Abstract
Selected Issues
Twenty Years of Independence: Lessons and Way Forward for the Bank of Japan1
The Bank of Japan has used unconventional monetary policies (UMPs) to fight deflation and stabilize the financial system since its independence in the late 1990s. While the BoJ’s reflation efforts have evolved over time, inflation has remained stubbornly low. The purpose of this chapter is to examine monetary policy in Japan over the past twenty years, in order to draw relevant lessons and propose ways to strengthen the Bank of Japan’s policy framework. In doing so the analysis focuses on three aspects of monetary policy: (i) objectives and goals, (ii) policy strategies, and (Hi) the communication framework.
A. Evolution of the Bank of Japan’s Policy Objectives and Goal
1. In the late 1990s, the central bank law was revised to give the Bank of Japan (BoJ) greater independence and clarify its policy objectives. Following the collapse of Japan’s asset price bubble in the early 1990s, two important lessons emerged: (i) stable and low inflation was not sufficient to ensure financial stability and soundness of the national economy, and (ii) the BoJ needed greater independence from the government to secure credibility with the public and financial markets. Consequently, a new central bank law was adopted in 1998, separating the BoJ from the Ministry of Finance and providing the legal underpinning for a broad-based policy approach with explicit policy objectives to (i) achieve price stability and (ii) contribute to the stability of the financial system.2 3
Japan: Asset and Consumer Prices, 1987–1999
(Index=100, 1987)
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
Source: Haver Analytics.2. The importance of the BoJ’s price stability objective has increased over time along with greater goal transparency. While the revised Bank of Japan Act (1998) specified the BoJ’s policy objectives, it gave the Bank autonomy to determine their relative importance and to set specific policy goals.
Relative weight on policy objectives. During 2000–06, financial and price stability issues were front and center for the BoJ. Non-performing loans weighed on financial intermediation while deflation became more pronounced. Over time, however, as financial vulnerabilities became less prevalent and the urgency to reflate the economy more pressing, the price stability objective grew in importance. This was particularly true following the government’s introduction of Abenomics in 2012 (see text figure) which put forth an ambitious policy agenda to raise growth and exit deflation.
Goal transparency. Despite early discussions about adopting an explicit inflation target, the exact definition of “price stability” remained vague following BoJ’s independence. Fearing that a numerical inflation goal would reduce policy flexibility, the BoJ broadly defined price stability as a situation that was “neither deflationary nor inflationary.”4 However, in 2006—as part of a new monetary policy strategy—the BoJ saw the need for greater clarity regarding its price stability target. Consequently, the BoJ Board decided to disclose that individual Board members’ understanding of medium to long-term price stability ranged between 0 and 2 percent with a median of around 1 percent. Six year later, shortly after the U.S. Federal Reserve announced a 2 percent inflation goal, the BoJ adopted a single numerical inflation goal of 1 percent to help clarify its policy stance. Importantly, the new price stability goal was not tied to the views of Board members but to that of the institution. Finally, a year later—with the introduction of Abenomics and in line with other major central banks— the 1 percent goal was replaced by a 2 percent inflation target.5 Hence, it took the BoJ almost 15 years before adopting a clear and transparent goal for its price stability objective (Figure 1).
Japan: Inflation and GDP Growth, 1998–2019
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
Source: Haver Analytics.Japan: The BoJ’s Price Stability Target and the Public’s Awareness of the Price Stability Objective relative to Financial Stability Objective1
(Index Dec 2005=100)
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
1 The measure is calculated as the ratio between the share of respondents saying they have knowledge of the price objective to the share of respondents saying they have knowledge of the financial stability objective Source: Bank of Japan; Opinion Survey on the General Publics Mindset and Behavior.B. Unconventional Strategies to Reflate the Economy
3. Shortly after independence, the BoJ adopted UMPs to exit deflation and safeguard financial stability. In the late 1990s and early 2000s the Japanese economy was facing slowing demand, declining consumer prices, and financial instability due to a confluence of factors, including the 1997 consumption tax hike, a domestic banking crisis, and the Asian Financial Crisis (see Figure 1 and 2). With the policy rate close to the zero-lower bound (ZLB), the BoJ embarked on a number of unconventional policy measures.
Zero Interest Rate Policy (ZIRP). In February 1999, the BoJ lowered the policy rate “as low as possible” and later added that ZIRP would continue until deflationary concerns subsided. However, by August 2000, the BoJ judged that current economic conditions had improved enough to exit ZIRP and raised the overnight call rate into positive territory. This normalization effort, however, occurred despite a slightly unfavorable outlook (see text figure).
