Owen F. Humpage and Michael Shenk
The Federal Open Market Committee has lowered its federal funds rate target 4.5 percentage points since August 2007. It is now at 1 percent, and financial markets expect a further substantial cut. The United States has entered a recession, and the outlook for next year seems so somber that some economists are asking if deflation—a drop in overall prices—is not a distinct possibility.
Very low interest rates and deflation are a precarious combination. At zero interest rates, open market operations are less effective than under normal circumstances because reserves and short–term Treasury bills are near perfect substitutes on banks’ balance sheets. As a result, open market operations, which substitute reserves for Treasury bills, may not spur bank lending. In addition, declining prices discourage consumption and investment spending, especially when interest rates approach zero.
Japan underwent a decade–long odyssey with deflation and the zero–bound problem. The Bank of Japan’s experience during this period offers a guide for getting back to more familiar economic turf.
Economic activity in Japan slowed precipitously following the collapse of the so–called bubble economy in December 1989, and Japan began to experience deflation by early 1995. During this initial period, while the economy was slowing, forecasters and policymakers consistently underestimated the extent of Japan’s economic malaise. Consequently, while monetary policy seemed appropriate in terms of the prevailing outlook, the loosening proved woefully inadequate in hindsight.
After a series of fairly ineffectual policy actions, the Bank of Japan undertook its famous quantitative easing policy from March 19, 2001, to March 9, 2006. Under this policy, the Bank shifted its day–to–day operating target from the overnight, call–money rate to the level of current–account balances (reserves) at banks. Over the five years that the program was in place, the Bank of Japan raised its current–account target nine times. In implementing the quantitative easing policy, the Bank of Japan also increased its outright purchases of longer-dated Japanese government securities. The objective was to flood banks with excess reserves, which, of course, would keep the call-money rate at zero.
The Bank’s previous policy, maintained between February 1999 and August 2000, had been a zero interest rate policy, but the Bank had supplied only enough reserves to keep the call–money rate at zero. Hence, the quantitative easing was a more profound and visible policy shift.
When it introduced the quantitative easing policy, the Bank of Japan also promised to maintain the policy until the core CPI either reached zero or rose on a year–over–year basis for several months. This inflation target was stronger than the Bank’s zero interest rate policy, which only promised to maintain zero interest rates until the economy showed signs of recovery. Since inflation lagged economic activity and since the Bank had a history of being hawkish on inflation, the zero interest rate policy was not a strong commitment to a positive inflation rate. In contrast, the new commitment required clear evidence that deflation had ended.
Analytically, the quantitative easing policy consisted of three distinct parts: a commitment to maintain zero interest rates until deflation clearly ended; a significant increase in the Bank of Japan’s balance sheet; and a change in the composition of the Bank’s balance sheet. Generally, empirical analysis seems to suggest that the quantitative easing policy lowered the term structure of government securities by increasing expectations that future short–term interest rates would remain near zero, but not by affecting term premia on government securities or risk premia on other assets. In addition, the quantitative easing policy eventually helped banks—and firms that depended on them for financing—by indicating that the Bank of Japan would continue to provide liquidity. This reduced uncertainty about future funding.
The connection between the quantitative easing policy and the macroeconomic recovery remains somewhat more flimsy. Most observers believe that because the quantitative easing policy aided the banking sector, economic activity at least did not deteriorate further. The pace of economic activity did pick up, with contributions from consumer spending and investment, but exports, which benefited from growth among Japan’s trading partners, spurred much of the improvement. Although deflation ended in 2006, along with the quantitative easing policy, it returned after a very short hiatus in 2007, and continued until the recent commodity price boom.
The Japanese experience suggests that when inflation and short–term interest rates approach zero, central banks should act aggressively, giving greater than normal weight to downside risks. Moreover, they should commit to an inflation target and clearly explain their actions in terms of that target.
http://www.clevelandfed.org/research/trends/2008/1208/01intmar.cfm
