Section 2 Advancing Deflation and Monetary Policy

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Chapter 1

Preconditions to Strong Recovery of the Economy

Section 2 Advancing Deflation and Monetary Policy

The Japanese economy is now in a mild deflationary phase. There are three causes of the deflation: (a) "Supply-side structural factors" such as increase in low-priced imports, (b) "Demand factors" caused by a lack of strength of the economy, (c) "Financial factors" caused by disintermediation of bank-system lending. In Japan, corporations are saddled with excessive debts and banks with a large amount of non-performing loans. Deflation, even if it is mild, has adverse effects on the Japanese economy. Deflation restrains business investment in the following two ways: (a) by increasing the debt burdens of corporations saddled with excessive debts and (b) by raising real interest rates and real wages, and thus erodes corporations' profitability.

Although monetary policy is not a cure-all to bring about a complete recovery of the economy, it is believed that the Bank of Japan is now in the stage where it should positively consider further measures to ease deflationary pressures.

These points will be examined in detail below.

1 Present State of Deflation and its Background

First deflation in the post-war period

The Japanese economy is in a mild deflationary phase. The deflation here is defined as a persistent decline of prices. In Japan, the term "deflation" also means simultaneous occurrence of a recession and a price decline. But, in this Report, the internationally recognized definition of the above is used(14).

When did the Japanese economy enter the deflationary phase? The Consumer Price Index (General, excluding fresh food) has been staying below year-earlier levels since the autumn of 1999. It posted a negative year-on-year growth of 0.9% in 2001 (January-September), after having remaining flat in 1999 and posting a negative growth of 0.4% in 2000. Judged from the CPI, a price index that has a direct bearing on people' s consumption life, the Japanese economy has already been in a mild deflationary phase for about two years. Judged from the GDP deflator that shows the price level of overall economic activity of a country, the Japanese economy has been in a mild deflationary phase since the mid-1990s. The deflator posted a negative year on year growth of 1.6% in 2000 and a negative growth of 1.1% in the first half of 2001. This is the first experience of such kind in the post-war period for Japan and other advanced countries as well (Figure 1-2-1)(15).

Factors behind deflation

Why the Japanese economy has been in a deflationary phase will be analyzed here with particular attention paid to the past two years or so, when the CPI began to post a year-on-year decline.

Basically, there are three factors and they are mutually related.

(a) "Supply-side structural factors" such as an increase in low-priced imports

The structural factors that depress prices, such as inflow of low-priced imports from China and other countries, IT and other technological innovations, and the distribution revolution, have increased more than ever. Imports of textile products and durable goods, such as TVs and VTRs, have been increasing sharply since 1999. In particular, the proportion of imports from China to total imports increased. Increases of imports of locally manufactured products from China and other Asian countries that have expanded their supply capacity are depressing product prices (Figure 1-2-2).

Incidentally, the Japanese yen has been depreciating in 2001. Moreover, imports of textile products show signs of slackening and the proportion of imports from China has already reached a considerably high level. Therefore, the downward price pressures of textile products are likely to weaken somewhat in the future. On the other hand, the proportion of Chinese-made TVs and VTRs to total imports has been increasing in 2001. Since local production in China of these electric appliances and other machinery is expected to further expand, their downward pressures on prices are likely to remain for some time to come.

(b) "Demand factors" caused by a lack of strength of the economy

Although the economy recovered in the spring of 1999, the strength of the recovery was weak. The economy turned downward again in the beginning of 2001 and deteriorated further in and after the middle of the year. The lack of strength of the economy has depressed demand and is driving down prices.

As will be explained in Section 3 of Chapter 2, the GDP gap was on an expansionary trend throughout the 1990s. With demand remaining depressed and the inflation rate on a downward trend for a long time after the collapse of the bubble economy, people' s expectations of deflation (people' s expected price-declining rate) has increased gradually (Figure 1-2-3).

(c) Financial factors

It is known that inflation and deflation (opposite of inflation), are determined by the movement of money supply in the long run. Therefore, if money supply is amply provided, deflation can be avoided. The Bank of Japan has implemented monetary easing policies in a drastic way not seen before. However, as will be described later, the policies have yet to lead to increases in bank lending and money supply. This is because the structural factors and the demand factors have strong power to drive down prices and because corporations are not eager to raise funds and banks' intermediation function has declined due to the excessive debts of corporations and the closely related problem of non-performing loans.