Quantitative Easing Policy (QEP). The economy weakened substantially in early 2001 and the BoJ decided to re-instate ZIRP and reinforce it with QEP. The new policy strategy entailed a change in policy instrument—from the short-term rate to quantity of reserves—and purchases of long-term JGBs to increase the monetary base. To convince markets that the policy would be maintained, the Board committed to maintain ZIRP until core inflation became stably above zero or recorded an increase year on year.6
Measures to ensure financial stability. Financial system stress occurred several times during this period, causing liquidity and risk premia to rise. Apart from the liquidity support through QEP, the BoJ also took specific steps to target pockets of financial vulnerability, including widening the range of acceptable collateral for its fund providing operations and allowing banks to sell stocks directly to the BoJ.7
Japan: Monetary Policy Operations, 1998–2019
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
Source: Haver Analytics.Japan: BoJ: Forecasts when Exiting ZIRP in August 2000
(In percent)
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
Sources: BoJNote: The March 2001 forecasts were published in October 2000. The intervals around the forecasts indicate the range of Board members’ forecasts4. In 2006, the BoJ started to normalize policy as economic conditions improved. In early 2006, economic growth had recovered, inflation was rising, and financial and corporate sectors were in the best shape in over a decade.8 Moreover, the legacy problem of non-performing loans, which had hampered financial intermediation, was largely resolved. Hence, in March 2006 the BoJ judged that the conditions for exiting QEP had been met and re-introduced the overnight interest rate as the main policy tool. However, similar to the 2000 episode, the BoJ’s economic forecast published around the time of the decision did not seem to indicate a strong case for normalization.9
5. The BoJ also introduced a new monetary policy framework to improve policy predictability while preserving flexibility The framework consisted of two components. First, the BoJ Board members decided to disclose their “understanding” of price stability (ranging from 0 to 2 percent). Second, policy decisions were to be guided by a “two perspective” approach. The first perspective entailed an assessment of whether the near-term outlook (1–2 years) followed a path of sustainable growth under price stability. The second perspective was to examine various risks to the outlook over the longer term, including financial stability risks.
6. The BoJ was relatively slow in returning to UMPs following the Global Financial Crisis (GFC). In the summer of 2008, the GFC significantly depressed economic activity and caused a sharp drop in inflation (Figure 1). The overnight rate was again lowered to the ZLB and number of measures were taken to strengthen financial institutions and market functioning.10 However, it was not until October 2010 that the BoJ reverted back to quantitative easing by introducing its Comprehensive Monetary Easing (CE) framework. The CE framework re-introduced ZIRP together with an asset purchase program consisting not only of JGB purchases, but also risky assets to reduce term and risk premia.11 However, compared to the U.S. Federal Reserve and the European Central Bank (ECB), the BoJ’s response to the GFC was more protracted and smaller in size (see text figure).
Size of Balance Sheet: BoJ, ECB and U.S. Federal Reserve
(index=100; August 2008)
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
Source: FRED7. In 2013, the BoJ scaled up its quantitative easing program to quickly boost inflation expectations and achieve the new two percent price stability target. The policy shift occurred in the context of Abenomics—a coordinated policy effort by the BoJ and the government to (i) achieve the new two percent inflation target, (ii) boost potential growth and increase competitiveness, and (ii) ensure long-run debt sustainability.
Quantitative and Qualitative Easing (QQE). In April 2013, just a few months after raising the price stability target to 2 percent, the BoJ introduced QQE—a significant scale-up of CE—consisting of a sharp increase in purchases of JGBs and risky assets. Under QQE, the BoJ explicitly committed to increase its annual purchase JGBs holdings by about ¥50 trillion per year. The new program signaled a determined effort by the BoJ to back up its commitment to the higher inflation target through strong and transparent actions. The new strategy appeared initially successful. Inflation rose, the exchange rate depreciated, and growth picked up. However, economic conditions started to deteriorate in the second half of 2014 as a fall in oil prices and weak demand following the consumption tax rate hike in April 2014 exerted downward pressure on inflation and growth.12
Negative Interest Rate Policy (NIRP). Despite the scale-up of QQE, domestic growth weakened further in 2015, and inflation continued to fall (Figure 1). Moreover, concerns were emerging that the BoJ would soon run out of JGBs to purchase and that options to further stimulate the economy were limited. To dispel these concerns, the BoJ surprised market participant in early 2016 by lowering the interest rate on excess reserves into negative territory. The intention was to put downward pressure on short-term interest rates and raise inflation expectations by re-confirming the Bank’s commitment to achieving the inflation target. However, the impact on yields was larger than anticipated, leading to a significant flattening of the yield curve (see text figure). The large compression of term spreads triggered worries about financial sector side-effects (i.e., increased risk taking and further decline in profitability of financial institutions).
