Frameworks for Monetary Stability

3 Implementation of Monetary Policy in Japan

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
  • ShareShare
Show Summary Details

This paper gives an overview of changes in Japanese financial conditions in the last decade, such as financial deregulation and globalization, aggressive bank lending to the real estate sector, and asset inflation followed by declines in asset prices and the deterioration of bank asset quality as well as monetary policy. Finally, current formation of monetary policy is summarized.

Changes in the Financial Environment

The 1980s witnessed a number of dramatic changes on the Japanese financial scene. Financial deregulation and globalization, which had begun in the 1970s, gained momentum from the mid-1980s, as did innovation in the areas of data-processing and telecommunications technology, giving an impetus to financial innovation and liberalization. Indeed, all these elements interacted to form a synergy, in turn accelerating the development of each.

Financial Deregulation

Interest rate liberalization was first triggered by the large issuance of long-term government bonds in the late 1970s. The liberalization of long-term rates further progressed with the expanded use of the auction method for many types of government bonds in the 1980s. Also, short-term interest rates, which had long been regulated and linked to the official discount rate, were liberalized in the 1980s, particularly in the late 1980s. In June 1993, time deposit interest rates were completely liberalized (Table 1). The remaining regulated deposit interest rates—liquid deposit interest rates—will be liberalized in 1994 except for those on current deposits (checking accounts), which will remain regulated (zero interest rate). Now that a significantly large portion of funds raised by banks consists of those with unregulated interest rates, a mechanism has been established through which interest rate changes effected by the money market operations of the Bank of Japan are transmitted to the fund-raising cost of financial institutions in a relatively short period.

Table 1.Japan: History of Deregulation of Deposit Interest Rates
YearMonthInterest Rate Policies
1979MayIssuance of negotiable certificates of deposit (CDs) authorized (minimum amount, ¥500 million; term, 3–6 months)
1984Jan.Minimum CD denomination lowered to ¥300 million
1985AprilMinimum CD denomination lowered to ¥ 100 million; minimum term shortened to 1 month
Issuance of money market certificates (MMCs) authorized (minimum amount, ¥50 million; term, 1–6 months)
Oct.Deregulation of interest payable on large time deposits (minimum amount, ¥1 billion; term, 3 months-2 years)
1986AprilMaximum CD term extended to 1 year
Minimum denomination of large time deposits lowered to ¥500 million
Maximum MMC term extended to 1 year
Sept.Minimum denomination of large time deposits lowered to ¥300 million
Minimum denomination of MMCs lowered to ¥30 million
1987AprilMinimum denomination of large time deposits lowered to ¥ 100 million
Minimum denomination of MMCs lowered to ¥20 million
Maximum MMC term extended to 2 years
Oct.Minimum term of large time deposits shortened to 1 month
Minimum denomination of MMCs lowered to ¥10 million
1988AprilMinimum denomination of CDs lowered to ¥50 million; term broadened to 2 weeks-2 years
Minimum denomination of large time deposits lowered to ¥50 million
Nov.Minimum denomination of large time deposits lowered to ¥30 million
1989AprilMinimum denomination of large time deposits lowered to ¥20 million
JuneSmall denomination MMCs introduced (minimum amount, ¥3 million; term, 6 months-1 year)
Oct.Minimum denomination of large time deposits lowered to ¥10 million
Small MMCs term broadened to 3 months-3 years
1990AprilMinimum denomination of small MMCs lowered to ¥ 1 million
1991AprilMinimum denomination of small MMCs lowered to ¥500,000
Nov.Minimum denomination of large time deposits lowered to ¥3 million
Maximum large time deposit term extended to 3 years
1992JuneMinimum denomination of small MMCs eliminated
Introduction of “nontime” deposit instruments bearing market-related interest rates (minimum denomination, ¥200,000)
1993JuneTime deposit rates fully liberalized

As interest rate liberalization has progressed, new types of financial instruments have emerged, such as certificates of deposit (CDs), foreign currency deposits, commercial paper (CP), government bills and bonds with diversified maturities, and various types of financial derivatives (Table 2). In particular, off-balance-sheet markets have recently developed very rapidly in Japan. Worldwide financial innovation also stimulated swap and option transactions leading to the introduction of government bond futures on the Tokyo Stock Exchange in 1985 and the debut of the Tokyo International Financial Futures Exchange (TIFFE) in 1989. In line with the emergence of new financial instruments and diversification of open markets, the Bank of Japan has responded positively by liberalizing the interbank markets—namely, the call and bill markets (Table 3). At the same time, it has endeavored to enhance arbitrage transactions between interbank and open markets (Table 4). These measures are based on the conviction that the more active use of interest rates will ensure the effectiveness of monetary policy.

Table 2.Japan: Progress of Financial Liberalization
YearMonthMoney MarketMonthDeposit/Bond MarketMonthGlobal Financial Market
1979AprilAbolition of call rate quotationMayLiberalization of short-term
MayCommencement of certificates of deposit (CDs) (sold at city banks)impact loans and repurchase trading by nonresidents allowed
Oct.Abolition of bill rate quotation
1980Jan.Establishment of medium-term government bond fundsDec.Amendment of Foreign Exchange Law (impact loans fully liberalized, etc.)
1981JuneIntroduction of term deposits with designated maturity and new loan trusts (“Big”)
OctIntroduction of new financial debentures (“Wide”)
1984JuneInitiation of public bond dealing by financial institutionsAprilAbolition of “actual demand principle” in forward foreign exchange transactions
JuneLiberalization of yen conversion
1985JulyInitiation of uncollateralized call transactions (brokerage by money-market dealers)MarchIntroduction of money market certificates (MMCs)
Oct.Establishment of bond futures market

Beginning of phased deregulation of large time deposits
Dec.Introduction of new money trusts (“Hit”)
1986MarchIntroduction of long-term government bond fundsDec.Establishment of Japan Offshore Market (JOM)
1987Oct.Removal of ceiling on CD issuanceJuneEstablishment of stock futures market
Nov.Establishment of domestic commercial paper (CP) market
1988Nov.Abolition of quotation for uncoll tateralized call rates and bill rates