Effect of deflation on the Japanese economy

It is clear that if an economy falls into a deflationary spiral, it will have a major adverse effect on the economy. The deflationary spiral means that prices and economic activity spiral downwards together(16). Some argue that the kind of mild deflation that Japan is now experiencing, in which the CPI posts a year on year decline of only about 1%, will have no major adverse effect on the economy. Some also argue that price declines resulting from the correction of the high-prices structure of the Japanese economy and progress in technological innovation are inevitable and desirable. How should we respond to these arguments?

Before the current "managed monetary system," under which the central bank controls the amount of circulating currency, was introduced, deflation was not so unusual in many countries. Although deflation often occurred at the same time as a recession, there were times when the economy posted positive growth under a deflationary phase. In the second half of the 19th century, the economies of the U.K. and the United States were in a mild deflationary phase for a long period of more than 30 years. However, the two countries posted fairly strong economic growth for the period (In the case of the U.K., for the period from 1873 to 1896, retail prices declined 1.7% and the economy grew 1.9% on average. In the case of the U.S., for the period from 1864 to 1897, consumer prices declined 1.9% and the economy grew 5.6% on average)(17).

Such experiences of the U.K. and the U.S. show that a mild deflationary phase, in some cases, does not have a major adverse effect on the economy just as a mild inflation of 2~3% has almost no adverse effects on the economy. However, under the current situation of the Japanese economy, even a mild deflation is believed to have adverse effects on the economy. The Japanese economy is now suffering from prolonged stagnation, with banks saddled with a large amount of non-performing loans and corporations with excessive debts. Moreover, nominal interest rates on both short- and long-term loans are now nearing close to zero percent. Under such circumstances, deflation is dragging down the economy. Therefore, it is important to extricate the Japanese economy from the deflationary phase as early as possible.

Deflation is expected to have adverse effects on the economy in the following ways:

(a) Since deflation increases the effective debt loads of corporations, particularly of corporations saddled with excessive debts, it works as a restraint on new business investment.

(b) In the case where prices decline but nominal interest rates and nominal wages do not decline as much (a nominal interest rate cannot decline below zero percent), the real interest rates and real wages will increase, depressing corporate profits and restraining business investment.

Let' s examine this in detail.

1） Effect through an increase in corporations' real debts

Many corporations have debts to carry out business activities and the debts usually are more than the financial assets of the corporation. Since the amount of debt repayment is determined by the nominal amount, deflation effectively increases the debt service burden (the real debt load obtained by deflating the nominal amount of debt repayments by a price level). In other words, under a deflationary phase, even if a corporation' s sales volume remains the same, the prices of its products will decline and the sales value (sales volume x product prices) will decrease. As a result, it will make it difficult for the corporation to repay the debts with its annual cash flow and to make new business investment. In some cases, corporations with weak balance sheets may go bankrupt.

If a corporation' s outstanding balance of real debts increases due to deflation, the corporation will restrain business investment. In fact, as will be described in Section 2, Chapter 2, industries and corporations with higher balance of net debts (debts - credits) tend to be more cautious about business investment and spend less on forward-looking investment. Since the 1990s, the excessive debts held by corporations, especially those held by three industries (real estate, construction, and wholesale/retail) in particular, have become a problem. Moreover, with land prices continuing their decline, the asset value of the land held by them has eroded. If the nominal value of sales/profit does not rise due to a decline in prices, the effect of an increase in the balance of real debts will become bigger, making it difficult to repay the debts determined on the nominal base.

Next, we will take a look at the actual state of corporate debts. The nominal net debt of the private corporate sector (excluding financial institutions; based on the Financial Statements Statistics of Corporations by Industry, Quarterly) has been on a downward trend since the end of FY 1997 due to corporations' financial restructuring efforts. It decreased more than 10% (about ¥50 trillion in value) in three years (Figure 1-2-4)(18) However, the decrease of the real net debt that takes into account the price decline during the period (it comes to a decline of 3.5% for the three years, if it is calculated using the GDP deflator that shows the price level of overall economic activity) is about two-thirds the decline in nominal value. Although both the manufacturing and non-manufacturing industries reduced net debts on nominal and real bases, the feeling of excessive debts is still strong in the non-manufacturing industries, in particular in the three industries of construction, real estate, and wholesale/retail, compared with that before the collapse of the bubble economy.

