Haruhiko Kuroda, Governor of the Bank of Japan
Speech at the University of Oxford, June 8, 2017
2.Deflation in Japan: Declines in Potential Growth Rate and Inflation Expectations.
Since the 1990s, economic volatility has sharply decreased in many advanced economies. Former Federal Reserve Chairman Ben Bernanke referred to this as the “Great Moderation” and argued that a major reason was the dramatic improvement in the ability of central banks in those economies, including the United Kingdom, to stabilize inflation expectations through the introduction of measures such as inflation targeting.
Meanwhile, Japan’s economy found itself in a completely different situation. Japan experienced a major asset bubble from the late 1980s to the early 1990s and, following the collapse of the asset bubble, suffered a sharp economic slowdown and serious financial instability. Moreover, firms had to deal with the so-called three excesses — excess production capacity, excess employment, and excess debt — while financial institutions had to grapple with the nonperforming loan problem. While the negative legacy of the asset bubble had been more or less dealt with by the mid-2000s, Japan’s potential growth rate, which had been around 4 percent in the early 1990s, dropped to about 1 percent by the late 1990s (Chart 5). On the price front, the annual rate of change in consumer prices fell into negative territory in 1998 and generally remained negative over the following decade and a half. Against this background, inflation expectations also seem to have declined, although they were not accurately captured in a timely manner.
On the monetary policy side, the policy interest rate, which was 6 percent in the early 1990s, had been lowered to 0.5 percent by 1995. At this point, conventional monetary easing measures through cuts in the short-term policy interest rate had been more or less exhausted. Paul Krugman dubbed this situation “Japan’s trap”and stated that Japan had actually fallen into a liquidity trap, which had long been regarded as just a theoretical possibility written in the back pages of macroeconomic textbooks. In order to get out of this trap, the Bank of Japan introduced a zero interest rate policy in 1999, followed, in 2001, by quantitative easing, in which the outstanding balance of current accounts that financial institutions hold at the Bank of Japan was set as the operating target for money market operations. Thus, the Bank of Japan pioneered the introduction of unconventional monetary policies, but unfortunately Japan was unable to overcome deflation.
Why did Japan’s economy fail to get out of the liquidity trap even though the Bank of Japan had taken unprecedented monetary policy steps? With the benefit of hindsight, we now know that Japan faced a simultaneous decline in the natural rate of interest and in inflation expectations. Under these circumstances, as nominal short-term interest rates faced the zero lower bound, it was difficult to lower real interest rates to level well below the natural rate of interest and achieve sufficient monetary easing. As a result, the downturn in growth during this period caused a decline in prices, further reducing growth through the rise in real interest rates, so that weak economic growth and deflation reinforced each other over a long period.
Then, in 2008, the global financial crisis led to another sharp contraction in Japan’s economy (Chart 6). Even though Japan’s financial institutions had already resolved the nonperforming loan problem by that time and had only limited exposure to subprime-related products, Japan experienced a precipitous decline in real GDP that was more severe than that in Europe and the United States, which was the epicenter of the crisis. There are a number of reasons for this, but what certainly played a role is that at the time the policy interest rate in Japan was only 0.5 percent, so that — unlike in Europe and the United States, where rate cuts of 3 – 4 percentage points were possible — there was little room for a monetary policy response through cuts in the