Inclusion of 1-week bill transactions

Inclusion of 6-month uncollateralized call transactions
Sept.Initiation of stock index futures transactions
1989AprilInclusion of 1-year uncollateralized bill transactionsMayInitiation of bond lending market
JuneIntroduction of small-lot money market certificates (MMCs) Initiation of financial futures (interest rates and foreign exchange)
1990AprilLiberalization of commercial paper (CP) issuance by securities firms

Reduction of minimum transaction unit for treasury bills and financing bills (¥50 million-¥ 10 million)
MayInitiation of options on long-term government bond futuresJuneInitiation of options on Euro-yen rate futures on Singapore International Monetary Exchange (SIMEX)
Sept.Initiation of Nikkei Stock Average futures and futures options on the Chicago Mercantile Exchange (CME)
Nov.Abolition of quotation for collateralized call ratesInitiation of Japanese government bond and Tokyo Stock Exchange (TSE) stock index futures and futures options on the Chicago Board of Trade (CBOT)
1991Nov.Initiation of spot transactions for uncollateralized call money (1 month-1 year)Nov.Introduction of 2-year long-term credit bank debenturesJulyInitiation of Euro-yen interest rate futures options on the Tokyo International Financial Futures Exchange (TIFFE)
1992JulyInitiation of spot transactions for bills (1 month-1 year)MayIntroduction of MMFs (money management funds)AprilFull exemption of foreign corporate bodies from taxation on

treasury-bill and financing-bill investments
JuneFinancial System Reform Law enacted

Introduction of “nontime” deposit instruments bearing market-related interest rates
1993MarchInclusion of 1-week spot transactions lor uncollateralized call money and billsJuneLiberalization of interest rates on time deposits with specified periods (liberalization of interest rates on time deposits completed)JulyRelaxation of Euro-yen bond issuance by nonresidents
Oct.Introduction of time deposits with Floating rate
Table 3.Japan: Money Market Reforms After November 1988
Year/MonthItemBefore ReformAfter Reform
1988/Nov.Bill maturities

Collateralized call money maturities

Uncollateralized call money maturities

Maturities of bills eligible for Bank of Japan operations
1-6 months

Unconditional-3 weeks

Overnight-3 weeks

1-3 months
1 week-6 months

Unconditional-6 days

Overnight-6 months

1 week-3 months (mainly 1-3 weeks)
1989/Jan. Unit for call money and bills 1/16 percent1/32%
AprilBill maturities

Uncollateralized call money maturities
1 week–6 months

Overnight–6 months
1 week-1 year

MayCommercial paper (CP) operationsIntroduced
Aug.Disclosure of demand/supply of funds and market operationsFigures for the previous day and revised estimates for the day: 10 a.m.

Results for the day and estimates for the following day: 4 p.m.
Advanced acceptance of bills used as collateral for bill operationsNot acceptedCommencement of “rollover” of bill operations
Dec.Borrowers of collateralized credits extended by Bank of Japan

Disclosure of demand/supply of funds and market operations
City banks, long-term credit banks, major regional banks, etc.

Results for the day and estimates for the following day: 4 p.m.
Shinkin Banks, foreign banks, and some others added

Results for the day and estimates for the following day: 3 p.m.

Offered operations of the day (recorded services): 10 a.m.
1990/Jan.Treasury bill operationsIntroduced
Feb.Limitations on use of uncollateralized call loans by investment fundsUp to 30% of total amount of call loans incorporated in fundsUp to 50% of the aggregate amount of call loans and bills incorporated in funds
AprilSecurities eligible as collateral for Bank of Japan advancesPublicly-offered municipal bondsSome non-publicly-offered municipal bonds added
JuneAuction schedules of treasury-bill operations, rotative bond purchases, and bond reposFrom offers to notice of bids: 3 hours to 30 minutesFrom offers to notice of bids: 2 hours to 50 minutes
Aug.Disclosure schemes for fund demand/supply and market operationsDisclosure of figures based on increase/decrease in banknotesDisclosure of figures based on surpluses/shortages in the market

Commencement of disclosure of difference between current reserve amount and required reserves not satisfied
Nov.Collateralized call ratesQuotation systemCommencement of offer/bid system
1991/Jan.Bill operations (rate determined by auction)Introduced
Nov.Spot transactions for uncollateralized call money (1 month-1 year)Introduced
1992/JulySpot transactions for bills (1 month-1 year)Introduced
Oct.Disclosure of surplus/shortage of funds and market operationsRevised estimates ter the day: 10a.m.Revised estimales for the following day: 5:20 p.m.
1993/MarchSpot transactions for uncollateralized call money and bills (1 week-3 weeks)Introduced
Expansion of transaction time9a.m.–3 p.m.9a.m.–5 p.m.
Disclosure of surplus/shortage of funds and market operationsResults for the day (preliminary figures) and estimates for the following day: 3 p.m. and 5:20 p.m.Results for the day (preliminary figures) and estimates for the following day: 5:20 p.m.
Results for the previous day (definite figures): 10 p.m.Results ter the previous day (definite figures): 10 p.m.
Table 4.Japan: Money Market Funds Outstanding
Type of FundsOutstanding

(end-year, ¥ trillion)
Average Annual Growth

Interbank market6.79.819.841.060.17.915.115.7
Open market2.311.734.1116.697.638.523.927.9
Certificates of deposits (CDs)2.49.718.916.632.214.3
Commercial paper (CP)15.812.2
Financing bills1.01.8
Treasury bills7.610.4
Bonds with repurchase agreement1.
(business/wholesale nonresidents)2.39.924.320.433.919.7
Large time deposits5.0215.7339.9112.3
Sources: Bank of Japan, Economic Statistics Annual; Bank for International Settlements, International Banking and Financial Market Development.

Liabilities reported by banks in industrial countries only.

Subject to yen conversion limits prior to 1984.

Sources: Bank of Japan, Economic Statistics Annual; Bank for International Settlements, International Banking and Financial Market Development.

