Abstract

The Bank of Japan Law states that “The Bank of Japan has for its object the regulation of the currency, the control and facilitation of credit and finance, … in order that the general economic activities of the nation might adequately be enhanced.” The primary objectives of monetary policy pursued by the Bank of Japan in accordance with this law have evolved considerably since the early 1970s. Prior to that time, monetary policy was primarily directed at supporting the rapid growth in output and productivity and maintaining the yen at a fixed exchange rate, consistent with an acceptable rate of inflation and a manageable balance of payments position. With the move to floating exchange rates and the inflationary consequences of the first oil price shock in the early 1970s, the Bank has accorded high priority to price and exchange rate stability, although the maintenance of economic growth and low unemployment have remained important objectives.32

Intermediate Targets and Instruments

The Bank of Japan Law states that “The Bank of Japan has for its object the regulation of the currency, the control and facilitation of credit and finance, … in order that the general economic activities of the nation might adequately be enhanced.” The primary objectives of monetary policy pursued by the Bank of Japan in accordance with this law have evolved considerably since the early 1970s. Prior to that time, monetary policy was primarily directed at supporting the rapid growth in output and productivity and maintaining the yen at a fixed exchange rate, consistent with an acceptable rate of inflation and a manageable balance of payments position. With the move to floating exchange rates and the inflationary consequences of the first oil price shock in the early 1970s, the Bank has accorded high priority to price and exchange rate stability, although the maintenance of economic growth and low unemployment have remained important objectives.32

Since the late 1970s, Japanese monetary policy has evolved from a system fundamentally reliant on credit control at regulated interest rates to a system geared more toward monetary control with flexible interest rates fostered by extensive financial and foreign exchange liberalization.33 As part of this evolution, the intermediate target of monetary policy employed by the Bank of Japan was shifted in mid-1978 from lending by financial institutions to the nonbank sector (mainly to the corporate sector) to a broadly defined money stock.34 This change in the intermediate target reflected in part a declining share of corporate sector lending in the portfolios of financial institutions and a commensurate sharp increase in claims on the public sector and nonresidents, which resulted in a weakening of the link between bank lending to the corporate sector and the ultimate objective of monetary policy. At the same time, greater emphasis was given to interbank money market interest rates, in particular the call and bill discount rates, as primary instruments for money market operations to achieve the desired monetary aggregate objective.35 Previously, money market operations by the Bank of Japan had depended mainly on “window guidance” or moral suasion to regulate the volume of bank credit as well as the control of major lending and deposit rates. This instrument has become less important since lending by financial institutions was replaced by monetary aggregates as intermediate targets.

The decision to give greater emphasis to the call and bill discount rates as the instruments for money market operations was coincident with a policy shift aimed at promoting the development of more liberal interbank and open money markets. Markets for certificates of deposit and Gensaki transactions36 were developed and expanded in the late 1970s. The Euro-yen market was liberalized and expanded, and interest rate arbitrage between the domestic market and the Euro-yen market became very active in the period since 1980 when the New Foreign Exchange and Trade Control Law was enacted. Consequently, changes in the interbank market rates came to be highly correlated with changes in the open market rates and Euro-yen market rates.37 The new environment provided an effective mechanism to transmit initial policy actions on the call and bill discount rates to the rest of the money markets and the monetary aggregates.

Thus, the Bank of Japan came to designate the call and bill discount rates as the key operating variables in its conduct of monetary policy since the late 1970s. Furthermore, it began to influence those rates indirectly by controlling the supply of reserves to the banking system, rather than by regulating directly those rates in the quotation system as in the past.38 In order to control the supply of reserves, the Bank adjusts its direct lending to banks or intervenes in the interbank money markets (bill discount operations) and in certain of the open money markets. These operations are designed to either offset or complement the net cash inflow (or outflow) into the banking system from the rest of the economy such that the total supply of reserves is brought to a desired level. The Bank of Japan employs an operating strategy that involves the use of the “reserve progress ratio” (see below) to guide the call and bill discount rates by means of control of reserves.

