating low inflation, mainly due to a sharp yen appreciation, from 260 yen/dollar in February 1985 to 150 yen/dollar in the summer of 1986, and to 120 yen/dollar in December 1987. When the CPI inflation rate is about 0.5% while the stock and land prices are increasing at 30% annually, what should monetary policy do? The low inflation rate, which is below typical inflation targets of around 2%, might suggest there is room for monetary easing, while stopping the asset price inflation requires tighter monetary policy. There seems to be dilemma for monetary policy. There is a fundamental law in (linear model) economics that there should be at least two policy instruments to pursue two policy objectives. No perfect solution for the interest rate policy can be obtained to pursue both CPI price stability and asset price stability. Assessment of monetary policy in Japan in 1987 and 1986 is difficult. Could one justify the monetary policy that lowered the discount rate to 2.5% in February 1987 and maintained it at 2.5%, then the record low, until May 1989? One may argue that the Bank of Japan should have applied tight monetary policy in 1987 in order to curb asset price inflation. But, it would have been difficult to justify the action given the low CPI inflation rate, the slow economic recovery from the yen-appreciation recession of 1986, and the aftermath of Black Monday in October 1987. We are not confident that preventing asset price inflation was an overriding priority of the central bank in 1987. On the other hand, the tradeoff had disappeared in 1988 when both CPI price forecasts and asset price movements now indicated that at least modest tightening would have been justifiable. The BOJ was probably behind the curve in 1988. 2.2. Bubble Overkill? In the beginning of the asset price decline, public opinion was favorable toward monetary and regulatory policy to stop the bubble. Housing was considered to have become too expensive to ordinary citizens, so stopping the housing price from skyrocketing was considered to be a good thing. Despite the burst of the bubble, robust consumption and investment continued in 1991. The GDP growth rate remained higher than 3% in 1990 and 1991. The Japanese economy slowed down considerably in 1992. Stock prices plummeted in the summer of 1992, to the level of 15,000 in Nikke 225 index, losing more than 60% of the peak value in two and half years. The quarter-to-quarter GDP growth rate became negative in the spring-summer of 1992. Lending to the real estate sector from banks slowed down after 1991 due to regulation, but there was a loophole. Lending via nonblank financial institutions (such as leasing companies) continued and total lending to the real estate, construction, and nonbank sectors remained high until the mid-1990s. Nonperforming loans, due to nonpayment of interest by real estate companies

became a popular topic of business discussion, but was not yet showing up in any banking statistics inthe first half of the 1990s.Thediscountratewasloweredto5.5%inJuly1991,to5%inNovember1991,to4.5%inDecember1991.The decline of the official discount rate continued in 1992and 1993.A fiscalstimulus package was introduced in 1992 in response to the weakening economy.This was thebeginning of a series of fiscal stimulus packages.Theeconomywas stagnantfrom1992to1994,withthegrowthratebelow1.2percent,threeyears in a row. Land prices continued to decline steadily. The CPI inflation rate declined from justabove 2 percent in the beginning of 1992 to 0 percent by mid-1995.Monetary policy was relaxed in1992and1993in responseto weakeningof theeconomy.TheODRwaslowered from4.5%to3.75%in April 1992, to 3.25% in July 1992, to 2.5% in February 1993, and to 1.75% in September 1993.There was no change intheODR in1994,but it was lowered to1%inApril1995,andfinallyto0.5%inSeptember1995.The question from the viewpoint of preventing deflation is whether the pace of the interestratecutfrom1992to1995was quick enough.Thefact that the economy continued to be stagnantandthe inflation rate dropped to 0% suggested that the Bank of Japan might have underestimateddeflationary forces.Duringtheperiod1992to1995,thenonperformingloansproblembecameworseandworse.Many construction and real estate companies were virtuallybankrupt, since the market value of realestate in inventory had become much lower than their purchase values, and cash flows were dwindling.As a result, these companies were having trouble making interest payments on their bank loans.However, thebanks,fearing that losses would become apparent and having a falsebeliefthe real estatemarket would rebound soon,kept lending to these companies that could not service theirdebt-apractice that became known as “ever-greening." The balance sheet of corporations and banks werequickly deteriorating.Smaller financial institutions-housing loan companies, credit unions, one regionalbank-failed in 1995.The banking problem was worsening,but no serious policy was introduced toaddress the problem. Since the seriousness was hidden behind murky accounting rules and a lenientbank supervisor (the Ministry of Finance),the public was not informed of the magnitude of theproblem or a coming crisis.Since the public and politicians were not alarmed, there was littlesympathy toward any suggestions for fiscal injections to recapitalize the banks.Many economists called for introducing prompt corrective action for weak institutions andfiscal injection, if necessary,for either closing institutions or rehabilitating them.But,fiscal injectionwas politicallydifficult.Instead, in 1995, the Ministry of Finance,on the one hand guaranteed alldeposits, suspending the deposit insurance ceiling, and on the other hand declared that no major bankwould fail.7