Liabilities reported by banks in industrial countries only.

Subject to yen conversion limits prior to 1984.

Financial Globalization and Progress in Data Processing

Cross-border financial transactions have increased considerably since 1980, when the Foreign Exchange Law was amended and impact loans were deregulated. In 1984, yen conversion limits were lifted and regulations on forward transactions removed, thereby virtually completing the deregulation of foreign exchange transactions. All such measures contributed to expanding international financial transactions.

One important aspect of such “internationalization” of financial transactions is increased substitutability among financial assets, as deregulation has taken place on the domestic front. The lifting of yen conversion limits resulted in expanding Euro-yen interbank transactions and Eurodollar transactions with foreign exchange swaps, which, in turn, contributed most significantly to increased arbitrage between domestic interbank and open markets. Another important aspect of internationalization is that, by enhancing cross-border capital mobility, the sensitivity of exchange rates to interest rate changes has increased.

In the 1980s the Japanese economy became more open to the world economy also, in the sense that international trade captured a larger share of aggregate national output and that both the import of manufactured goods and overseas direct investments increased considerably. As a result, exchange rate movements gained greater importance vis-à-vis the development of the overall economy. On the other hand, Japan’s presence in the world economy has also increased along with its economy, consequently having a greater influence on other countries.

In the meantime, progress in data processing and telecommunications has also had a significant impact on financial transactions, accelerating innovation and encouraging the globalization of financial markets in which international banks operate. Japanese banks have expanded internationally and an increasing number of foreign financial firms have entered Japan’s markets.

Economic Developments and Monetary Policy Since the Mid-1980s

Buildup of the Speculative Bubble

Under such dramatic changes in the financial environment, the banking sector was increasingly exposed to competition from less tightly regulated financial sectors—securities houses in particular.

Increased competition triggered deregulation, which, in turn, intensified competition among banks themselves as well as with other financial institutions, including securities houses, insurance companies, pension funds, etc. The process squeezed banks’ profit margins sharply. On the liability side, the deregulation of deposit rates and competition for funds with other financial institutions brought about a visible increase in funding costs. On the asset side, securitization, for example, eroded banks’ relative position as lenders.

Aggressive Bank Lending

In response to downward pressure on profit margins, banks rapidly increased the provision of credit to profitable but riskier projects—i.e., real estate projects. In Japan, the ratio of bank lending to real estate firms and nonbank financial institutions to total bank lending rose from 17.9 percent in 1985 to 26.7 percent in 1992. As Japanese nonbanks mostly specialize in real estate financing, loans to them can be regarded as being channeled through to real estate firms.

In addition to increasing loans to real estate firms, Japanese banks extended considerable credit to business firms for investment in stocks and other financial assets. Such aggressive lending by banks for projects related to real estate and investments in financial assets obviously contributed to a sharp rise in the prices of property and other assets. In addition to increasing the value of the assets held as collateral, the surge in asset prices improved actual and prospective profitability, thus prompting bankers to finance even more asset purchases. In this regard, it should be noted that aggressive lending reflected banks’ mismanagement in responding to intensified competition because such a rapid increase in asset-related lending implies insufficient risk assessment and underestimation of the possible deterioration of their own assets. An important background factor to this mismanagement is likely to have been, in turn, banks’ tacit expectation of assistance from peer banks and the authorities—namely, so-called “moral hazard.”

This process of bank lending and asset inflation feeding on each other pushed up asset prices to levels unjustifiable by economic fundamentals. This is none other than the formation of a speculative bubble, a phenomenon commonly observed in many areas of the world, particularly in the late 1980s.

Land prices started to rise in Tokyo as increased emphasis on service-oriented and information-oriented growth, together with the further internationalization of the Tokyo financial market, attracted domestic and foreign enterprises to Tokyo. Construction of office buildings became very brisk. Backed by strong real demand and supported by easy money conditions, land speculation emerged. The Tokyo stock market became very active and the Nikkei Stock Average showed a very strong rise. Golf club membership fees also soared sharply, first in the greater Tokyo area and then in other big cities. While conventional price indices, such as the consumer price index (CPI) and the wholesale price index (WPI), remained very stable (even staying below the prior-year level), asset prices showed a strong rise (Chart 1).

Chart 1.Price Developments

In the meantime, the rate of growth in money supply maintained a high level. Even during the depressed 1986-early 1987 period, money supply (M2 + CDs) maintained a high rate of growth and since the latter part of 1987, exceeded 10 percent, year to year (Chart 2). The accumulation of financial assets by the nonfinancial sector, in particular the corporate sector, was very rapid as the low interest rates encouraged the expansion of bank credit and financial engineering.

Chart 2.Monetary Aggregates and Bank Lending Developments

Note: Definitions of Monetary Aggregate Indicators

M1 = Cash currency in circulation + deposit money

Cash currency in circulation represents the amount of bank notes issued and coins in circulation, less the amount of cash currency held by financial Institutions surveyed.

Deposit money represents the total of demand deposits (current deposits, ordinary deposits, savings deposits, deposits at notice, special deposits, and deposits for tax payments) among private and public deposits in financial institutions surveyed minus checks and bills held by these institutions.

M2 + CDs = M1 + quasi-money + CDs

Quasi-money represents the total of private deposits and public deposits, less demand deposits in financial institutions surveyed.

CDs (certificates of deposit) include those of private corporations, individuals, and the public sector in financial institutions surveyed.

Broadly defined liquidity = M2 + CDs plus deposits of post offices and agricultural cooperatives, fishery cooperatives, credit cooperatives, labor credit associations (including CDs), and money trusts and loan trusts of all banks (excluding interfinancial institution deposits, trust accounts, and the checks and bills held by financial institutions) plus bonds with repurchase agreements, bank debentures, government bonds, investment trusts, money deposited other than money in trust, and foreign bonds.

Broadly defined credit aggregates = outstanding funds raised by the nonfinancial sector (private corporations, individuals, and the public sector).

