Ebook Monetary and Fiscal Policy in a Liquidity Trap: The Japanese Experience 1999-2004
Recent developments in the Japanese economy are characterized by the concurrence of two rare phenomena: deflation and zero nominal interest rates. The year-on-year CPI inflation rate has been below zero for about six years since the second quarter of 1998 (see Figure 1). On the other hand, the uncollateralized overnight call rate has been practically zero since the Bank of Japan (BOJ) policy board made a decision on February 12, 1999 to lower it to be “as low as possible” (see Figure 2).
The concurrence of these two phenomena has revived the interest of researchers in what Keynes (1936) called a liquidity trap, and various studies have recently investigated this issue. These studies share the following two features. First, regarding diagnosis, they argue that the natural rate of interest, which is defined as the equilibrium real interest rate, is below zero in Japan, while the real overnight call rate is above zero because of deflationary expectations, and that such an interest rate gap leads to weak aggregate demand. This diagnosis was first made by Krugman (1998) and shared by Woodford (1999), Reifschneider and Williams (2000), Jung et al. (2003), and Eggertsson and Woodford (2003a, b) among others.
Second, based on this diagnosis, these studies write out a prescription that the BOJ should make a commitment to an expansionary monetary policy in the future. Woodford (1999) and Reifschneider and Williams (2000) argue that, even when the current overnight interest rate is close to zero, the long-term nominal interest rate could be well above zero if future overnight rates are expected to be above zero. In this situation, a central bank could lower the long-term nominal interest rate by committing itself to an expansionary monetary policy in the future, thereby stimulating current aggregate demand.
As emphasized by Woodford (1999), Jung et al. (2003), and Eggertsson and Woodford (2003a, b), an important feature of this prescription is monetary policy inertia: a zero interest rate policy should be continued for a while, even after the natural rate of interest returns to a positive level. By making such a commitment, a central bank is able to achieve lower long-term nominal interest rates, higher expected inflation, and a weaker domestic currency in the adverse periods when the natural rate of interest significantly deviates from a normal level. This is as if a central bank “borrows” future monetary easing in the periods when current monetary easing is exhausted.
This idea of borrowing future easing has been discussed not only in the academic arena, but also in the policy-making process. Just after the introduction of a “zero interest rate policy” in February 1999, there was a perception in the money markets that such an irregular policy would not be continued for long. Reflecting this perception, implied forward interest rates for longer than six months started to rise in early March. This was clearly against the BOJ’s expectation that the zero overnight call rate would spread to longer-term nominal interest rates.
Forced to make the bank’s policy intention clearer, Governor Masaru Hayami announced on April 13, 1999 that the monetary policy board would keep the overnight interest rate at zero until “deflationary concerns are dispelled”. Some researchers and practitioners argue that this announcement has had the effect of lowering longer-term interest rates by altering the market’s expectations about the future path of the overnight call rate (Taylor (2000)). Given such a similarity between the BOJ’s policy intention and the prescriptions proposed by academic researchers, a natural question is whether or not the BOJ’s policy commitment is close to the optimal one. The first objective of this paper is to measure the distance between the optimal monetary policy rule derived in the literature and the BOJ’s policy in practice.
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