Japan: Flattening of the Yield Curve Following NIRP
(In Percent)
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
Source: Haver Analytics.8. In 2016, the BoJ changed policy strategy again amid concerns about financial side-effects and persistently-low inflation expectations. With actual and expected inflation still below target more than three years after the introduction of QQE, the BoJ launched a comprehensive review of its monetary policy framework. The review was published in September 2016 and concluded that (i) the lowering of real interest rates along the yield curve had been the most effective tool to stimulate economic activity, and (ii) inflation expectations had proven to be more backward-looking than previously thought. Based on these observations the BoJ changed strategy.
Digging in for the long-run. Instead of aiming for a quick reflation, the BoJ switched to a more protracted reflation approach that was more compatible with the adaptive nature of Japanese inflation expectations. Specifically, by generating a persistent positive output gap through sustained accommodative policy, realized inflation would gradually rise and eventually re-anchor inflation expectations at the two percent target. However, this prolonged “high-pressure” strategy would need to be complemented by measures to mitigate financial side-effects and ensure policy sustainability.
The Yield Curve Control (YCC) framework. To support the new reflation strategy, the BoJ implemented a new operational framework. The purpose of YCC was to shape the yield curve by targeting both the short-term interest rate (NIRP) and the long-term interest rate (10-year JGB yield). By buying JGBs along the entire yield curve, the BoJ would be able to prevent the long end of the curve from falling while keeping the short end unchanged. This would make monetary accommodation more sustainable since lending rates are benchmarked to short- to medium-term interest rates, while the profitability of financial institutions such as pension funds and insurers is influenced by long-term term spreads.13 Moreover, the YCC would allow the BoJ to reduce JGB purchases and hence address concerns that it was running out of JGBs to buy.
9. While macroeconomic outcomes have somewhat improved under YCC, actual and expected inflation remain below the inflation target and financial side-effects continue to accumulate. Economic growth has average above potential since 2016 and core inflation appears to have stabilized at slightly below one percent. Moreover, the yield curve has steepened compared to the levels seen right before the implementation of YCC, and the BoJ’s purchases of JGBs have fallen markedly. However, little progress has been made in terms of permanently lifting inflation expectations. Moreover, low bank profitability and search for yield by financial institutions still pose a significant risk to financial stability over the medium-term.
C. Communication Strategies and Inflation Expectations
10. Pre-Abenomics, unconventional monetary policy communication focused on exploring the so-called “duration effect.” The duration effect was intended to influence market expectations about the future course of monetary policy, and hence stabilize interest rates at a low level and lift inflation expectations.14 Initially, under QEP, the BoJ communicated that monetary easing would “continue until the CPI (excluding perishables) registers stably a zero percent or an increase year on year.”15 While this commitment reduced uncertainty about the policy rate and laid out relatively clear exit conditions, it was largely backward looking and did not tie policy to a price stability target. This was somewhat reversed with the introduction of the “two-perspective approach” in 2006 which anchored policy guidance in a medium-term numerical “understanding” of price stability. For instance, when introducing CE in 2010, the BoJ stated that it would “maintain the virtually zero interest rate policy until price stability is in sight on the basis of the “understanding of medium- to long-term price stability.” While this guidance was better tied to the price stability objective and hence more forward looking, it was more ambiguous regarding exit conditions.
11. The BoJ’s communication strategy changed drastically with the introduction of the two percent inflation target. The new communication strategy focused on quickly re-anchoring inflation expectations at the higher price stability target. First, by promising to achieve the price stability target “at the earliest possible time, with a time horizon of about two years,“ the BoJ deviated from its previous position that price stability should be pursued over the medium to long-term.16 Second, the time-dependent guidance indirectly implied an almost unconditional commitment to price stability, effectively deprioritizing other objectives. Third, by committing to the massive increase in JGB purchases, the BoJ showed that it was willing to back up its verbal commitment to the inflation target with strong and transparent policy actions.