Monetary Ease

As mentioned, aggressive bank lending to the real estate sector was the main background to asset inflation. It cannot be denied, however, that monetary policy after the Plaza Agreement also contributed.

It may be recalled that the Plaza Agreement of September 1985 was the manifesto of the revision of the “strong dollar policy” of U.S. President Reagan. The Group of Five ministers and governors agreed that “…policy coordination for redressing the large and growing external imbalances was important and that exchange rates should play an important role in adjusting external imbalances.” They also expressed their view that some further orderly appreciation of the main nondollar currencies against the dollar was desirable. According to this agreement. Group of Five countries acted in concert in the foreign exchange markets in order to lower the dollar rate vis-à-vis other currencies.

After the Plaza Agreement, the yen appreciated against the dollar from ¥240 in mid-1985 to around ¥120 at the end of 1987, in spite of the efforts to stabilize markets and the exchange rate at around ¥150–160 throughout most of 1987. Such a rapid and sharp appreciation of the yen was a heavy blow to Japanese export industries. Exporters complained to the government and the central bank that such a drastic change in so short a span of time was beyond their ability to adjust to it and that it would have a disastrous impact on the Japanese economy as a whole. While the advantages of a stronger currency over the long run were recognized, the Japanese economy had to face the more immediate adverse consequences of the deflationary effect.

On the other hand, Japan’s balance of payments was producing a large and growing current account surplus which, as a ratio of nominal gross national product (GNP), reached 3.6 percent in 1985. International pressure on Japan to reduce its surplus mounted. Reduction of the surplus by stimulating domestic demand was widely regarded as an international commitment for Japan (Chart 3).

Chart 3.Current Account of the Balance of Payments and Foreign Exchange Rate

To mitigate the deflationary effects of the yen’s appreciation and reduce the surplus, the Bank of Japan lowered the official discount rate five times up to early 1987, from 5 percent to 2.5 percent. As a result of the reductions in the official discount rate, the deflationary impact of the yen’s appreciation was considerably mitigated. In fact, thanks to the resiliency of Japanese industry, the painful initial phase was well bridged to the next phase, where the positive and advantageous impact of the strong yen rendered benefits to the economy. Imports of cheaper raw materials, together with lower oil prices, contributed to price stability and improved terms of trade, which, in turn, strengthened the competitiveness of Japanese industry. The low level of interest rates and better terms of trade stimulated private fixed investment. Thus, once the initial adverse effect of appreciation was overcome, a virtuous circle was set in motion.

By mid-1987 it became clear that the worst had been seen and that the economy had started on an upswing, in which domestic demand was the major driving force (Chart 4). It was at this stage that a special emergency fiscal package, comprising a large stimulatory ¥6 trillion, was introduced. Some critics termed this fiscal package as “too large, too late” and indeed, in retrospect, it might also have contributed to the buildup of excessive demand not only for goods and services but also for assets.

Chart 4.Economic Activity and Interest Rate Developments

It became increasingly apparent in the summer of 1987 that the economy had bottomed out and prices of some commodities, such as construction materials, were starting to rise. However, so-called Black Monday in October 1987 made it difficult for the Bank of Japan to tighten its monetary control. In fact, it followed monetary authorities in the major countries and took emergency measures, including an extra injection of liquidity.

Collapse of the Bubble

In 1989, both Japan’s trade and current account surpluses posted considerable declines and the yen weakened against the dollar. Pressure on prices gradually increased and a 3 percent consumption tax was newly introduced. Under such circumstances, in May 1989 the Bank of Japan raised the official discount rate 0.75 points for the first time since August 1980—following nine years of continuing decline. However, most market participants and speculators ignored this increase as there was still considerable inertia stemming from low interest rates. The Bank thus raised the official discount rate twice, in October and December 1989, to 4.25 percent, and finally the market realized that the watershed had been passed and interest rates had reversed direction. The Ministry of Finance, for its part, asked banks in 1990 to contain the growth rate of their real estate-related lending to less than that of total lending.

The year 1990 began with what is termed in Japan a “triple decline”—declines in stock and bond prices as well as in the yen rate. The “triple decline” also triggered a fall in the prices of other assets—land, houses, condominiums, and golf club memberships. In March 1990, the Bank raised the official discount rate for the fourth time to 5.25 percent. In August 1990, as the Gulf War crisis started and oil prices rose sharply, the Nikkei Stock Average tumbled (48 percent off from the peak) once again, partly due to the perception abroad of the vulnerability of the Japanese economy to an oil shortage, but mainly in the expectation of monetary tightening. In fact, the official discount rate was increased for the fifth time to 6 percent in late August, with a view to preventing “imported” inflation from becoming “homemade” inflation.

Recession and the Balance Sheet Problem

In 1991, the slowing of economic activity and the stability of price developments became very apparent. It was in such circumstances that the Bank of Japan shifted its policy stance toward easing. In fact, the Bank has cut the official discount rate seven times since mid-1991 and its current level is the historical low (1.75 percent).

As a consequence of the fall in land and stock prices, the quality of bank loans deteriorated significantly. Total nonperforming assets held by city banks, the bulk of which consisted of loans to real estate and nonbank firms, stood at ¥12.8 trillion at the end of March 1993, or 3.2 percent of total outstanding loans, and thus recorded a 60 percent increase in only one year.

Further, the fall in asset prices caused the problem that economic agents suffer from—the accumulation of bad assets on the asset side and heavy borrowing on the liability side. The “balance sheet problem” was first recognized in the United States and then in a number of countries around the world, including Japan. In Japan’s case, sharp declines in stock and property prices (what is called “the bursting of the bubble”) were particularly felt by real estate companies and financial institutions, including nonbank firms.

On the other hand, the balance sheet problems of individuals and ordinary corporations are less serious in Japan than those in the United States. With respect to individuals, although the ratio of their borrowing to disposable income increased rapidly during the bubble period in Japan as well, Japanese individuals are still large net financial asset holders. For corporations, leveraged buyouts (LBOs), one cause of excess borrowing in the United States, have seldom been seen in Japan, though some corporations that extended their business to include property-related transactions and speculative financial engineering (so-called zaitech) “burned their fingers.”

