A farewell to zeroTOKYO - The countdown has begun to the Japanese central bank's exit from years of ultra-loose, near-zero-interest-rate monetary policy, amid growing signs of a recovery taking root and chronic deflation finally releasing its grip on the world's second-largest economy.
The Bank of Japan's departure from its so-called "quantitative easing" policy, possibly as early as next week and probably by the end of April at the latest, is widely seen as a foregone conclusion. So the biggest questions now are: Exactly when will the BOJ make the move? And what will come next?
BOJ governor Toshihiko Fukui has suggested for a while that the end to the quantitative easing policy is coming soon. In his strongest signal to that effect, Fukui told an upper house committee of the diet, Japan's parliament, on last Thursday that he hopes "immediately" to end quantitative easing once the conditions for doing so are met.
Under the present policy, which was introduced in March 2001, the BOJ flooded Japanese financial markets with excess cash in the hope of encouraging lending, while anchoring short-term interest rates near zero. The BOJ has vowed that it will stick to the policy until deflation (a continuous decline in prices), which has long plagued the Japanese economy, is beaten. Deflation has acted as a drag on the economy by eroding corporate earnings and paychecks. Fukui, who took the BOJ helm in March 2003, has won the confidence of the markets largely by being seen as more firmly committed than his predecessor, Masaru Hayami, to quelling deflation.
The BOJ has set three conditions for ending the quantitative easing policy:
The BOJ has not always done a stand-up job in fulfilling its mission. In August 2000, it announced an end to its zero-interest-rate policy, which had been in place since February 1999, and raised interest rates too early. This, coupled with the bursting of the information-technology bubble in the United States, plunged the Japanese economy back into recession. In the face of a barrage of criticism, the BOJ restored the zero-interest-rate policy and introduced the quantitative easing as a main tool to steer its monetary policy.
This time around, however, the BOJ is more confident of its policy shift. Concerns over Japanese financial institutions have eased significantly as the once-huge mountains of bad bank loans returned to normal levels. Major companies have cleared away the excess debts, equipment and labor that had weighed on their fortunes, and are expected to log record profits for the current fiscal year ending this month. The BOJ has been increasingly encouraged by recent upbeat economic data showing that Japan has finally emerged from the decade of stagnation that ensued after the "bubble economy" burst in the early 1990s.
Industrial output in 2005 posted its highest level since 2000. In a preliminary report on Tuesday, the government said industrial production rose a seasonally adjusted 0.3% in January from the previous month, the sixth straight monthly increase. The January output index stood at its highest level since 2000.
Unemployment declined for the third year in a row in 2005, to 4.4% from 4.7% in 2004, with the December figure down 0.2 percentage point from November's 4.6%. In December, the number of job offers and job seekers matched for the first time in more than 13 years. Amid the improving job environment, Japanese consumers are loosening their purse strings. The consumption propensity of Japanese wage-earning households, which is measured by the ratio of household spending to disposal income, registered its highest level in 15 years, at 74.7%, in 2005.
Furthermore, the average stock price on the Tokyo Stock Exchange (TSE) rose by about 40% in 2005. Toward the end of the calendar year, the benchmark Nikkei 225 index topped the 16,000 level for the first time in more than five years. Japanese stock prices have weathered the "Livedoor shock" that hit the country in mid-January. Enjoying a tailwind from positive economic data, the Nikkei average has been hovering in the 16,000 range in recent days.
Indeed, economic data show that deflation seems to be nearing an end. The core CPI rose 0.1% in December from a year earlier after a 0.1% increase in November, which was the first two-month run of increases in almost eight years. The core CPI in October was flat.
Government data released on February 17 show that Japan's gross domestic product (GDP) expanded for the fourth quarter in a row during the October-December quarter, posting robust 1.4% growth from the previous quarter and an annualized 5.5% growth in real terms. On February 9, the BOJ kept its assessment of the economy unchanged, saying in its monthly report that a steady recovery is continuing.
After the release of the GDP figures, the government of Prime Minister Junichiro Koizumi on February 22 upgraded its own assessment of the overall economy for the first time in six months. "The economy is recovering," the Cabinet Office said in its monthly report for February, using more upbeat language than the previous month's report, which stated that the economy was "recovering at a moderate pace".
In late December, the Koizumi government projected modest economic growth of 1.9% in real terms in fiscal 2006, which starts on April 1: 1.5% from domestic demand and 0.4% from exports. It also forecast that the CPI will register a year-on-year rise of 0.5% and that the GDP deflator, which reflects general price movements, will inch up by 0.1% in fiscal 2006.