7 became a popular topic of business discussion, but was not yet showing up in any banking statistics in the first half of the 1990s. The discount rate was lowered to 5.5% in July 1991, to 5% in November 1991, to 4.5% in December 1991. The decline of the official discount rate continued in 1992 and 1993. A fiscal stimulus package was introduced in 1992 in response to the weakening economy. This was the beginning of a series of fiscal stimulus packages. The economy was stagnant from 1992 to 1994, with the growth rate below 1.2 percent, three years in a row. Land prices continued to decline steadily. The CPI inflation rate declined from just above 2 percent in the beginning of 1992 to 0 percent by mid-1995. Monetary policy was relaxed in 1992 and 1993 in response to weakening of the economy. The ODR was lowered from 4.5% to 3.75% in April 1992, to 3.25% in July 1992, to 2.5% in February 1993, and to 1.75% in September 1993. There was no change in the ODR in 1994, but it was lowered to 1% in April 1995, and finally to 0.5% in September 1995. The question from the viewpoint of preventing deflation is whether the pace of the interest rate cut from 1992 to 1995 was quick enough. The fact that the economy continued to be stagnant and the inflation rate dropped to 0% suggested that the Bank of Japan might have underestimated deflationary forces. During the period 1992 to 1995, the nonperforming loans problem became worse and worse. Many construction and real estate companies were virtually bankrupt, since the market value of real estate in inventory had become much lower than their purchase values, and cash flows were dwindling. As a result, these companies were having trouble making interest payments on their bank loans. However, the banks, fearing that losses would become apparent and having a false belief the real estate market would rebound soon, kept lending to these companies that could not service their debt—a practice that became known as “ever-greening.” The balance sheet of corporations and banks were quickly deteriorating. Smaller financial institutions—housing loan companies, credit unions, one regional bank—failed in 1995. The banking problem was worsening, but no serious policy was introduced to address the problem. Since the seriousness was hidden behind murky accounting rules and a lenient bank supervisor (the Ministry of Finance), the public was not informed of the magnitude of the problem or a coming crisis. Since the public and politicians were not alarmed, there was little sympathy toward any suggestions for fiscal injections to recapitalize the banks. Many economists called for introducing prompt corrective action for weak institutions and fiscal injection, if necessary, for either closing institutions or rehabilitating them. But, fiscal injection was politically difficult. Instead, in 1995, the Ministry of Finance, on the one hand guaranteed all deposits, suspending the deposit insurance ceiling, and on the other hand declared that no major bank would fail

In spite of a weak economy, the exchange rate was appreciating from 1993 to 1995.Theexchange rate appreciatedfrom100 yen/dollar to 80 yen/dollar in the spring of 1995, with no apparentmacro-fundamental reasons for such a sudden move.The exchange rate appreciation dampened anexpectation of early recovery and contributed to disinflation and then deflation.The economy started to grow in the second half of 1995,and theyear1996turned out tobea good one, with the growth rate exceeding 3 %. The yen depreciated to a level above 110 yen/dollar,providingadditional support for a recovery.Afragileeconomic recovery of 1996 accelerated in thefirst quarter of 1997, as the pre-announced consumption tax rate increase of April 1997 inducedconsumers to accelerate big-ticket consumption.In April 1997,the consumption tax rate was raisedfrom3%to5%,and thetemporaryspecial income taxcut was allowedto expire,bothasplanned.Thegrowth rate significantly slowed down in the second half of 1997.This was the result of the Asiancurrency crisis, and the banking crisis of the Japanese economy in November.The economycontinued to deteriorate in 1998:the year 1998 recorded negative growth for the first time since1976.From1997to1998, Japanese financial markets sufferedfrom a severe crisis, as banks werelosing capital dueto high ratios of nonperforming loans andfalling asset prices.Three largebanks—Hokkaido Takushoku, Long-term Credit, and Nippon Credit—failed, and other banks werealso sufferingfrom declining capital.Banks were curtailing lending anda severe credit crunch wasobserved.The resulting negative effects on aggregate demand then pushed the economy into deflation.The government finally decided to inject capital into the banks.The first capital injectionin March 1998 turned out to be insufficient but the second capital injection of March 1999 finallycalmed themarket.Ito and Harada(2000)showed thatthe Japan premium-a riskpremiumdemandedbywesternbanksuponJapanesebanksfor interbanklending/borowing-disappearedafterMarch 1999.2.3.AssetPrices andmonetarypolicyInretrospectof1985-2003,thereareseveralquestionson whattheBank of Japan shouldorcould havedone.The first question is whethertheBank of Japan should have prevented thebubble.If all thetrouble of the 199Os originates from the bubble,stronger actions should have been taken against theasset price increases. This question relates to a new debate over the objective of central banks.Someresearchers, more than others, think that asset prices should be considered as a part of price stabilitythat is the sole objective of many independent central banks. Cecchetti, et al (2000) argued strongly toput asset prices as direct measure of the goal of monetary policy.6 Afew conference volumes dedicated to this question have been published,seefor example,Hunter.WilliamC.; George G.Kaufman,and Michael Pomerleano,(2003)and Richards,Anthony and TimRobinson (2003).8