The difficulties currently experienced by Japanese financial institutions pose some problems for the Bank of Japan in terms of the conduct of monetary policy. While the Bank has relaxed monetary policy and reduced interest rates to a significantly low level, bank lending has not necessarily expanded. Even considering the weak demand for loans from the customer side, there are indications, according to the Bank’s quarterly Short-Term Economic Survey of Enterprises in Japan (Tankan), that small and medium-sized non-manufacturing corporations face some difficulty in obtaining credit from banks owing to lack of suitable collateral. Since these small and medium-sized nonmanufacturing industries have always been the first to expand their capital spending when monetary conditions eased, there is a possibility that the credit-availability problem for such industries could affect expected economic recovery to some extent.

Another difficulty that the Bank of Japan may face in this regard is how to secure the right balance between macroeconomic management and prudential concern. To support the self-efforts of Japanese banks to solve their balance sheet problem, the Bank of Japan should stand ready as lender of last resort to rescue solvent but illiquid banks, particularly when a specific incident of bank failure could develop into a systemic crisis. However, the basic principle is that overall monetary policy should not be turned into a bank rescue operation, except in very dire circumstances. At present, Japan is certainly not in such a situation, and the Bank of Japan is now focusing clearly on macroeconomic management.

Current Formation of Monetary Policy

As mentioned, in the last decade the Bank of Japan exhibited a good performance in achieving general price stability. Nevertheless, it also experienced some difficulties. A salient difficulty was how to implement monetary policy when there existed a sharp contrast between flow prices and asset prices. Also, the Bank of Japan experienced difficulty in assessing the growth of the money supply during rapid financial deregulation. Furthermore, it has been difficult for the Bank to correct the external imbalance compatibly with other policy objectives. Lessons learned from the experiences of the late 1980s, as well as various developments, are reflected in the current conduct of monetary policy.

Price Stability as the Final Objective of Monetary Policy

Price stability, upon which the sustainability of economic growth can be secured, is the final objective of monetary policy. Traditionally, the Bank of Japan has used the CPI and WPI as pilot indicators to gauge inflation. Experience in the 1980s, however, has led the financial experts to question the implementation of monetary policy focusing solely on general flow prices indicated by the CPI and WPI. As mentioned already, during the late 1980s, the Bank maintained an expansionary monetary policy in view of the stability of general flow prices and the weakness of economic activity. On the other hand, asset prices rose sharply through the buildup of the speculative bubble, the bursting of which caused the ensuing recession to be deeper and longer. In this context, the question of which index of inflation should be focused on in the conduct of monetary policy has become an important issue.

The Bank of Japan has stated that it cannot be denied that monetary policy in the late 1980s contributed to asset inflation at least to a certain extent. Based on this experience, it has also made clear that it would watch asset price movements more carefully as a factor in deciding monetary policy. It may be said that this argument is widely accepted, although opinions differ as to the desirability of making the stability of asset prices part of a target for monetary policy rather than just an indicator. The fact that many experts disagree with the idea of making asset price stabilization an objective reflects their concern that a commitment to it is too risky because such prices are influenced not only by monetary factors but also by real factors. In fact, monetary policy can explain only a part of the rise in asset prices that occurred in the late 1980s.

Therefore, it still remains an open question as to what degree asset price movements should be taken into account in the conduct of monetary policy. The implication of asset price movements on monetary policy is under closer scrutiny in the Bank.

Monetary Aggregates as Intermediate Targets/Indicators

Central banks in some countries have come to attach more importance to monetary aggregates as an intermediate target for their policy implementation since the mid-1970s. In fact, official targets or target ranges are in place for certain monetary aggregates in many countries. While the Bank of Japan has never set a target for any specific monetary aggregate, it has continued to disclose its quarterly projection for M2 + CDs since 1978, following the experience of the emergence of excess liquidity and high inflation in the early 1970s. In this sense, the Bank of Japan has also come to focus more on monetary aggregates in conducting monetary policy since the mid-1970s. The growth rate of M2 + CDs has been gradually brought down since then, although there have been some fluctuations. As a result, the rate of inflation was significantly lower and stable until the early 1980s. It can therefore be said that implementation of monetary policy during the period had been successfully guided by M2 + CDs.

However, doubts have gradually grown about the usefulness of monetary aggregates since the mid-1980s, prompted by progress in financial innovation and liberalization, as well as the rapid appreciation of the yen. Because of the gradual liberalization of time-deposit interest rates, the “shift-in” of funds to, and “shift-out” from, M2 + CDs became far more active than before, resulting in volatile movements in its growth rate. M2 + CDs had traditionally been regarded as “a set of financial assets which could be used as a means of payment,” but this characteristic also changed gradually. These developments have made it difficult for the Bank to make accurate projections for M2 + CDs.

In addition, the rapid appreciation of the yen after the Plaza Agreement in September 1985 put continued downward pressure on the CPI and WPI. Since M2 + CDs continued to grow at a relatively high rate, reflecting the easy monetary policy of the period, developments in M2 + CDs and price indices seemingly diverged, and the usefulness of the former as a leading indicator of the general price level diminished significantly.

As mentioned, the Bank of Japan has never set and pursued a target for M2 + CDs in a mechanical manner; its official position has been described as “conducting monetary policy based on an overall judgment that takes account of monetary aggregates as well as other indicators” (Table 5). Nevertheless, it must be admitted that the emphasis on M2 + CDs in deciding policy stance has been downgraded since the late 1980s.