We have just studied the effects of deflation on the increase in corporate debt burden. How about its effects on households through debts and assets? Since households as a whole have more financial assets, such as deposits, than debts, a decline in prices is expected to increase consumption on account of real assets effect (the effect of increasing the real value of assets held). However, studies made in the past show that the real assets effect on households is not so large in Japan. Moreover, as was described in Section 1 of this chapter, since 1999, when consumer prices began to decline, the decrease of consumption by households having housing loans has been larger than the households not having housing loans. This suggests that the real assets effect on households as a whole is not so large(19). Beside its effect through these assets and debts, deflation could also prompt people to refrain from consumption by causing them to expect a continued decline in prices and increasing people' s uncertainty about the future direction of the economy.

Deflation also has an effect of increasing the government' s real debt burden. As will be described in Section 1 of Chapter 3, the Japanese government drastically increased its fiscal deficits during the 1990s and, as a result, its long-term debts, including public bonds, have swelled to an enormous amount (As of the end of FY 1999, the long-term debts of central and local governments stood at about ¥600 trillion, accounting for about 120% of GDP). As things stand now, the Japanese government sector has more debts than financial assets. The advancing deflation is increasing the real debt burden faster than the nominal increase in outstanding debts, making fiscal reconstruction all the more difficult.

The above analyses show that, among the effects of deflation on the real economy through an increase in real debts, the effect of contracting business investment through an increase in corporations' real debts and thereby curbing economic growth is particularly important.

2） Effects through a rise in real interest rates and real wages

As for the effect through interest rates, if real interest rates go up due to a price decline, it would work as a restraint on the investment of corporations. In fact, although nominal interest rates have declined as a result of the Bank of Japan' s monetary easing measures, the room for a further cut in interest rates has been narrowing. Meanwhile the margin of price declines has been expanding since the autumn of 2000. Therefore, real interest rates remain almost flat or are on an upward trend, eroding the effect of the monetary easing (Figure 1-2-5).

Next, We will take a look at the effect through a rise in real wages. In the case where prices decline but nominal wages do not decline enough due to their downward rigidity, real wages will rise and this, in turn, will erode corporate profits. Therefore, it will restrain investment activity and, through a decrease in production/income, have a negative effect on consumption. If the nominal wages were adjusted flexibly in response to the price decline, there would not be such a negative effect.

Then, what is the actual situation of the Japanese economy? From 1999 to 2000, personnel expenses were restrained due to corporations' restructuring efforts and corporate profits increased. As was described in Section 1 of this chapter, corporations adjust wages flexibly to some extent mainly by adjusting bonus payments and using part-time workers. In 2001, however, while sales slackened amid continuing expansion of price declines, personnel expenses stopped declining and corporate profits leveled off (based on the Financial Statements Statistics of Corporations by Industry, Quarterly). This suggests that a price decline, if it occurs when demand is decreasing, has a major adverse effect on corporate profits even if the decline is mild, because cutbacks on personnel expenses lag behind the price decline.

As was seen in the above, deflation has negative effects on the entire economy, such as restraining corporations' business investment, through 1） an increase in corporations' real debts and 2） a rise in real interest rates and real wages.

"Good deflation" ?

There is a "theory of good deflation" that maintains that "a price decline caused by a rise in productivity is desirable" and that "deflation is desirable because it is a process through which high prices in Japan are corrected." How should we respond to this theory? We believe that the "theory of good deflation" is debatable for the following two reasons:

(1) First of all, we have to divide price declines into changes of "relative prices" that are caused by declines of individual prices, and declines of "general price levels." Deflation is a decline of overall price levels (that is to say, a decline of general price levels) and this is different from declines of individual prices (for example, casual clothes and charges for mobile phone calls). Price declines of individual goods would not necessarily lead to a decline of overall price levels if people, whose income had increased effectively due to the price declines of individuals items used the increased income for the purchase of other goods and, as a result, if the prices of the other goods rose. Changes of relative prices caused by supply-side structural factors (such as low-priced imports and technological innovation) may be good for Japan. But, it is problematic that declines of general price levels are having adverse effects on the Japanese economy. Deflation is not "good."