Even as it continued to claim that its quantitative easing policy has helped the Japanese economy emerge from years of stagnation and beaten deflation, the BOJ recently began to stress one of the major negative effects of that policy. Last Thursday, it released an estimate that Japanese households have suffered a total of 304 trillion yen (US$2.6 trillion) in lost interest revenue because of the extremely low interest rates of recent years. The BOJ had long minimized this negative aspect of its policy by saying that interest revenue accounts for only about 5% of overall Japanese household income, while salaries and other payments by companies make up about 80%.
The BOJ vs the government
The Koizumi government and the ruling Liberal Democratic Party (LDP) have often clashed with the BOJ over the state of the Japanese economy. Government ministers and LDP officials have urged the BOJ to be cautious about ending the ultra-loose monetary policy, so as not to choke off the nascent economic recovery. At the height of the policy battle with the BOJ, some LDP officials, including Hidenao Nakagawa, the party policy chief, even called for revisions to the BOJ law to put pressure on the central bank.
Indeed, the BOJ Law was revised in 1998, for the first time in 56 years, to ensure the central bank's greater independence from the government and transparency in policy decisions. Under the revised law, the government lost the power to fire the BOJ governor, although it retained the right to appoint him. The nine-member BOJ Policy Board was created. It became obligatory for the BOJ to release minutes of board meetings and the BOJ governor to give testimony before the diet at least twice a year. While Article 3 of the BOJ Law guarantees the central bank's independence from the government in currency and monetary policy adjustments, Article 4 of the law calls for the central bank to communicate fully with the government to ensure that its policy is consistent with the basic government economic policy.
If the BOJ commits a policy blunder, as it did when it prematurely lifted its zero-interest-rate policy in the summer of 2000 under the strongly independence-minded then-governor Hayami, formidable political pressure could mount for further amendments to the law to weaken the BOJ's independence.
The government is not completely convinced that the deflation menace is gone. During the October-December quarter, the GDP deflator, a barometer of the overall trend in prices, fell 1.6% from a year earlier. The drop in the GDP deflator was larger than 1.3% during the July-September quarter. Emphasizing the significance of this index, the government has insisted that Japan is still mired in deflation. "I cannot say we have overcome deflation," Koizumi said on Monday. Although the BOJ is exploring the possibility of ending its ultra-easy monetary policy as early as next week, some officials of the government and the LDP still want the central bank to delay any policy shift until April or later, if possible.
Still, the government is poised to let the BOJ decide the timing of any policy change. In fact, even if the BOJ proposes a vote on a policy shift at a next meeting of the Policy Board on March 8-9, the government is leaning toward letting two government officials - one from the Finance Ministry and another from the Cabinet Office, who attend the meeting as observers - refrain from invoking their rights to request the postponement of the vote until another meeting. (The board decision is made by a majority vote, and the two government observers have no voting rights.)
The immediate focus of attention is on exactly when the BOJ's move will come. The earliest possible date would be during next week's Policy Board meeting. Prior to that meeting, the CPI for January will be released this Friday. Most analysts expect the index to log another rise of 0.4-0.5% from a year earlier, further convincing the board members that deflation has ended in Japan. (The CPI for January, released on March 3, rose 0.5 percent from a year earlier.)
It is also possible that the BOJ will take into consideration concerns within the government and the LDP and wait until seeing the CPI data for February, due on March 31, and the closely watched "tankan" quarterly survey of corporate sentiment, due on April 3. In that case, a widely anticipated policy shift could come at either one of two board meetings set for next month - one on April 10-11 and the other on April 28.
The BOJ's next move
The BOJ has said repeatedly that it will keep its zero-interest-rate policy intact for some time even after ending the ultra-loose monetary policy. Governor Fukui said in parliamentary testimony last Thursday that the end to quantitative easing wouldn't mean an immediate tightening in policy, but would be a stepping stone toward a more "normal" monetary policy and "a return to more neutral interest rates".
Analysts calculate that it will take four to five months for the BOJ to drain all excess liquidity from the market after dismantling the ultra-easy monetary policy, by lowering private banks' daily reserves at the BOJ to a legally required level of about 6 trillion yen, from between 30 trillion and 35 trillion yen at present. The time required for this step will make it difficult for the bank to raise interest rates during this period.