Table 5.Japan: Factors in the Control of Monetary Policy
Price developmentsSince maintaining price stability, upon which sustainability of economic growth can be secured, is the ultimate objective of monetary policy, price performance must be watched very closely. History has taught Japan to carefully monitor asset price movements.
Economic activityThe judgment of business conditions based on various economic indicators is also an important factor. Japan’s quarterly economic survey (Tankan) is very helpful because it reflects the collective business sentiment of almost 7,000 companies regarding current and future economic conditions. At the same time, Japan’s Research and Statistics Department and branches all over Japan conduct hearings with many corporate executives to obtain their views on current and prospective economic conditions to avoid making unnecessary mistakes in interpreting various economic indicators.
Money supplyIn some countries, such as Germany, money supply figures seem to have relatively greater importance than other factors for monetary policy decisions because they are announced as target figures. In recent years, however, the relationship between the real economy and money supply as a leading indicator has become unclear. In the light of this, the U.S. Federal Reserve has gradually downgraded the role of money supply as an intermediate target in the formulation of its monetary policy. In Japan, while money supply figures have never been a target, they were considered an important indicator. However, the role of money supply as a leading indicator has been somewhat downgraded as well and now appears to be more correlated with current economic conditions than the future. The growth of money supply has been very weak recently although it appears to have hit bottom. Both demand-side and supply-side factors are responsible. On the demand side can be cited the decline in corporate demand for money, reflecting a large drop in capital spending, and the unwinding of the steep rise in asset prices and excess corporate liquidity (zaitech) as the main causes. According to an internal analysis using a money demand function, it appears that the decline in land prices contributed significantly to the decline in demand for money in addition to weak economic activity. On the supply side, the prudent lending attitude of banks seems to have exerted some influence on the slow growth of money supply.
Exchange rateAs the maintenance of the external value of the yen is one of the objectives of the Bank, it pays close attention to the exchange fate of the yen in the conduct of monetary policy. But, as it is affected by factors beyond the control of the Bank of Japan, such as the economic fundamentals of trading partners and the political situation, etc., it is not the Bank’s practice to assign monetary policy mainly to exchange rate developments. Of course, the Bank is careful not to lower interest rates when the yen is depreciating, but it is indicated that using monetary policy mainly for the purpose of stabilizing the exchange rate has often brought about undesirable consequences. Experience in the early 1970s, in the late 1970s, and most recently the late 1980s when monetary policy was substantially eased mainly to cope with the steep appreciation of the yen, supports such an assessment.
Money market ratesAlthough the Bank announces its policy intention by changing the official discount rate and/or adjusting the overnight call money rate, thus changing market rates in general, market rates sometimes move ahead in anticipation of such moves. In some cases, official discount rate action could follow and endorse what has already happened in the market. However, there are other cases where market rates simply move because of speculation and the Bank of Japan has to check such moves by counter operations. At any rate, market interest rates are a useful indicator for assessing market sentiment regarding the economy.
International considerationsIn view of the increased weight of Japan in the world economy and the internationalization of financial markets, the Bank of Japan takes more account of what implications its policy actions have for the world economy and international financial markets.

Currently, the Bank of Japan pays attention to movements in broader aggregates, such as “broadly-defined liquidity” and “broadly-defined credit aggregates” in addition to those in M2 + CDs. Change of this sort in the use of monetary aggregates should not be ruled out in the future.

International Considerations

International considerations should be given to secure sustainable noninflationary growth over the medium and long term, and not to seek short-term effects. In other words, exchange rate stability and sustainable external positions should not be regarded as the direct and ultimate objectives of monetary policy. They can only be attained by convergence of policies of individual economies in pursuit of sustainable noninflationary growth.

After recording almost

120 billion in 1992, Japan’s current account surplus for 1993 is considered to have reached around
130 billion, over 3 percent of nominal GNP. Such a large surplus is certainly not sustainable in current economic circumstances since it leads to friction with Japan’s trading partners and could invite protectionism. Therefore, it goes without saying that it is of great importance to make the utmost efforts to open up domestic markets through further deregulation and change in Japanese trading practices. From a macroeconomic policy viewpoint, it is also important to stimulate domestic demand. In this regard, what can be done without causing undesirable consequences for the Japanese economy is limited, however, since the current account surplus is tantamount to differences between national rates of saving and investment balances. In the case of Japan, the positive net saving balance is partly due to structural factors as well as cyclical ones. If Japan tries to reduce the structural portion of its current account surplus within a relatively short period of time, it may risk rekindling inflationary pressures that would not be compatible with sustained growth. Moreover, if such a situation arose, the resultant rise in interest rates might spread globally. It should also be kept in mind that Japan’s surplus is being recycled in the form of capital outflows, contributing to employment increases outside. For example, Japanese direct investment is benefiting economic development in neighboring countries.

Official Discount Rate and Market Interest Rates

In the past, policy change was initiated by a change in the official discount rate because short-term lending rates had long been linked to it. At present, however, the Bank of Japan can influence short-term lending rates in a timely manner through money market operations even without changing the official discount rate (Tables 6 and 7). This is due to the fact that the lending rates of financial institutions have become more sensitive to money market rates with interest rate liberalization. Although money market rates cannot arbitrarily deviate from the official discount rate, this type of policy measure has widened policy options and enhanced maneuverability. In this context, changes in the official discount rate are now regarded as an instrument to be employed when the Bank wishes to convey the change in its monetary policy stance vocally, enabling money market rates to be adjusted simultaneously.

Table 6.Japan: Monetary Policy Instruments of the Bank of Japan1
Daily credit control through lending and market operationsSee Table 7.
Changes in the official discount rateThe Bank of Japan’s lending is by far the most important means of providing/withdrawing credit to/from private financial institutions in conducting day-to-day reserve management since such lending is the most flexible instrument available to it. The interest rate on Bank of Japan’s lending (i.e., the official discount rate) is in fact the basic interest rate in Japanese financial markets. Changes in the official discount rate are, accordingly considered by corporations and individuals to indicate changes in the basic policy intent of the Bank. In other words, these changes have a significant announcement effect. They also have a cost effect upon economic activity in the sense that changes in various interest rates following changes in the official discount rate influence the lending behavior of financial institutions and the investment/expenditure behavior of corporations and households.
Changes in reserve requirement ratiosThe reserve deposit requirement system was introduced in 1957 under the Law Concerning the Reserve Deposit Requirement System. Under this system most private financial institutions are required to deposit a certain reserve in proportion to their deposits and other liabilities. The reserves are held in non-interestbearing accounts at the Bank of Japan. Similar to changes in the official discount rate, changes in reserve requirement ratios can have an impact upon the lending behavior of financial institutions through cost effect as well as announcement effect. However, changes in reserve requirement ratios in Japan have become less frequent in recent years and now play a minor role as an instrument of monetary policy, compared with changes in the official discount rate.
Window guidanceAs a supplementary instrument of monetary policy during a period of monetary tightening, the Bank of Japan used to employ so-called “window guidance,” which was informal guidance to private financial institutions, particularly major banks such as city banks and long-term credit banks, with respect to their loan plans. “Window guidance” was only moral persuasion but was quite effective in restraining the increase in lending by private financial institutions during a monetary tightening period partly because those institutions cooperated with the Bank of Japan.