Money market interest rates appear to have a relatively robust relationship with broadly defined money and the economy, mainly through the following three channels.39 First and most important, a change in interbank rates induces a corresponding change in other interest rates, which in turn influences the level of aggregate spending and thereby affects the demand for credit and ultimately the demand for money. Second, changes in interbank rates affect the profitability of bank loans as the loan rates are less flexible because they are tied to the prime lending rates which are, in turn, based on regulated deposit rates. Third, changes in market rates relative to deposit rates may generate disintermediation or re-intermediation, which affects the reserve positions of banks and hence, their ability to provide credit. The relative importance of these latter two channels should diminish as liberalization of deposit rates proceeds and their relative inflexibility is reduced.40

In more recent years, the structure of the Japanese financial market and its relationship with the international financial centers has undergone further change as the process of financial liberalization has continued in the domestic market and the offshore yen markets have expanded sharply both in Europe and in Tokyo. These developments contributed to reducing the degree of controllability of short-term interest rates and to weakening the link between the intermediate target and the ultimate objectives of monetary policy. For example, the Bank of Japan maintained a relatively accommodative policy stance during 1987–88 even though the rate of growth of the monetary aggregate generally exceeded the targeted rate during that period. In addition, the two-month bill discount rate, the interbank rate that was central for the Bank of Japan’s daily operations, diverged considerably from comparable rates in the open markets, especially in the summer of 1988 when the Euro-yen rates rose.

In an effort to counter these developments, the Bank of Japan introduced in November 1988 some important measures to reform the domestic money markets and to alter the procedures for money market intervention.41 A key feature of these changes was to replace market operations intended to influence the bill discount rates in the maturity range of one to three months with operations in the markets for bills of shorter maturities, namely one to three weeks. Furthermore, the Bank of Japan began conducting overnight operations in commercial paper in the spring of 1989 in order to enhance its ability to influence and to fine-tune banks’ reserve positions on a daily basis. As a result, the two-month bill discount rate is now determined more by market supply and demand than by the Bank’s monetary policy stance, rising to a level roughly consistent with other comparable market rates. Moreover, while the daily variation in the two-month bill discount rate prior to the November reform was typically very small, presumably reflecting the smoothing operations by the Bank of Japan designed to regulate the supply of reserves to stabilize money market interest rates in the short run, this rate has shown larger fluctuations following the November reform. The two-month bill discount rate had also been regarded as the second official discount rate, an important indicator of the policy stance of the Bank of Japan and as such, was considered to be more important than the official discount rate itself, which has been changed very infrequently.42 With these reforms, however, interest rates on shorter-maturity instruments, that is, overnight call rates and the one- to three-week bill discount rates, are more appropriate indicators of the Bank of Japan’s current monetary policy stance.

The November reform marked a turning point in the conduct of monetary policy in Japan. The reform was intended to permit the Bank of Japan to maintain some control over short-term interest rates but at the same time to enhance the functioning of interest rate arbitrage between the domestic and offshore markets, as well as between the interbank and open money markets. It would appear that the Bank of Japan is increasingly focusing on influencing the short-term interest rates and directly influencing the general economy rather than conducting monetary policy through the strict application of monetary targeting. This new approach is expected to enhance the effectiveness of Japanese monetary policy to the extent that officially induced changes in the shorter-term interest rates impart appropriate signals to the banking system and the rest of the economy.

Formulation and Implementation of Policy

The Bank of Japan Law authorizes the Policy Board for the Bank of Japan to formulate, direct, and supervise monetary policy. This Board is composed of the Governor of the Bank of Japan, a representative of the Ministry of Finance, and four representatives of the private sector with experience in banking, industry, commerce, and agriculture. While the Board retains an advisory role, monetary policy is effectively conducted by the Bank of Japan. The Governor, the Deputy Governor, and several Executive Directors meet four times each week to review current economic and financial conditions and to evaluate the current stance of monetary policy. The Bank’s senior staff from the operations department meets daily with the Governor to advise on recent developments and also to receive operational directives.