Japan: Annual Change in the BoJ’s JGB Holdings, 2010–19
(Trillion Yen)
Citation: IMF Staff Country Reports 2020, 040; 10.5089/9781513529424.002.A004
Source: Haver Analytics.12. The 2016 shift to a gradual reflation approach under YCC required the BoJ to once again adjust its communication strategy. In line with the new gradual reflation approach under YCC, the time horizon for achieving the inflation target was gradually de-emphasized. Moreover, BoJ Board members began to acknowledge financial side-effects more prominently, while arguing that the new framework was more flexible and sustainable. In addition to YCC, the BoJ also tried to make inflation expectations more forward-looking by committing to expand the monetary base until the inflation target was achieved (e.g., the so-called overshooting commitment). Policy guidance, however, became more complicated. Despite switching operationally from quantity to interest rate targeting under YCC, the BoJ was reluctant to abandon its quantitative guidance on JGB purchases. This has resulted in a growing discrepancy between the quantity guidance and actual JGB purchases (see text figure).
13. In 2018, speculation of a premature normalization prompted the BoJ to introduce explicit forward guidance on policy rates. In response to upward pressure on the 10-year JGB yield in the summer of 2018, the BoJ (i) increased the variability range around the zero percent yield target and (ii) strengthened its commitment to achieving 2 percent inflation by introducing forward guidance for policy rates. Initially, the forward guidance was time-dependent to ensure that rates would remain low beyond the implementation of the scheduled October 2019 consumption tax rate increase. However, in the fall of 2019, the BoJ shifted to a more state-based guidance by committing to keep short- and long-term interest rates low “as long as it is necessary to pay close attention to the possibility that the momentum toward achieving the price stability target will be lost.”
D. Lessons Learned and Way Forward
14. Based on the BoJ’s twenty years of reflation experience, there are a number of measures that could be taken to strengthen the overall monetary policy framework. In particular, the BoJ could: (i) clarify its commitment to the inflation target while increasing policy flexibility to address competing objectives, (ii) improve the internal decision-making process, and (iii) simplify and strengthen its communication framework.
Policy Objectives and Goals
15. The lack of stability and clarity of policy objectives have complicated policy implementation and hampered reflation efforts. During the early years, the relatively large weight on the financial stability objective combined with the absence of a clear price stability target may have contributed to insufficient monetary stimulus and a bias towards premature policy normalization (e.g., the 2000 and 2006 episodes). On the other hand, the large relative weight on price stability combined with an over-optimism to achieve the inflation target during the QQE/NIRP/YCC period has likely negatively impacted policy credibility and contributed to keeping inflation expectations persistently low. In particular, the emphasis on achieving the price stability target “as soon as possible” together with unrealistic inflation forecasts have been particularly problematic given limited policy space, a clogged monetary transmission, and rising financial stability costs. Finding the right balance between the price and financial stability objectives and setting realistic conditions for achieving the inflation target is key to improve policy credibility and better anchor long-run inflation expectations.
16. The BoJ should consider strengthening and clarifying its commitment to the target while increasing policy flexibility to address financial stability concerns. Specifically, the BoJ could announce a comprehensive review of its price stability objective—similar to the reviews conducted in 2000, 2006, and 2013. The review would allow the BoJ to:
Re-confirm or re-evaluate the inflation level viewed as consistent with price stability. Moreover, the BoJ should clarify that the price stability target will be achieved over the medium- to long-term. This would help dispel a lingering perception that the BoJ is trying to achieve the two percent target as soon as possible regardless of the short-term costs.
Introduce a range around the inflation target. This would enable a more gradual reflation process that is more consistent with realistic inflation projections while also providing more flexibility to credibly address financial side-effects.
Better communicate its views on the trade-offs between financial stability and price stability objectives. The BoJ should clarify that it is not excessively focused on inflation, but that other objectives, including financial stability, also matter for monetary policy. This would help avoid speculation of premature normalization and a loss of credibility when financial stability costs rise.
17. The re-evaluation of the inflation target and introduction of greater policy flexibility would need to be carefully communicated. A target range and a longer time horizon would allow the BoJ to more effectively take into account (i) downward pressure on inflation from structural forces, (ii) limited available policy space, and (iii) financial sector side-effects. However, these adjustments could be interpreted as a reduced commitment to the inflation target and hence depress inflation expectations. It is therefore crucial to communicate these adjustments in a careful and systematic manner. For instance, an announcement of a comprehensive review of the price stability objective would allow the BoJ to clearly lay out the underlying motivation and rationale for the changes. Indeed, the BoJ could replicate the communication strategy of the YCC, which successfully allowed the Bank to reduce JGB purchases without triggering policy normalization concerns. Moreover, the BoJ could point out that introducing a target range and a longer time horizon is largely consistent with the practice of other major central banks. Indeed, as shown in Table 1, several major central banks specify a tolerance range around their inflation target while emphasizing the medium- to long-term nature of the target horizon.