In line with financial deregulation, however, “window guidance” was abolished in July 1991 and currently the loan decisions of private financial institutions are completely left to their own business judgment. The fundamental background for this policy change is the perception that private financial institutions can maintain prudent lending behavior because of their concern over capital adequacy and profitability and also that the effectiveness of monetary policy through the interest rate mechanism has been enhanced as a result of financial deregulation.

All are effected through financial transactions between the Bank of Japan and private financial institutions and have a direct impact on variuos financial markets, thus affecting real economic activities.

All are effected through financial transactions between the Bank of Japan and private financial institutions and have a direct impact on variuos financial markets, thus affecting real economic activities.

Table 7.Japan: Credit Control Methods of the Bank of Japan
InstrumentDate of

Interest RateObjectiveCharacteristicsOutstanding Balance at End-Oct. 1993 (¥100 million)
Bank of Japan lending to city banks and foreign banks, etc.Nov. 1962Official discount rateControl of short-term supply and demand of fundsLoan decisions can be made any time within business hours (9:00 a.m. to 3:00 p.m.).54,991
Foreign banks, Dec. 1989On days when a large shortage/surplus drain of funds is projected, loans are made (recalled) In the morning as well as operations to inject drain liquidity into/from the market. When the final estimate of the day’s fund surpluses/shortages (i.e., estimated change in bank reserves) becomes available and the Bank of Japan finds it undesirable, loans can be made/recalled at very short notice before the closing of the Bank’s counters at 3:00 (when it is already too late for operations).

In addition, it is useful to flexibly adjust market conditions in line with the Bank of Japan’s point of view.

Bank of Japan loans to banks are made/recalled solely upon its initiative, as is the size of the loans. This makes the Bank’s lending a very flexible and attractive means of controlling reserve supply in Japan’s short-term money market, which is characterized by large fluctuations of funds.
Bill operationJune 1972Bill rates determined in the interbank bill marketCredit accommodation for short-term fund shortagesThe Bank purchases bills (called “cover bills”) drawn by financial institutions and backed by commercial bills drawn by private firms. Purchase is made via short-term money market dealers. Term ranges from one to three weeks.

In addition, the Bank has started bill-buying operations of longer maturity (one to three months) through competitive bidding since January 1991.
Commercial paper operation (CP)May 1989CP repo rates, or call ratesControl of overnight interest ratesThe Bank purchases commercial paper from financial institutions as well as securities companies (via short-term money market dealers as in the case of commercial bills operations) with resale agreements. So far these have been exclusively overnight.0
Treasury-bill operationJan. 1990Rate determined by auctionCredit accommodation for short-term fund shortagesThe Bank buys securities (in practice, treasury bills or short-term government bills) from financial institutions and securities companies with resale agreements.4,878
Financing-bill operation (FB)May 1981FB repo rates or bill ratesAbsorption of short-term fund surplusesThe Bank sells financing bills (short-term government bills) to short-term money market dealers with repurchase agreements. The dealers resell them to financial institutions and securities companies, which, inturn, distribute them to various banking and nonbanking institutions.58,830
Outright purchases of securitiesNov. 1962Rate determined by auctionCredit accommodation for long-term demand for funds (in particular, long-term demand for cash)The Bank buys securities (in practice, long-term government bonds) from financial institutions and securities companies. The current operating method in which a purchase offer of a relatively small size is made to a limited number of institutions chosen by the Bank on a rotational basis was introduced in June 1984 in order to mitigate the impact of the operation on the market prices of bonds.Amount purchased Jan.-Oct. 1993 16,965
Purchase of securities with resale agreementDec. 1987Rate determined by auctionCredit accommodation for short-term fund shortagesThe Bank buys securities (in practice, long-term government bonds) from financial institutions and securities companies with resale agreements.1,644
Note: In addition to the types of loan listed here, some limited amount of lending is made available upon the bank’s request (the lending takes the form of discounting eligible commercial bills and import settlement bills).
Note: In addition to the types of loan listed here, some limited amount of lending is made available upon the bank’s request (the lending takes the form of discounting eligible commercial bills and import settlement bills).

The following episode illustrates how the Bank of Japan conducts monetary control. In mid-August 1993, economic growth was weaker than expected and there were no clear indications of imminent recovery. This recognition was shared by the Bank and the market. In such circumstances, the Bank judged that money market rates should be set at the lower end of the range that was compatible with the level of the official discount rate, which was 2.5 percent at that time. Thus, the Bank tried to ease reserve pressure through money market operations. As a result, the overnight money market rate declined by about a quarter of a percent toward the end of the month, which gave downward pressure on short-term lending rates.

In September, the weakness of the economy became more apparent with the release of the Industrial Production Index, the Short-Term Economic Survey of Enterprises (Tankan), and other macroeconomic statistics. Accordingly, the Bank thought that further interest rate reduction would be necessary to facilitate the process of bringing Japan’s economy onto a noninflationary sustainable growth path. This time, there was little room for money market rates to decline, given the 2.5 percent official discount rate. Furthermore, the Bank judged that a significant reduction was necessary and that this monetary policy stance should be made clear, because the economy was suffering from the prolonged recession. In these circumstances, the Bank decided to reduce the official discount rate by 0.75 points, to 1.75 percent on September 21, 1993. In line with this, the Bank induced money market rates to decline through money market operations in order to lower short-term lending rates.