The Bank of Japan implements monetary policy by influencing the reserve position of the banking system. It adjusts the total supply of reserves in the banking system to desired levels by altering its direct lending to financial institutions and by intervening in the interbank and open money markets. The scale and direction of such operations are determined so as to either counteract or complement the estimated net cash flow into the banking system from the public sector, the corporate and household sectors, and the net official intervention in foreign exchange markets. The net cash flow is projected as the sum of changes in currency in circulation and in government deposits with the Bank of Japan, less changes in net foreign reserves.43 In smoothing operations, the Bank of Japan offsets the net cash flow into, or out of, the banking system. When a fundamental change in the call and bill discount rates is deemed necessary, the Bank of Japan either counteracts or complements the net cash flow so that either more relaxed or more stringent conditions are generated in the money market, thereby placing pressure on these rates so that they move in the desired direction.44

The basic strategy employed by the Bank of Japan in its management of reserves involves the use of the reserve progress ratio. Banks are required to maintain reserve deposits at the Bank of Japan. At the end of each reserve maintenance period, the average of each institution’s deposits during that period must be at least equal to the legal requirements calculated for the preceding calendar month. The reserve progress ratio is defined as the ratio of the reserve deposits accumulated up to the current date within the maintenance period to the total reserve deposits required for the preceding calendar month. While the Bank of Japan neutralizes any shortage or surplus of reserves over the entire reserve period, it adjusts the reserve progress ratio within the period to convey its policy intentions to the banking system.45 For example, if banks maintain their daily reserve balances at the average daily requirements, the reserve progress ratio would rise by 3.3 percent each day.46 If the Bank of Japan wished to raise the call and bill discount rates, it would not supply sufficient reserves to enable the reserve progress ratio to rise by 3.3 percent each day. As financial institutions turned to the interbank market to acquire the reserves necessary to meet their reserve requirements, the call and bill discount rates would rise.

The Bank of Japan uses a variety of methods to provide or absorb reserves in the daily implementation of monetary policy. Regardless of the type of operation employed, the terms and volume of the market operation affect interest rates (particularly, the call and bill discount rates) and consequently indicate the current stance of monetary policy. Direct lending through the discount window to financial institutions, mainly city banks, is the most flexible instrument employed by the Bank of Japan and hence is typically used to smooth daily fluctuations in the banking system’s reserve position. Since the official discount rate, the interest charged by the Bank for lending to financial institutions, is usually below the call and bill discount rates, lending is effected under a rationing procedure. Furthermore, lending by the Bank of Japan may be withdrawn at any time at the Bank’s option and the interest charged on lending is calculated on the period of the loan plus one day so that the effective interest rate exceeds the discount rate and may even be a penalty rate for very short-term loans.47 To accommodate seasonal fluctuations or to influence banks’ reserve positions, the Bank customarily operates in the money markets, dealing mainly in bills of corporations with high credit ratings,48 bills drawn on banks with bills of corporations as collateral, in short-term government bills,49 in certificates of deposit beginning in 1986, or in commercial paper beginning in 1989. The Bank of Japan also accommodates the long-term demand for reserves generated by secular changes in the demand for money associated with economic growth by dealing outside of the interbank market in long-term government bonds.

The Bank of Japan may also employ changes in the official discount rate. Changes in the official discount rate, however, are effective primarily to the extent that they “announce” a change in the Bank’s policy stance and hence influence expectations on the part of market participants, as the official discount rate ordinarily remains below market rates. However, the effect on market expectations is quite strong, as changes in the official discount rate are usually followed by reinforcing operations in the money market by the Bank of Japan.

Identifying Changes in Policy

The policy stance of the Bank of Japan generally manifests itself in changes in the call and bill discount rates. These rates, in the maturity range where the Bank of Japan intervenes, usually exhibit very little changes in the very short run mainly because of the Bank’s smoothing operations. The call and bill discount rates, however, have shown much more variability in the monthly data over the medium term, exhibiting large swings. For example, immediately following the Plaza Agreement in 1985, the Bank of Japan attempted to reverse the declining trend in the foreign exchange value of the Japanese yen. The Bank of Japan sharply curtailed its direct lending to banks and its bill discount operations, thereby putting pressure on the banks to obtain reserves in the interbank money markets. As a result, the two-month bill discount rate rose sharply and other short-term rates, particularly the call rate, soon followed due to active interest rate arbitrage across the call and bill discount markets.50 Similarly, after the reforms, short-run volatility in the overnight call rate and the one- to three-week bill discount rates has declined. However, these rates demonstrated an upward trend during the last several months of 1989 and into 1990 as the Bank of Japan tightened its policy stance.