Japan: Monetary and Financial Stability Objectives and Goals of Selected Central Banks
Japan: Monetary and Financial Stability Objectives and Goals of Selected Central Banks
| Central Bank | Monetary Policy | Financial Stability Objective | Macroprudential Policy Responsibility | ||
|---|---|---|---|---|---|
| Objective(s) | Target/range | Horizon | |||
| Reserve Bank of Australia (RBA) | Price stability (taking into account activity and employment levels) | 2–3 % | Medium-term average | Promote overall financial stability | Council of Financial Regulators (incl. RBA). Power resides with members. Australian Prudential Regulation Authority (APRA) is responsible for MaPP |
| Bank of Canada(BoC) | Price stability | 2%+/-1% | Six to eight quarters depending shock persistence | Fostering a stable and efficient financial system | Powers over macroprudential tools lie with the Department of Finance and OSFI. |
| Bank of England (BoE) | Price stability | 2% target; Letter to Government if outside 1–3% | None | Protect and enhance the stability of the financial system | BoE’s Financial Policy Committee (FPC) identifies, monitors and takes action to remove or reduce systemic risks. |
| Bank of Japan (BoJ) | Price stability | 2% | As soon as possible | Contribute to the maintenance of stability of the financial system | The Financial Sevices Agency is the designated regulatory and supervisory authority for all financial institutions and responsible for the implementation of macroprudential policy in Japan. The BoJ also assesses systemic risks and conduct on-site examinations and offsite |
| European Central Bank (ECB) | Price stability | Below 2 % | Medium-term | Contribute to the smooth conduct of policies pursued by competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system | Macroprudential policy is a shared competency between national authorities and the ECB. |
| Reserve Bank of New Zealand (RBNZ) | Price stability and maximum sustainable employment | 2%+/-1% | Medium-term with a focus on keeping future inflation near the 2 percent mid-point | Promote a sound and efficient financial system | RBNZ is responsible for macroprudential policy. Ministry of Finance is consulted ahead of policy decisions. |
| Riksbanken | Price stability | 2 % with a variation band of 1–3% | None | Promote stability in the financial system as a whole | Financial Stability Council (incl. Riksbanken). Powers reside with members. The Financial Supervisory Authority is responsible for MaPP |
| U.S. Federal Reserve (U.S. Fed) | Price stability and maximum employment | 2% | Long-run goal | Foster the safety and soundness of individual institutions and promote financial stability (shared with other government agencies) | Financial Stability Oversight Council (FSOC) -includes all regulatory agencies (incl the FRB). FSCO is consultative and powers reside with members. |
Japan: Monetary and Financial Stability Objectives and Goals of Selected Central Banks
| Central Bank | Monetary Policy | Financial Stability Objective | Macroprudential Policy Responsibility | ||
|---|---|---|---|---|---|
| Objective(s) | Target/range | Horizon | |||
| Reserve Bank of Australia (RBA) | Price stability (taking into account activity and employment levels) | 2–3 % | Medium-term average | Promote overall financial stability | Council of Financial Regulators (incl. RBA). Power resides with members. Australian Prudential Regulation Authority (APRA) is responsible for MaPP |
| Bank of Canada(BoC) | Price stability | 2%+/-1% | Six to eight quarters depending shock persistence | Fostering a stable and efficient financial system | Powers over macroprudential tools lie with the Department of Finance and OSFI. |
| Bank of England (BoE) | Price stability | 2% target; Letter to Government if outside 1–3% | None | Protect and enhance the stability of the financial system | BoE’s Financial Policy Committee (FPC) identifies, monitors and takes action to remove or reduce systemic risks. |
| Bank of Japan (BoJ) | Price stability | 2% | As soon as possible | Contribute to the maintenance of stability of the financial system | The Financial Sevices Agency is the designated regulatory and supervisory authority for all financial institutions and responsible for the implementation of macroprudential policy in Japan. The BoJ also assesses systemic risks and conduct on-site examinations and offsite |
| European Central Bank (ECB) | Price stability | Below 2 % | Medium-term | Contribute to the smooth conduct of policies pursued by competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system | Macroprudential policy is a shared competency between national authorities and the ECB. |
| Reserve Bank of New Zealand (RBNZ) | Price stability and maximum sustainable employment | 2%+/-1% | Medium-term with a focus on keeping future inflation near the 2 percent mid-point | Promote a sound and efficient financial system | RBNZ is responsible for macroprudential policy. Ministry of Finance is consulted ahead of policy decisions. |