The ultimate objective of monetary policy has been, and continues to be, price stability upon which the sustainability of economic growth can be secured. In order to achieve this objective, the Bank of Japan implements monetary control through lending and market operations on a daily basis, changes in the official discount rate, and changes in reserve requirement ratios. In the implementation of monetary policy, its stance has traditionally been “pragmatic”—i.e., policy formation is based on eclectic judgment, taking into account various factors including price developments, economic activity, money supply, the exchange rate, money market rates, and international considerations. This is more or less the approach adopted by many central banks; the point is that the Bank of Japan does not rely on a single target or a set of quantitative indicators.

Such fundamental orientation of the Bank’s monetary policy remains unchanged. However, the dramatic changes in financial conditions in the 1980s, particularly in the second half, persuaded the Bank to review the situation and, in fact, the degree of emphasis on each individual economic variable has changed, which perhaps reflects the Bank’s traditional pragmatic stance. As mentioned so far, the Bank of Japan now places greater emphasis on money market rates because the effectiveness of monetary policy through the interest rate mechanism has been enhanced as a result of financial deregulation. It should be added that because of financial globalization the Bank has to take greater account of foreign exchange markets, international financial markets, and the global economy.

With respect to the implementation of monetary policy, the Bank of Japan has to continue its efforts to improve the functioning of financial markets, following up money market reforms and deregulatory measures. However, several problems remain. First, there are different tax rates imposed on similar financial transactions, a procedure which is inconsistent with practice in other major countries. Resolving this would lead to better access to Japanese financial markets from abroad. Second, Japan’s domestic capital markets, in particular the corporate bond market, are still not very active, owing partly to the inconvenience that current registration and other procedures impose on bond issuers in the private sector. Because of the inactive primary bond market, the secondary market is similarly dull. In contrast, Japanese bonds have been issued and traded heavily in Eurobond markets. Third, for facilitating the Bank of Japan’s market operations, there is also the need to develop a market that is capable of handling a large volume of homogeneous and liquid instruments issued by the most creditworthy entities (e.g., government financing bills or other short-term government paper). The development of such markets, together with a same-day settlement facility, would solve technical problems the Bank has faced with respect to market operations.

In conjunction with pursuing market reform along these lines, the Bank will continue to review its market operations in terms of instruments, timing, and other features so as to communicate its policy intent more precisely to the markets.


    Fukao, Mitsuhiro, “Liberalization of Japan’s Foreign Exchange Controls and Structural Changes in the Balance of Payments,”Monetary and Economic Studies, Vol. 8, No. 2 (Institute for Monetary and Economic Studies, Bank of Japan, September1990), pp. 101–165.

    • Search Google Scholar
    • Export Citation

    Fukui, Toshihiko, “Recent Developments of the Short-Term Money Market in Japan and Changes in Monetary Control Techniques and Procedures by the Bank of Japan,”Special Paper No. 130 (Research and Statistics Department, Bank of Japan, January1986).

    • Search Google Scholar
    • Export Citation

    Fukui, Toshihiko, “Missions and Responsibilities of a Central Bank in a Contemporary Context,”Bank of Japan Quarterly Bulletin, Vol. 1, No. 3 (August1993), pp. 27–31.

    • Search Google Scholar
    • Export Citation

    Mieno, Yasushi, “Current Economic Developments in Japan and Abroad,”Special Paper No 227 (Research and Statistics Department, Bank of Japan, 1993).

    • Search Google Scholar
    • Export Citation

    Money Market Studies Group, “Japan’s Short-Term Money Market and Its Issues” (unpublished, June8, 1990).

    Nagashima, Akira, “Japan’s Economy and Monetary Policy” (unpublished paper presented at the Annual General Meeting of the Institute of Foreign Bankers in Tokyo, November16, 1993).

    • Search Google Scholar
    • Export Citation

    Nakajima, Zenta, and HirooTaguchi, Toward a More Stable Financial Framework: Long-Term Alternatives—An Overview of Recent Bank Disruption Worldwide (Institute for Monetary and Economic Studies, Bank of Japan, 1993).

    • Search Google Scholar
    • Export Citation

    Nakao, Masaaki, “External Balance Adjustment, Monetary Policy Management and the Mobility of International Private Capital Flows,”International Capital Flows, Exchange Rate Determination and Persistent Current-Account Imbalances (Basle: Bank for International Settlements, June1990).

    • Search Google Scholar
    • Export Citation

    Nakao, Masaaki, “Recent Developments in Lending Rates: Changing Behavior of Banks under Interest Rate Liberalization,”Special Paper No. 206 (Research and Statistics Department, Bank of Japan, September1991).

    • Search Google Scholar
    • Export Citation

    Nakao, Masaaki, and AkinariHorii, “The Process of Decision-Making and Implementation of Monetary Policy in Japan,”Special Paper No. 198 (Research and Statistics Department, Bank of Japan, March1991).

    • Search Google Scholar
    • Export Citation

    Shigehara, Kumiharu, “Japan’s Experience with Use of Monetary Policy and the Process of Liberalization,”Monetary and Economic Studies, Vol. 9, No. 1 (Institute for Monetary and Economic Studies, Bank of Japan, March1991), pp. 1–22.

    • Search Google Scholar
    • Export Citation

    Suzuki, Yoshio, The Japanese Financial System (London: Oxford University Press, 1987).

    Suzuki, Yoshio, AkioKuroda, and HiromichiShirakawa, “Monetary Control Mechanism in Japan,”Monetary and Economic Studies, Vol. 6, No. 2 (Institute for Monetary and Economic Studies, Bank of Japan, November1988), pp 1–27.

    • Search Google Scholar
    • Export Citation

    Takeda, Masahiko, and PhilipTurner, “The Liberalisation of Japan’s Financial Markets: Some Major Themes,”BIS Economic Papers No. 34 (Basle: Bank for International Settlements, November1992).

    • Search Google Scholar
    • Export Citation

    Other Resources Citing This Publication