(2) Secondly, with regard to high prices in Japan, or price differentials between Japan and other countries, it is true that prices of the goods that were protected by regulations and not exposed to international competition are now increasingly converging to the international price levels thanks to deregulation. However, price differentials between domestic and foreign markets are basically phenomena caused by the fact that relative prices of tradable goods (goods that can be exported or imported, such as various manufactured products and farm products) and non-tradable goods (goods that cannot be exported or imported, such as various services) are different from one country to another. In other words, since exchange rates are adjusted so that prices of tradable goods will converge to international levels over the long run, price differentials of non-tradable goods between domestic and foreign markets inevitably widen in the countries whose productivity of non-tradable goods is lower than its productivity of tradable goods compared with those in other countries. As a result, price differentials of the entire economy, prices of tradable goods and non-tradable goods combined, between domestic and foreign markets also widen. In fact, the prices of services and other non-tradable goods, tend to rise faster than the prices of tradable goods, such as automobiles and electric machinery in Japan as compared with those in the United States and some other countries(20). Since exchange rates are determined in response to the price movement of tradable goods over the long run, price differentials between domestic and foreign markets will not be eliminated as long as there exists a gap in the speed of productivity increase between tradable goods and non-tradable goods(21). Price differentials between domestic and foreign markets should basically be eliminated by a decline of the price levels of non-tradable goods relative to the price levels of tradable goods through a rise in productivity of services and other non-tradable goods, not by declines of general price levels, or deflation(22).

2 Monetary Policy under Deflationary Economy

Deflation and political measures

As was described in the previous section, the Japanese economy is now in a mild deflationary phase. In order to get out of the deflationary economy, it is basically necessary for the Japanese economy to extricate itself from the prolonged stagnation and shift to a growth economy. To that end, the government must adjust industrial structures (shift from low-productivity sectors to high-productivity sectors) by promoting deregulation to activate private-sector vitality, solving the problem of non-performing loans, and pushing for fiscal and other structural reforms. The government must create sustainable demand and eliminate the supply/demand gap and expectation of deflation as well as uncertainties about the future in corporations and households.

In the short term, structural reforms will create new private demand. But, at the same time, it will further intensify deflationary pressures as it involves disposal of non-performing loans. Moreover, the deflation may delay the necessary adjustment of structural adjustment of industries. Under the circumstances, monetary policies that are expected to have the effect of easing deflationary pressures will be studied below.

In implementing such monetary policies, it is necessary for the Bank of Japan and the government to fully communicate with each other so that the policies will be consistent with government' s economic policies.

Bank of Japan' s monetary policy

First of all, we will review the monetary policies that the Bank of Japan has implemented since 1999.

• (1) Adoption of a zero interest rate policy
  The Bank of Japan at its Monetary Policy Meeting in February 1999 decided "The Bank of Japan would provide more ample funds and encourage the uncollateralized overnight call rate to move as low as possible." In April the same year, the BOJ governor said that the central bank would keep the uncollateralized overnight call rate at virtually zero percent "until deflationary concerns are dispelled." (23)
• (2) Lift of the zero interest rate policy
  The zero interest rate policy was maintained for about one and half years. Then, at its Monetary Policy Meeting in August 2000, the Bank of Japan decided to encourage the uncollateralized overnight call rate to move on average around 0.25% and lifted the zero interest rate policy.
• (3) Monetary easing measures adopted in March 2001
  The Bank of Japan at its Monetary Policy Meeting in February and March adopted monetary easing measures. At the March 19 meeting, the Bank decided (a) to change the main operating target for money market operations from the current uncollateralized overnight call rate to the outstanding balance of the current accounts at the Bank of Japan and to increase the outstanding balance of the current accounts to about ¥5 trillion (an increase from about ¥4 trillion), (b) to continue the new procedures for money market operations in place until the Consumer Price Index (General, excluding fresh food) registers a zero percent or more annual increase on a stable basis, and (c) to increase the amount of its outright purchase of long-term government bonds from the current ¥400 billion per month, in case it considers that increase to be necessary for providing liquidity smoothly(24). The uncollateralized call rate returned to almost zero percent as a result of (a) and the time frame for the new money market operations was set as "until the Consumer Price Index registers a zero percent or more annual increase on a stable basis" by (b), a more clear standard than the "until deflationary concerns are dispelled" standard set in the previous zero-interest rate policy.
• (4) Additional monetary easing policies in and after August 2001
  At the Monetary Policy Meeting on August 14th , the Bank of Japan decided to raise the outstanding balance of current accounts held at the BOJ from around ¥5 trillion to around ¥6 trillion and to increase the amount of outright purchase of long-term government bonds from ¥400 billion per month to ¥600 billion per month. Amid increasing uncertainties about the prospects for the economy caused by the terrorist attacks in the United States, the Bank of Japan decided at its Monetary Policy Meeting on September 18 to aim at maintaining the outstanding balance of current accounts held at the Bank at above ¥6 trillion and to reduce the official discount rate (0.25% 0.10%).