Yet there are concerns that long-term interest rates could rise sharply if market players act according to what they think the central bank will choose to do once it jettisons its current monetary policy. In fact, Japanese Government Bond (JGB) prices tumbled and the yen surged against the US dollar on Fukui's diet testimony. (As with all bonds, JGB prices and yields move in the opposite direction.) On the day of Fukui's testimony, the yield on the newest benchmark 10-year bonds jumped 0.04 percentage point to 1.555%, while the dollar weakened to about 117.20, down more than 1 yen from late the previous day. Prices of Japanese government bonds have gyrated since government officials began to suggest they would no longer stand in the way of the central bank's move to end its ultra-easy monetary policy.
There are concerns that a policy change would send the BOJ into uncharted territory. Some government officials and LDP members have proposed setting an inflation target to raise the price increase rate to a certain level. However, the BOJ and some experts object to the idea, raising questions about the effectiveness of such a target and claiming that it would become difficult for the central bank to implement flexible monetary policies. Setting an inflation target would have the merit of boosting the transparency of BOJ policy, but at the same time it would have the demerit of depriving the central bank of room for flexible policy implementation.
Amid growing concerns that the end to the ultra-easy monetary policy could disturb the financial markets, the BOJ itself seems to be at pains to devise some new criteria for implementing its monetary policy, although it remains adamantly opposed to setting an inflation target. Instead of adopting specific numerical goals, the central bank is considering improving its biannual economic-outlook report and statements released after every policy-setting panel meeting to help stabilize market expectations and boost transparency in monetary policy. To be sure, the Koizumi government seems to have raised the white flag in a policy battle with the BOJ this time. But another round of policy battle could break out later this year over how fast the BOJ should move to raise short-term interest rates.
The government does not want to see any hasty interest-raise move by the BOJ for fear of sharp rises in long-term interest rates, which would lead to a rise in government debt-servicing costs. Japan's fiscal condition is the worst among major industrialized countries, with pubic debts, including those owed by local governments, expected to reach 775 trillion yen at the end of fiscal 2006, about 150% of the nation's GDP. The Finance Ministry estimates that every 1% rise in long-term interest rates - which are now around 1.6% - will increase government debt-servicing costs by at least 1.5 trillion yen. The fiscal 2006 government budget plan, now pending in the diet, calls for 18.8 trillion yen in debt-servicing outlays. Of this amount, 8.6 trillion yen will be used for interest payments. Under such circumstances, the BOJ is widely expected to move slowly to raise rates. Some analysts say that the BOJ will be very cautious about raising rates because it remains traumatized by the policy debacle in the summer of 2000 when it prematurely lifted its zero-interest-rate policy, triggering a recession.
Many analysts have suggested in recent days that the BOJ is likely to raise the unsecured overnight call rate, the interest rate banks charge one another, by the end of the year, but only to 0.25%. But the BOJ is now mulling ways to put an upper limit on an anticipated rise in short- and long-term rates, not only to cushion the impact of the policy shift but also to secure the support of the government and the LDP for terminating the current policy.
Specifically, the central bank is expected to ensure that the uncollateralized overnight call rate does not exceed 0.1%, effectively keeping the key rate close to zero. The 0.1% figure is equivalent to the official discount rate, at which the BOJ provides funds to financial institutions facing liquidity constraints. And in a bid to prevent a sharp rise in long-term interest rates, the BOJ has indicated it would continue to make outright purchases of 1.2 trillion yen in long-term government bonds each month. When the quantitative easing policy was launched in early 2001, the BOJ initially purchased 400 billion yen in those bonds each month. The purchase amount was gradually increased.
As the BOJ has pumped a massive amount of liquidity to maintain a balance of 30 trillion to 35 trillion yen of current accounts held by private banks at the central bank, the unsecured overnight call rate, which serves as the money-market benchmark, has stayed at 0.001-0.002%. But the current-account balance is expected to decline to the legally required level of about 6 trillion yen in several months. As the supply of funds tightens, the overnight call rate could spike.
Meanwhile, the implications of the BOJ's anticipated policy shift might not be limited to the Japanese economy alone. Analysts point out that the process the BOJ is about to start after more than a decade of near-zero interest rates and five years of quantitative easing could ripple through global capital markets for years to come. If Japanese rates rise, Japanese capital that has flowed into the US could start to return home. Foreign investors, who have already played a leading role in the rally on the Japanese stock market in the past year or so, could begin investing more broadly in Japanese assets. This could push US interest rates higher and the dollar lower, as Japanese investors shift away from US assets.
Hisane Masaki is a Tokyo-based journalist, commentator and scholar on international politics and economics. Masaki's e-mail address is [email protected].
Hisane Masaki is WSN Editor Japan.