8 Monetary Policy: Summary of Staff Views

Tamim Bayoumi, Guy Meredith, and Bijan Aghevli
Published Date:
June 1998
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Guy Meredith

The economic environment facing the monetary authorities in Japan during the 1990s has been exceptionally difficult. Asset prices fell sharply in 1990, and continued to decline thereafter, triggering severe balance sheet difficulties in the financial and business sectors. The yen appreciated rapidly from early 1993 to mid-1995, which placed significant pressures on the export sector. And the economy suffered a deep and protracted economic downturn following the collapse of the bubble economy. The Bank of Japan responded by progressively easing short-term interest rates during 1991-95, ultimately bringing interest rates to record lows. Nonetheless, recovery has been troublingly sluggish.

Against this background, the staff’s views on Japan’s monetary conditions in recent years have been as follows:

  • The staff’s concern about the relatively slow pace of interest rate cuts following the bursting of the asset-price bubble led it to call for an earlier and more aggressive easing of monetary policy. In particular, there was concern that indicators, such as the level of nominal interest rates, were not sending the correct signal regarding monetary conditions, given the decline in inflation and the drag on the economy from the appreciation of the yen and the balance sheet difficulties experienced in the financial and corporate sectors. The relatively slow monetary policy response to these factors was seen as prolonging the slowdown in activity.

  • An additional concern has been the appropriate role of the exchange rate in the formulation of monetary policy. The authorities were mindful that efforts to resist the yen’s appreciation had contributed to overly easy policies during the 1980s. In recent years, as a result, the authorities were reluctant to adjust policies in the face of exchange rate developments. The staff agreed that short-term exchange rate stabilization should not be weighted highly as a domestic monetary policy objective. However, the effects of exchange rate movements (as well as the movements of other financial variables) on future economic activity still needed to be taken into account in setting policy.

  • In this context, the staff raised the broader issue of the adequacy of the monetary policy framework. In particular, monetary policy in the past has tended to be “behind the curve,” and needed adjustments in the monetary stance delayed until the effects of shocks had already shown up in aggregate demand. Thus, the need for a more forward-looking policy framework was indicated that took into account the effect of shocks on future activity and the lags between monetary policy actions and their economic impact.

  • The staff has generally supported proposals for increasing the Bank of Japan’s independence. At the same time, it is also important to strengthen the accountability and transparency of monetary policy by defining explicit medium-term policy objectives. For example, the staff has suggested the objective of aiming for a low and stable underlying inflation rate in the range of 1-2 percent. This is preferable to the objective of absolute price stability, given the biases in measured inflation and the need to retain the flexibility to cut interest rates in the face of deflationary shocks.

The staff’s analytical work has provided an important foundation for its policy advice. In particular, the staff’s analysis of the role of monetary indicators in Japan has highlighted that interest rates provide incomplete information regarding monetary conditions, and suggests the need to focus instead on a broader set of indices. For example, a monetary conditions index (MCI) constructed by the staff suggested that the yen’s appreciation had limited the ease in monetary conditions that occurred following the collapse of asset prices, and buttressed the staff’s call for deeper and more rapid cuts in interest rates during 1993—95.1

Evidence pointing to the usefulness of the MCI approach was initially provided by simulations of a small model of the Japanese economy. This work suggested that an MCI-based policy rule performed better for stabilizing income than rules based on the money supply or nominal income.2 Subsequent analyses (as background for the 1993 World Economic Outlook and bilateral consultation discussions) stressed the need for monetary policy to pay greater attention to asset price inflation for gauging the stance of policy.3 This was followed by work that extended the MCI framework to take into account the effect of stock prices and the stance of fiscal policy.4 While not suggesting the adoption of a monetary conditions index as a target for policy, the staff’s work in this area has highlighted the useful role that such indices can play in aggregating information and providing a clearer signal of the combined effect of financial variables on demand.

A second strand of the staff’s analysis has focused on the extent to which balance sheet difficulties in the banking sector, as well as other factors, may have adversely affected the supply of credit—causing a “credit crunch”—and made monetary conditions more restrictive than otherwise. In 1994, the staff examined whether “abnormal” credit conditions existed in the early 1990s, and concluded that credit conditions may have been unusually tight in early 1990, possibly owing to the fall in asset prices and efforts by the banking sector to meet the new Bank for International Settlements (BIS) capital-adequacy requirements. However, it appeared that by 1992, credit conditions had returned to levels consistent with previous historical relationships. More recent studies suggested that the period of unusually tight credit conditions that was identified in the earlier study might have been longer lasting, particularly for small- and medium-sized firms, but acknowledged that the evidence for this was uncertain.5

Looking ahead, the monetary authorities face significant challenges. In particular, there remains the difficult task of supporting the recovery. At the same time, interest rates also are extremely low from a historical perspective, and at some point, the Bank of Japan will have to begin the process of restoring interest rates to more sustainable levels in a way that minimizes disruptions to financial markets and preserves the credibility of its commitment to price stability.

Structural changes will also continue to affect the environment in which the Bank of Japan must operate to achieve its objectives. Financial market deregulation has already caused the monetary authorities to move toward more market-oriented operating procedures, and substantial additional deregulation of financial markets is expected. At the same time, proposals are being considered to increase the independence of the Bank of Japan, and to improve the transparency and accountability of monetary policy. Both these forces are likely to require a further evolution of the way in which policy is implemented, as well as a clearer definition of the longer-term objectives of monetary policy.


    International Monetary Fund1996Japan—Recent Economic Developments IMF Staff Country Report 96/90 (Washington: International Monetary Fund) chapter IV.

    LipworthGabrielle and GuyMeredith1998“A Reexamination of Indicators of Monetary and Financial Conditions,” in Structural Change in Japan: Macroeconomic Impact and Policy Challengesedited byBijanAghevliTamimBayoumi and GuyMeredith (Washington: International Monetary Fund) pp. 15767.

    MeredithGuy1992“Discretionary Monetary Policy Versus Rules: The Japanese Experience During 1986–91,”IMF Working Paper 92/63 (Washington: International Monetary Fund).

    SchinasiGarry and MonicaHargraves1993“Boom and Bust in Asset Markets in the 1980s: Causes and Consequences,” in Staff Studies for the World Economic Outlook (Washington: International Monetary Fund) pp. 127.

    WescottRobert1996“Assessing the Risks of a Credit Squeeze Among Smalland Medium-Sized Enterprises in Japan,”Japan—Selected Issues IMF Staff Country Report 96/114 (Washington: International Monetary Fund). pp. 6992.

The staff’s MCI for Japan is a weighted sum of changes in the real interest rate and the real effective exchange rate, and was based on work in this area done at the Bank of Canada. Note that in some cases, MCIs are used to gauge the stance of policy. The staff has used its MCI for Japan in a narrower context, to gauge the effect on aggregate demand of movements in variables that are affected by both monetary policy and overall economic conditions. See the October 1996 World Economic Outlook for a description of how the MCI approach has been applied in other countries.

Lipworth and Meredith (Chapter 11, this volume).

Wescott (1996). See also International Monetary Fund (1996).

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