8 In spite of a weak economy, the exchange rate was appreciating from 1993 to 1995. The exchange rate appreciated from 100 yen/dollar to 80 yen/dollar in the spring of 1995, with no apparent macro-fundamental reasons for such a sudden move. The exchange rate appreciation dampened an expectation of early recovery and contributed to disinflation and then deflation. The economy started to grow in the second half of 1995, and the year 1996 turned out to be a good one, with the growth rate exceeding 3 %. The yen depreciated to a level above 110 yen/dollar, providing additional support for a recovery. A fragile economic recovery of 1996 accelerated in the first quarter of 1997, as the pre-announced consumption tax rate increase of April 1997 induced consumers to accelerate big-ticket consumption. In April 1997, the consumption tax rate was raised from 3% to 5%, and the temporary special income tax cut was allowed to expire, both as planned. The growth rate significantly slowed down in the second half of 1997. This was the result of the Asian currency crisis, and the banking crisis of the Japanese economy in November. The economy continued to deteriorate in 1998: the year 1998 recorded negative growth for the first time since 1976. From 1997 to 1998, Japanese financial markets suffered from a severe crisis, as banks were losing capital due to high ratios of nonperforming loans and falling asset prices. Three large banks—Hokkaido Takushoku, Long-term Credit, and Nippon Credit—failed, and other banks were also suffering from declining capital. Banks were curtailing lending and a severe credit crunch was observed. The resulting negative effects on aggregate demand then pushed the economy into deflation. The government finally decided to inject capital into the banks. The first capital injection in March 1998 turned out to be insufficient but the second capital injection of March 1999 finally calmed the market. Ito and Harada (2000) showed that the Japan premium—a risk premium demanded by western banks upon Japanese banks for interbank lending/borrowing—disappeared after March 1999. 2.3. Asset Prices and monetary policy In retrospect of 1985-2003, there are several questions on what the Bank ofJapan should or could have done. The first question is whether the Bank of Japan should have prevented the bubble. If all the trouble of the 1990s originates from the bubble, stronger actions should have been taken against the asset price increases. This question relates to a new debate over the objective of central banks. 6 Some researchers, more than others, think that asset prices should be considered as a part of price stability that is the sole objective of many independent central banks. Cecchetti, et al (2000) argued strongly to put asset prices as direct measure of the goal of monetary policy. 6 A few conference volumes dedicated to this question have been published, see for example, Hunter, William C.; George G. Kaufman, and Michael Pomerleano, (2003) and Richards, Anthony and Tim Robinson (2003)

