Volume III Number 18 May 23, Japanese Monetary Policy. by Allan H. Meitzer

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1 The Fxhall Review Lawrence Kudlw & Assciates, Inc. 600 New Hampshire Avenue, N.W. The Watergate, Suite 715 Washingtn, D.C (202) imi A subsidiary f Rdman & Renahaw Capital Grut), Inc. 120 Suth La Salle Street Chicag, Illinis LAWRENCE A. KUDLOW President ANN MARIE HABERSKI Senir Vice-President KRIS P. DENTON Directr f Research Vlume III Number 18 May 23, 1985 Bard f Assciates PROF. KARL BRUNNER Graduate Schl f Management University f Rchester DR. GEOFFREY H. MOORE Directr Center fr Internatinal Business Cycle Research PROF. ALLAN H. MELTZER Graduate Schl f Industrial Administratin Carnegie-Melln University DR. ROY W. JASTRAM Schl f Business Administratin University f Califrnia Berkeley PROF. ROBERT H. RASCHE Department f Ecnmics Michigan State University PROF. JAMES M. JOHANNES Graduate Schl f Business University f Wiscnsin-Madisn JONNA LYNNE CULLEN Legislative/Plitical Cnsultant J.L. Assciates BRUCE R. BARTLETT Senir Fellw Heritage Fundatin Japanese Mnetary Plicy by Allan H. Meitzer Japan stands ut amng the majr ecnmies f the wrld fr many reasns. Nt least amng them shuld be its mnetary achievements f the last decade. In the middle seventies, Japan experienced inflatin as high as 20%. As late as 1980, cnsumer prices rse by 8%. Inflatin rates nw range between zer and 3%, depending n the brad measure f inflatin chsen. Of greater significance fr the rest f the wrld is the fact that wages and salaries rse less than prductivity, s that unit labr csts fell by 5% in 1984 fr the secnd year in a rw. If the annual spring labr ffensive results in mney wage increases f abut 5 1/2% r less, as nw seems prbable, unit labr csts will decline again in Japan's csts f prductin are, therefre, likely t remain lw relative t the United States. Brief Histry Inflatin has fallen in all the industrialized cuntries during the 1980's, but Japan is the nly majr cuntry that was able t reduce inflatin withut having a recessin. In fact, grwth f real utput has remained between 3 and 5% in each f the past five years.

2 Chart 1 REAL GDP GROWTH, JAPAN CX CH., 4TH/4TH) 2.S-J r r ^ * First three quarters. During the same perid, by way f cntrast, grwth f real utput in the U.S. has varied ver a range three times as wide 6% t -1.5%. Mnetary plicy cntributed t the relative stability f the Japanese ecnmy, just as it has cntributed t the relative instability f the U.S. ecnmy. Since July 1978 the Bank f Japan has publicly annunced a "mnetary prjectin" each quarter. Unlike the Federal Reserve, the Bank has nt chsen t annunce prjectins r targets fr three r fur different aggregates. Research by the Bank's ecnmists suggests that in Japan there is a clser relatin between mney and spending ver lng perids if mney is defined bradly, t include time depsits and CDs, s the Bank prjects nly ne aggregate, M2 + CDs. Each quarter, the Bank annunces its prjectin fr the fur quarters ending ne quarter ahead. Generally these annuncements shw a declining trend, but there have been exceptins. Over the whle perid, hwever, there is a marked decline in the grwth rate f all mnetary aggregates. Chart 2 shws the data fr M2 + CDs. Als shwn are grwth rates fr nminal GNP and fr real GNP. The difference between the latter tw grwth rates is the rate f inflatin, measured by the rate f grwth f the GNP deflatr. Nte that all rates f grwth are cmputed frm the same quarter f the previus year, nt frm the previus quarter

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4 The slid line drawn at first quarter 1975 marks the pint at which the Bank f Japan began t cntrl mney grwth. Befre that date, the Bank paid much less attentin t mney grwth. Grwth rates f mney fluctuated between 15% and 25%. Grwth rates f nminal and real GNP were just as variable. Since 1975, mnetary variability has been reduced, and the trend grwth rate f mney M2 + CDs has declined mre r less regularly. Mney nw grws at half the rate f and mney grwth is less variable. The change in mnetary plicy has had tw effects that are visible in the chart. First, the rate f inflatin has fallen, mre r less steadily. This is shwn by the narrwing f the spread between grwth f real and nminal GNP. Secnd, real GNP grwth has becme much less variable. The wide swings f the 1950's, 1960's and early 1970, s are n lnger visible. Real grwth nw remains in the 3 t 5% range with neither recessins nr majr bms. Operating Prcedures at the Bank f Japan The Japanese manage their mney stck t achieve price stability. Emphasis n price stability as the main bjective f mnetary plicy began after Mr. R. Shimamt, Executive Directr f the Bank f Japan explains why the change was made. "Befre abut 1975, there was n clear separatin f indicatrs and plicy bjectives... Rather, interest rate and quantitative adjustments were implemented with an eye n many plicy bjectives, such as credit cnditins, interest rates, quantities lent, prices, utput, and the balance f payments. Hwever, the escalatin f inflatin in demnstrated the existence f a clse relatin between mney supply and prices.... [T]he mney supply tk n much greater imprtance as the key medium-term indicatr, sitting between interest rates as the perating target and final gals."* *R. Shimamt, "Mnetary Cntrl in Japan" Central Bank Views n Mnetary Tarqetting, May