| Riksbanken | Price stability | 2 % with a variation band of 1–3% | None | Promote stability in the financial system as a whole | Financial Stability Council (incl. Riksbanken). Powers reside with members. The Financial Supervisory Authority is responsible for MaPP |
| U.S. Federal Reserve (U.S. Fed) | Price stability and maximum employment | 2% | Long-run goal | Foster the safety and soundness of individual institutions and promote financial stability (shared with other government agencies) | Financial Stability Oversight Council (FSOC) -includes all regulatory agencies (incl the FRB). FSCO is consultative and powers reside with members. |
Policy Strategy and Communication
18. Policy decisions should have been more forward looking and better tied to policy goals. As argued by Governor Kuroda, the BoJ’s pre-Abenomics commitment to reflation was at times ambiguous and likely rendered monetary policy insufficient to raise inflation expectations.17 The absence of an explicit long-term price stability target in the early days may have complicated policy discussions and the ability to manage inflation expectations.18 In addition, there appears to have been a tendency to place a large weight on current instead of future economic conditions when setting policy. This is particularly problematic given that monetary policy works with a lag. Moreover, discussions during policy deliberations tend to focus on current policy settings rather than the entire future policy path. Indeed, these features of the decision-making process may partly explain the premature nature of the two normalization episodes (2000 and 2006) and the delayed response to the GFC. The “two-perspective approach” implemented in 2006 and the subsequent clarifications of the numerical value of the price stability target clearly improved matters. However, even today, it is unclear how policy decisions are systematically guided by the BoJ Board’s economic forecasts and the two percent inflation target.
19. The communication strategy under Abenomics has at times been overly ambitious, ambiguous, and complicated. The commitment to achieve the inflation target in 2013 was an improvement and stood in sharp contrast to the pre-Abenomics period. However, one potential drawback was that the commitment was likely too extreme, hence resulting in reduced policy credibility. In particular, by communicating an unrealistic target horizon and overselling the available policy space to stimulate the economy, the public gradually come to discount the BoJ’s ability to achieve the inflation target. Moreover, communication during QQE/NIRP/YCC did not adequately ensure policy predictability and probably added to policy uncertainty and ambiguity. This is perhaps best illustrated by the surprise implementation of the NIRP, and the BoJ’s reluctance to remove redundant policy guidance when changing policy framework (i.e., keeping both quantitative and interest rate guidance under YCC). Overall, there is a need for the BoJ to better explain how its policy strategy can achieve the price stability target based on current and forecast economic conditions. Indeed, anchoring long-run inflation expectations at the 2 percent target critically depends on whether the public believes that the BoJ’s policy strategy and associated actions are consistent with achieving the target.
20. Implementation of Inflation Forecast Targeting (IFT) could strengthen the policy decision process and the BoJ’s ability to manage inflation expectations. The IFT framework was originally proposed by Svensson (1997) and has since been adopted by a number of central banks.19 IFT provides an intuitive and structured approach to policy making which enables a central bank to effectively communicate its strategy and manage expectations.20 The following adjustments could be made in the case of the BoJ.
Strengthen the decision-making process. In preparation for a monetary policy meeting (MPM), BoJ staff could construct inflation and growth forecasts based on given policy rate-paths and the latest economic information.21 These forecasts and associated policy paths would then be presented to the Board members at the MPM. They would vote on which policy path best fulfills the BoJ’s mandate.22 Hence, in contrast to today’s practice, the Board’s decision would not just take into account changes to current policy tools, but also the entire future path of policy decisions.
Publish the policy path and the associated economic forecast. Following the policy decision, the policy path and corresponding economic forecast should be published in the BoJ’s Economic Outlook Report. In addition, a detailed discussion to motivate the policy path and the forecast is crucial to make them credible. The outlook report should also discuss alternative scenarios to clarify implications of selected shocks. This would help generate a better understanding of the BoJ’s approach to managing macroeconomic risks, and thus help improve policy predictability. It would also reinforce that the baseline forecast of the policy path is conditional on economic developments.
