s 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 short-term policy interest rate. This episode highlights the importance of bringing about an increase in the so-called neutral interest rate — that is, the nominal interest rate level that is neutral to economic activity — by anchoring inflation expectations at about 2 percent and of securing the ability of monetary policy to respond.
I took office as Governor of the Bank of Japan in March 2013 and immediately introduced a monetary policy regime — quantitative and qualitative monetary easing (QQE) — that is quite different from past regimes. QQE consists of two pillars: (1) directly working on people’s expectations through a price stability target of 2 percent and a strong and clear commitment to doing whatever it takes to achieve this, and (2) directly encouraging a decline in long-term interest rates through large-scale purchases of long-term Japanese government bonds (JGBs). If inflation expectations rise as a result of the former and nominal long-term interest rates fall as a result of the latter, this will push real interest rates to levels below the natural rate of interest even in the face of the zero lower bound.
The policy in which a central bank lowers interest rates and deposit ratios to make credit more easily available. This makes borrowing easier for businesses, which stimulates investment and expansion of operations. The immediate result of monetary easing is generally a boost in stock prices. In the medium term, it promotes economic growth. However, if this policy remains for too long, it can lead to a situation in which there is a glut of currency or too many dollars chasing too few goods and services, leading to inflation. For this reason, most central banks alternate between policies of monetary easing and monetary tightening to encourage growth while keeping inflation under control.
In additional steps, the Bank of Japan in January 2016 introduced a negative interest rate policy in order to address the strong headwinds caused by turbulence in global financial markets. The negative interest ra