Bernanke and Gertler (1999) examined monetary policy in the presence of asset pricebubbles,with application to Japan.Theybuilt a model with an exogenous assetpricebubble,and thenapply alternative monetary policy rules.Then estimated reaction functions for the FED and BOJ.They applied the Clarida, Gali, and Gertler (1998) model to estimate reaction functions for the FederalReserve and the Bank of Japan.The model assumes rational expectation for estimating expectedinflation rate that is used to calculate the inflation rate gap.Their results indicate that the Japanesepolicywas tootightfrom1985to1988and toolaxfrom1988to1990,fuelinga stockbubble,andtootight, again, from 1992 until at least 1996. They argue that even without explicitly targeting the assetprices, the Bank of Japan should have tightened from 1998 to 1990, probably ending the bubble, muchearlier.Okina and Shiratsuka (2002)criticized Bernanke and Gertler (1999) on the grounds thatBerkanke and Gertler used a forward-looking inflation rate as expected inflation,but the inflation ratethey used was not adjusted for consumption tax rate changes. Okina and Shiratsuka argued that therapid increase of interest rate derived from the policy rule of Bernake and Gertler mainly resulted fromthe introduction of theconsumption tax in April 1989.Thepaper by Okina,Shirakawa, andShiratsuka (2001)contains a good review of why thebubble happened,howtheBOJreacted,and whatcould have been done, from the angle of the central bank. In section IV "Did the BO's MonetaryPolicyCreate the Bubble?,"the authors take the view that theBOJ lowered the interest rate from1986to 1987 to support the"policy coordination" framework, and to prevent the appreciation of the yen.Then paper then reviews the policy in 1988 and 1989.There are many criticisms of the view that the central bank should pay special attention toasset prices beyond their effects on CPI. See, for example, Mishkin (2001) and Mishkin and White(2003).Ito (2003)emphasizes therole of bank supervision,ratherthan monetary policy,forpreventing a bubble or managing a burst bubble.The difficulty in using monetarypolicy (raising and lowering of the interest rate)alonetoprevent a bubblecanbe summarizedasfollows.First,the central bankoften would notknow whetherasset prices are rising due to fundamentals or due to a bubble.Second, when the bubble is in force, itwould take very high interest rate to pop the bubble, and that would throw real variables into volatilefluctuations.Those skeptics emphasize the importance of supervision policy rather than monetarypolicy to maintain financial stability.Given that a bubble is created, the effects from the bursting of the bubble could bemoderated by monetary policy.The question is whether the Bank of Japan was behind the curve from1992 to1995.TheBankof Japanmay have been to slow to ease,possiblyforfear ofrekindling abubble.Similarly,theBankmayhavewaited toolongto adopt theZiRP,possiblybecauseit was anunprecedented move. Would policy have been better if the Bank adopted the ZIRP earlier thanFebruary1999?9

9 Bernanke and Gertler (1999) examined monetary policy in the presence of asset price bubbles, with application to Japan. They built a model with an exogenous asset price bubble, and then apply alternative monetary policy rules. Then estimated reaction functions for the FED and BOJ. They applied the Clarida, Gali, and Gertler (1998) model to estimate reaction functionsfor the Federal Reserve and the Bank of Japan. The model assumes rational expectation for estimating expected inflation rate that is used to calculate the inflation rate gap. Their results indicate that the Japanese policy was too tight from 1985 to 1988 and too lax from 1988 to 1990, fueling a stock bubble, and too tight, again, from 1992 until at least 1996. They argue that even without explicitly targeting the asset prices, the Bank of Japan should have tightened from 1998 to 1990, probably ending the bubble, much earlier. Okina and Shiratsuka (2002) criticized Bernanke and Gertler (1999) on the grounds that Berkanke and Gertler used a forward-looking inflation rate as expected inflation, but the inflation rate they used was not adjusted for consumption tax rate changes. Okina and Shiratsuka argued that the rapid increase of interest rate derived from the policy rule of Bernake and Gertler mainly resulted from the introduction of the consumption tax in April 1989. The paper by Okina, Shirakawa, and Shiratsuka (2001) contains a good review of why the bubble happened, how the BOJ reacted, and what could have been done, from the angle of the central bank. In section IV “Did the BOJ’s Monetary Policy Create the Bubble?,” the authors take the view that the BOJ lowered the interest rate from 1986 to 1987 to support the “policy coordination” framework, and to prevent the appreciation of the yen. Then paper then reviews the policy in 1988 and 1989. There are many criticisms of the view that the central bank should pay special attention to asset prices beyond their effects on CPI. See, for example, Mishkin (2001) and Mishkin and White (2003). Ito (2003) emphasizes the role of bank supervision, rather than monetary policy, for preventing a bubble or managing a burst bubble. The difficulty in using monetary policy (raising and lowering of the interest rate) alone to prevent a bubble can be summarized as follows. First, the central bank often would not know whether asset prices are rising due to fundamentals or due to a bubble. Second, when the bubble is in force, it would take very high interest rate to pop the bubble, and that would throw real variables into volatile fluctuations. Those skeptics emphasize the importance of supervision policy rather than monetary policy to maintain financial stability. Given that a bubble is created, the effects from the bursting of the bubble could be moderated by monetary policy. The question is whether the Bank ofJapan was behind the curve from 1992 to 1995. The Bank of Japan may have been to slow to ease, possibly for fear of rekindling a bubble. Similarly, the Bank may have waited too long to adopt the ZIRP, possibly because it was an unprecedented move. Would policy have been better if the Bank adopted the ZIRP earlier than February 1999?

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