These developments clearly suggest that the stance of Japanese monetary policy does not change dramatically on a daily basis, but rather goes through phases of gradual changes that last at least several months. The limited daily variance of the two-month bill discount rate prior to November 1988 is a reflection of the basic feature of the short-term money market operations by the Bank of Japan that was designed to eliminate seasonal fluctuations and other short-term aberrations. Thus, it would appear that both the call and bill discount rates can be considered important indicators of the stance of Japanese monetary policy. However, because of the money market reforms introduced in November 1988, more attention should now be paid to the movements of one- to three-week bill discount rates, rather than the two-month rate, to assess the stance of intervention by the Bank of Japan in the money markets and, more generally, the stance of monetary policy in Japan.

33

The extensive financial and foreign exchange liberalization occurred against the background of fundamental changes in the structure of the Japanese economy during the 1970s. Until the first oil crisis, the Japanese domestic financial system had been predominantly characterized by the channeling of funds from the household sector, with a high saving ratio, through the banking system to the corporate sector which demanded investment funds. For this reason, the banks’ asset portfolios had consisted largely of loans to corporations. However, in the wake of the first oil price shock, two fundamental changes emerged in the structure of Japanese economy and its flow of funds. First, the Japanese Government began to run large deficits in its operations in 1975 in an effort to counteract the recession that year, financing them with large issues of government bonds. Second, the growth of the Japanese economy sharply decelerated, as did the investment activity by the corporate sector, reducing its once predominant demand for domestic saving. As a result, the proportion of indirect financing was drastically reduced, and the government and foreign sectors began to absorb larger shares of domestic saving.

34

Broadly defined money consists of M2 (currency plus demand, savings, and time deposits) plus certificates of deposit. Since the third quarter of 1978, the Bank of Japan has announced its quarterly projections of the average outstanding M2 plus certificates of deposit for the next quarter in terms of year-over-year growth rates. Hutchison (1986) and Ito (1988) have questioned whether these projections are in fact targets or whether they should be viewed as forecasts that reflect the current level of economic activity and not the policy goals of the Bank of Japan.

35

The call rate is an interest rate in the short-term interbank money market. The bill discount rates are discount rates on various bills of short maturities traded in the interbank money market.

36

Gensaki transactions are repurchase agreements usually involving government securities.

37

See Fukui (1986), for example.

38

The quotation system in which the Bank of Japan had been setting the rates was discontinued in 1978.

39

See Hutchison (1986) and Suzuki (1990) for an empirical analysis of the relationship between interest rates and the monetary aggregates.

40

See Cargill (1986) for a discussion of the impact of financial market liberalization on the implementation of monetary policy.

41

The changes were introduced in the maturity structure of the interbank money markets to encourage increased interest rate arbitrage between the interbank and open money markets and to maintain the effectiveness of monetary control by the Bank of Japan. The maturities of collateralized commercial bills were extended on the short end to one week; thus, their maturities now range from one week to six months, compared with one to six months previously. The maturities of collateralized call trading were limited to overnight to one week, compared with slightly longer previous maturities of overnight to three weeks. On the other hand, the maturities of uncollateralized call trading were lengthened to a range of overnight to six months. These changes were intended to enable the Bank of Japan to intervene in the interbank money markets through purchasing operations of commercial bills mainly in the maturity range of one to three weeks, compared with the range of one to three months previously.

42

The official discount rate was reduced to a postwar low in February 1987 but was increased three times during 1989.

43

This relationship can be derived by rearranging the balance sheet of the Bank of Japan.

44

This formulation of monetary policy provides a link between foreign exchange intervention and money market intervention; in effect, it implies automatic sterilization of the reserves either generated or eliminated through official foreign exchange intervention.

46

The reserve progress ratio is usually measured as the deviation from the average because individual banks judge their actual reserve position in relation to the average daily requirement as a standard. For a fuller explanation of the reserve progress ratio, see Kanzaki (1988).

47

In late 1989, for example, with the current discount rate of 4.25 percent and the call rate of around 6.35 percent, the effective interest rate on loans for two days or less exceeded the call money rate.

48

These bills include commercial and industrial bills, trade bills, promissory notes, export and import bills, bills of exchange, etc.

49

The Bank of Japan began operations in short-term government bills in 1981, but the market is not yet deep enough to permit large purchase operations in this instrument.

50

For a discussion, see Takagi (1988).

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