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BoJ May End Easy Money Policy, but Zero Interest Rates to Continue

12, 21. 2005

   For the past four and half years, the Bank of Japan has continued to pump money into the economy through expansion of commercial bank lending. But with anxiety over the health of the financial system abating as the nonperforming loan issue approaches settlement, this 'quantative' monetary easing policy is set to change. At the same time, there now are also signs such as the long-awaited rise of consumer price index (CPI) into positive territory that Japan is emerging from deflation.

   The central bank began preparing to curb monetary expansion at the end of October, having predicted in its Outlook for Economic Activity and Prices for the medium term that the CPI would rise 0.1% in the current fiscal year, for its first upturn in eight years, and 0.5% in fiscal 2006.

'Easy Money Helps Keep Inefficient Firms Afloat'

The Bank of Japan is willing to lift quantitative easing policy.
The Bank of Japan is willing to lift quantitative easing policy.

   Easy money policies at zero interest rates are certainly without precedent in Japan. The Bank has repeatedly argued that sustained CPI growth above 0% was a precondition for any change in its financial policies. By forecasting in its Outlook report when the CPI growth rate would turn positive, the Bank only meant to send a message to the markets that it had an 'exit policy'-in other words, that monetary expansion policies were soon to end. The central bank later announced that the October CPI growth was zero percent year on year, emerging from negative territory for the first time in five months. This figure justified the central bank's earlier forecast, and confirmed it in its plan to turn off the easy money spigot-so much so that BoJ Governor Toshihiko Fukui declared that the central bank would definitely 'go the whole hog'-and end easy money policies-if positive CPI growth was sustained.
   Two reasons why the central bank is now so eager to shift away from its strategy of monetary expansion are that 1) it was not clear that it was working, and 2) it was gradually leading to unwanted side-effects. Some financial observers credit the policies with staving off economic meltdown, and giving companies breathing space to deal with excessive capital investment and debts. At this point, however, it is not possible to state categorically that these benefits were due to an expanded money supply. Some central bank officials even argue that blunting of the impact of interest rates caused by the easy money policy helps keep inefficient firms afloat, has hampered the efficient allocation of capital and disrupted the orderly functioning of markets. If this is the case, there is a worry that the current upturn in real estate and stock markets are symptoms of a 'mini-bubble economy' caused by inflows of surplus easy money, hardened to interest-rate risk, that had nowhere else to go.

LDP Remains Cautious on Monetary Policy Change

   Unlike the central bank, the Liberal Democratic Party-led government and bureaucracy remain highly cautious about ending monetary easing. They reason that if these policies are ended at an early date and long-term interest rates jump, the cost of meeting interest payments on government bonds and other expenditures would increase, preventing the government from fulfilling its fiscal reconstruction pledge and forcing up consumption and other taxes-which would damage popular trust. Citing the continued negative CPI growth, Heizo Takenaka, minister of internal affairs and communications, has argued in turn that overall perspectives, not only CPI trends, should be used in judging whether Japan has shaken off deflation. Prime Minister Junichiro Koizumi also signalled to the Bank that he thinks it still too early to end monetary expansion policies.
   If Japan were to persist with monetary easing policies even as the United States and European countries begin raising interest rates again, however, the gap between Japanese and U.S. rates would widen, and the yen would weaken too much against a strong dollar, which would push up the U.S. current-account deficit. This would also adversely affect the Japanese economy.
   A practical alternative then might be to take a wait-and-see stance regarding the economy after ending monetary expansion policies, while maintaining zero interest rates to enable flexible monetary policy conduct.

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