Simplify the communication strategy. To improve communication with financial markets and the public, the BoJ needs to simplify its policy guidance. Specifically, the quantity guidance on JGB purchases should be abandoned and the inflation overshooting commitment should be delinked from the monetary base. Note that if the BoJ was to publish the policy path associated with the forecast, then the forward guidance currently applied to policy rates would be redundant.
21. Inflation Forecast Targeting has been fully or partially adopted by other major central banks and would not constitute a drastic change from the BoJ’s current practices. Presently, the BoJ publishes economic projections by individual Board members that takes into account the effects of past policy decisions and financial market expectations regarding future policy. Hence, the forecasts do not incorporate the current policy decision nor the Board’s view on future policy settings. Adopting the IFT framework would imply a discontinuation of this practice in favor of publishing a staff forecast that is consistent with the Board’s view on current and future policy decisions. A commonly-voiced concern is that removing individual Board members’ projections would reduce transparency (i.e., the public can no longer observe the diversity in views). This concern could be addressed by allowing dissenting views to be reflected in the Summary of Opinions—currently published shortly after a MPM. Importantly, the guiding principles behind IFT are similar to the BoJ’s existing guidelines for conduct of monetary policy. Indeed, publishing the baseline staff forecast together with alternative risk scenarios could be viewed as a quantification of the “two-perspective approach” current employed. Finally, IFT has been adopted by a number of central banks in both emerging and advanced countries. Table 2 shows the publication policies by selected central banks regarding the baseline forecast, the associated policy path assumption, and risk assessments. Indeed, most central banks publish both the baseline forecast as well as the assumed underlying policy path.
Japan: Publication of Forecasts and Risk Assessments by Selected Central Banks
Japan: Publication of Forecasts and Risk Assessments by Selected Central Banks
| Central Bank | Publication of Forecast | Policy Path Assumption | Publication of Risk Assessment |
|---|---|---|---|
| Reserve Bank of Australia (RBA) | Staff forecast is published quarterly; No policy path assumption is published | Policy path is in line with financial markets | Uncertainty bands around forecast; Risks to the outlook discussed in detail. |
| Bank of Canada (BoC) | Staff forecast is published quarterly; No policy path assumption is published | Policy path endogenously determined within the model | Risks to outlook discussed in detail; Sometimes quantified risk assessments. |
| Bank of England (BoE) | Staff forecast is published quarterly; Policy path assumption is published | Two assumptions are used: The policy path is either (i) in line with financial markets or (ii) assumed to be constant. | Uncertainty bands around forecasts; Key judgments and risks; Occasional quantification of alternative risk scenarios. |
| Bank of Japan (BoJ) | Forecasts of individual Board members are published; No policy path is published | Policy path is in line with financial markets | General assessment of risks to the outlook. |
| European Central Bank (ECB) | Staff forecast published quarterly. Policy path assumption published | Policy path is in line with financial markets | Uncertainty bands around forecast; Quantification of alternative scenarios (e.g. oil price, and exchange rate path). |
| Reserve Bank of New Zealand (RBNZ) | Staff forecast published quarterly. Policy path assumption published | Policy path endogenously determined within the model | Key assumptions and uncertainties to the outlook; Alternative scenarios sometimes included. |
| Riksbanken | Staff forecasts published six times per year; Policy path assumption published | Policy path endogenously determined within the model | Detailed discussion of uncertainties and risks; Sometimes quantitative risk assessments and policy responses discussed. |
| U.S. Federal Reserve (U.S. Fed) | No monetary policy/inflation report; Projections by Board members published four times per year, including individual policy path projections. | Individual members pick a policy path deemed most likely to foster outcomes for economic activity and inflation that best satisfy the mandate. | The Fed does not publish a monetary policy report; No substantial risk assessment discussed in policy statement. |
Japan: Publication of Forecasts and Risk Assessments by Selected Central Banks
| Central Bank | Publication of Forecast | Policy Path Assumption | Publication of Risk Assessment |
|---|---|---|---|
| Reserve Bank of Australia (RBA) | Staff forecast is published quarterly; No policy path assumption is published | Policy path is in line with financial markets | Uncertainty bands around forecast; Risks to the outlook discussed in detail. |
| Bank of Canada (BoC) | Staff forecast is published quarterly; No policy path assumption is published | Policy path endogenously determined within the model | Risks to outlook discussed in detail; Sometimes quantified risk assessments. |