5 The Fxhall Review The Bank avids the disruptive effects f faulty seasnal adjustment prcedures by stating its prjectin as an annual grwth rate measured frm the same quarter f the previus year. Use f the annual grwth rate directs the Bank's and the market's attentin t the trend in mney grwth and avids the excessive attentin given in the United States t transitry fluctuatins in the mney supply. Spkesmen fr the Bank have stated publicly that ne main reasn fr annuncing prjectins is t stabilize public expectatins abut future inflatin, s prcedures are chsen with that aim in mind. The Bank cntrls mney in tw ways. One is traditinal central banking practice, and the ther is distinctly Japanese. The traditinal methd is the adjustment f shrt-term interest rates n the call market and the Treasury bill market by pen market peratins, changes in rediscunt rate and in reserve requirement ratis. Lending t Tky banks has been the mst imprtant surce f reserves, s changes in the discunt rates relative t pen market rates have a significant effect n the vlume f discunts. At times, the Bank has supplemented this methd f mnetary cntrl by using "windw guidance." In practice, windw guidance means that the Bank impses direct cntrls n lending by the principal (Tky) banks as a price f admissin t the discunt windw. Since Tky banks brrw a very large (but declining) share f their ttal reserves frm the Bank at belw market rates, windw guidance gets a quick respnse. Hwever, windw guidance fixes the shares f the Tky banks and reduces cmpetitin, s it is used much less nw than in the past. The discunt rate has remained at 5% since The Bank's principal means f changing the mney stck is t absrb r increase reserves by pen market peratins. By withdrawing reserves and reducing discunts, the Bank raises the interest rate n the call mney market (similar t the Federal funds rate), and by increasing reserves the Bank lwers the call mney rate. In practice, the Bank has nt fund it necessary t vary the call rate ver a wide range. Since mid 1982, the quarterly average call mney rate has remained between 5 3/4 and 7%. In cntrast, the U.S. Treasury bill rate has ranged between 7 3/4 and 10 1/2% during the same perid. -5-

6 Results The mnthly data shw that nt nly mney grwth rates shwn In Chart 2 but als interest rates have been mre stable in Japan than in the United States. Fr example in 1984, the mnthly average call mney rate in Japan varied between a peak f 6.45% and a trugh f 5.74% while the U.S. Treasury bill rate varied between 7.75% and 10.60%. Japanese and U.S. Interest Rates Japan 1984 Mnthly Cai 1 Mney U.S. Treasury Bills January February March Apri May June July August September Octber Nventer Decenber Surce: OECD Main Ecnmic Indicatrs March 1985 The lwer variability f Japanese shrt-term rates carries ver t lng-term interest rates. This greater stability is achieved in large measure because market participants are cnfident that the Bank will cme clse t its mnetary prjectins and will set its prjectins t keep inflatin lw. Cnfidence in the Bank is apparent in the public discussin f mnetary plicy. Annuncements f mnetary prjectins are nt fllwed by market speculatin abut the meaning f the Bank's annuncement. The use f a single aggregate and a histry f keeping mney grwth clse t prjectins makes the Bank's statements highly credible. -6-

7 The Fxhall Review Japanese unins appear t share this cnfidence in the Bank's cmmitment t nn-inflatinary grwth. Their wage demands are based n a belief in cntinued lw inflatin. By keeping inflatin lw and by aviding majr swings in interest rates, the Bank helps Japanese prducers t plan ver a lnger hrizn. Relative stability f interest rates and steady lw rates f inflatin reduces risk premiums and, thus, lwers interest rates. Lng-term rates f interest in Japan are nw 4 t 5 percentage pints lwer than lng-term rates in the United States. Differences in recent rates f inflatin in the U.S. and Japan accunt fr n mre than half the difference in lng-term rates. The remaining difference reflects differences in risk premiums (arising frm greater fluctuatins in mney grwth and rates f interest), differences in anticipated future inflatin and, pssibly differences in taxatin f interest incme. The differences in interest rates arising frm differences in risk is a disadvantage fr U.S. prducers since it raises the cst f capital in the U.S. Exchange Rates A cmmn belief in the U.S. is that the Bank f Japan intervenes t lwer the market value f the yen and gain a trade advantage. There is n evidence that this belief is crrect. In fact, the ppsite view is clser t the truth. In recent years, when the Bank has intervened t affect the exchange rate, it has mainly been in an effrt t appreciate the yen against the dllar. A main reasn fr this interventin is cncern abut trade restrictins. T say that the Bank intervenes is nt t say that it succeeds in adjusting the exchange rate. Buying r selling freign exchange instead f dmestic securities des nt have a nticeable effect n the exchange rate. If the Bank aims at a mnetary grwth rate and is expected t achieve its target, it is f secnd r third rder f imprtance whether the Bank supplies the reserves by buying freign instead f dmestic assets. The main difference is the wnership f varius assets. If the Bank supplies the same grwth f bank reserves and mney by purchasing dllars, the Bank hlds mre dllar securities and the market hlds mre dmestic assets. The effect is t shift the risk f exchange rate changes frm the market t the Bank. -7-

8 T change the exchange rate by interventin, the Bank must change the grwth f reserves and mney. T depreciate the yen against the dllar, the Bank must inflate mre than the U.S. This is the very ppsite f what the Bank set ut t d in 1975, and it has largely achieved its bjectives at substantially lwer cst and with greater credibility than ther central banks. Japan has benefitted Cpyright 1985 by Lawrence Kudlw & Assciates, Inc.