| Bank of England (BoE) | Staff forecast is published quarterly; Policy path assumption is published | Two assumptions are used: The policy path is either (i) in line with financial markets or (ii) assumed to be constant. | Uncertainty bands around forecasts; Key judgments and risks; Occasional quantification of alternative risk scenarios. |
| Bank of Japan (BoJ) | Forecasts of individual Board members are published; No policy path is published | Policy path is in line with financial markets | General assessment of risks to the outlook. |
| European Central Bank (ECB) | Staff forecast published quarterly. Policy path assumption published | Policy path is in line with financial markets | Uncertainty bands around forecast; Quantification of alternative scenarios (e.g. oil price, and exchange rate path). |
| Reserve Bank of New Zealand (RBNZ) | Staff forecast published quarterly. Policy path assumption published | Policy path endogenously determined within the model | Key assumptions and uncertainties to the outlook; Alternative scenarios sometimes included. |
| Riksbanken | Staff forecasts published six times per year; Policy path assumption published | Policy path endogenously determined within the model | Detailed discussion of uncertainties and risks; Sometimes quantitative risk assessments and policy responses discussed. |
| U.S. Federal Reserve (U.S. Fed) | No monetary policy/inflation report; Projections by Board members published four times per year, including individual policy path projections. | Individual members pick a policy path deemed most likely to foster outcomes for economic activity and inflation that best satisfy the mandate. | The Fed does not publish a monetary policy report; No substantial risk assessment discussed in policy statement. |
E. Conclusions
22. This chapter analyzes the Bank of Japan’s twenty-year effort to reflate the Japanese economy. Three main lessons can be drawn. First, the lack of stability and clarity of the BoJ’s price stability objective has complicated policy implementation and hampered reflation efforts. Second, policy decisions have not been sufficiently forward-looking and could have been better tied to policy goals. Third, the BoJ’s communication strategy has at times been overly ambitious, ambiguous, and complicated. To address these weaknesses the BoJ could consider: (i) increasing policy flexibility by introducing an inflation range around the target while emphasizing the medium-to long-term nature of achieving the price stability objective; (ii) adopting Inflation Forecast Targeting to improve policy credibility and predictability; and (iii) simplifying its policy guidance by abandoning the quantity guidance on JGB purchases and de-linking the inflation overshooting commitment from the monetary base.
References
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Prepared by Niklas Westelius (FIN).
The new Bank of Japan Act (Act No. 89 of June 1997) was enacted in 1997 by the Diet, and came into effect in April 1998.
The BoJ’s objective under the previous Bank of Japan Act (1942) was to help maximize the potential growth of the economy (Ito, 2004). The 1998 Act states that the objective for monetary policy should be “aimed at achieving price stability, thereby contributing to the sound development of the national economy” (Article 2) and that the purpose of the bank is to “[...] ensure smooth settlement of funds among banks and other financial institutions, thereby contributing to the maintenance of stability of the financial system” (Article 1).
The use of “goal” in 2012 reflected the belief that “target” might be construed as meaning rigidly conducting monetary policy with only price developments taken into account. See https://www.boj.or.jp/en/mopo/mpmscheminu/minu2013/g130122.pdf
At the time, the BoJ projected the two-year-ahead core inflation at slightly below one percent, with core inflation being positive for three consecutive months and expected to remain positive going forward. Moreover, according to the minutes from the policy meeting on March 9, 2006, many Board members judged that the output gap was only gradually narrowing, and unit labor costs were facing weakening downward pressures.
The risky asset purchases covered corporate bonds, commercial paper, exchange-traded funds (ETFs), and real estate investment trusts (REITs).
The BoJ responded to the weakening economy in October 2014 by raising the annual increase of JGB holdings from ¥50 trillion to ¥80 trillion.
See speech by Governor Kuroda (2017): https://www.boj.or.jp/en/announcements/press/koen_2017/ko171114a.htm/
As pointed out by Orphanides (2018), the lack of definition for price stability implied that BoJ Board members could use their discretion to define the inflation goal. The obvious problem with such a situation is that alternative policy goals imply different policy settings.
This discussion closely follows Svensson (2019) and Arbatli et al (2016).
While Svensson (2019) discusses an exogenous policy rate path, Clinton et al (2015) advocates for an endogenously determined policy rate path that is determined by a reaction function.
Note that while the forecast is a key input into the policy decision, the process does not exclude individual Board members from incorporating their own judgment.