Effects expected from monetary easing

What effects can we expect from a series of these monetary easing measures?

The central bank' s monetary policies affect prices, as they cause changes in demand through their effects on interest rates and bank lending. What we expect under the existent deflationary situation is that money supply (total of cash currency and deposit currency) and bank lending increase and that spending activities by corporations and others become active. But it is not that a central bank can directly increase money supply and bank lending. A central bank indirectly affects money supply and bank lending by increasing/decreasing the amount of funds (specifically, private financial institutions' outstanding balance of the current accounts at the Bank of Japan) in financial markets through trading bonds and bills with private financial institutions. With regard to financial policy, it is important to study by what means and through which mechanism it causes changes in the behavior of financial institutions and corporations and to what extent it is effective.

The effects that we can expect from the series of quantitative easing measures implemented so far would be (a) lower interest rates and spillover effects on lending, (b) more active lending and bond purchases as a result of an increase in the outstanding balance of the current accounts at the Bank of Japan, and (c) depreciation of the yen' s exchange rate.

• (1) Lower interest rates and spillover effects on lending
  First, as for interest rates, the measures will lower market interest rates, such as interest rates on short- and long-term government bonds, and this will lower banks' procurement costs, including deposit rates. Since financial institutions are expected to increase investment in financial assets other than government bonds, interest rates on corporate bonds and commercial paper (CP) and their credit spreads (interest rate differentials from government bonds) are expected to decline. Moreover, if asset values, such as land prices and stock prices, improve as a result of lower interest rates, it will lead to improvement of the balance sheets of banks and corporations. As for lending, banks will become active in their credit activities, as lower procurement costs expand profit margins (lending rate - procurement cost) and improve banks' balance sheets. Corporations, for their part, will increase their willingness to procure funds, as lower interest rates reduce their interest payment burden and improve the environment for corporate bond issuance, resulting in the improvement of their balance sheets.
• (2) More active lending and bond purchases as a result of an increase in the outstanding balance of the current accounts at the Bank of Japan
  If banks' non-interest bearing accounts with the Central Bank increase, the banks will become active in lending and purchases of corporate bonds in pursuit of profits.
• (3) Depreciation of the yen' s exchange rate
  A decline in domestic interest rates will prompt a shift in investment to foreign currency assets that carry relatively high interest rates, leading to the depreciation of the yen' s exchange rate and to an increase in exports and improvement of exporting firms' profitability and this, in turn, is expected to stimulate the economy.

Examination of the effects of monetary easing measures

We have just studied the positive effects that are expected from monetary easing measures. However, with the uncollateralized overnight call rate standing at almost zero percent and having little room to go down further, people have become increasingly cautious about the Bank of Japan' s additional monetary easing measures to provide further liquidity to the money market. That is to say, people have become skeptical about the effect of additional monetary easing measures on the economy and are seriously concerned about possible side-effects of such measures. In order to check this point, we will take a look at financial trends in 2001.

First, we will take a look at the movement of interest rates. In addition to the uncollateralized overnight call rate, interest rates on longer term instruments (two days ~ one year), short- and long-term government bonds, and corporate bonds fell sharply after easing measures were implemented in February-March 2001 (Figure 1-2-6). They stand below the levels where they were when the zero interest rate policy was in place from 1999 to 2000. The credit spreads of corporate bonds have also dropped. It is noteworthy that the shape of the yield curve that illustrates the term structure of interest rates shows that the interest rates on medium-term instruments (about five years) in and after March 2001 are lower than they were during the period of the zero interest rate policy (February 1999~August 2000), suggesting that interest rates have little room to go down further. This seems to reflect the fact that people now expect a prolonged period of monetary easing, as the Bank of Japan has set the more clear time frame of "until the CPI registers a zero percent or more annual increase on a stable basis" than "until concerns about deflationary concerns are dispelled" for its money market operations, amid the increasingly cautious view on the medium-term outlook for the Japanese economy. However, the expectation of a prolonged period of monetary easing has as its counterpart an expectation of prolonged deflation. The fact that interest rates have declined this much, therefore, can be interpreted that people have already discounted the forecast of a prolonged deflation. The magnitude of decline in credit spreads since the spring of 2001 is smaller than during the period of the zero interest rate policy. When the zero interest policy was put into effect, the credit spread stayed at a high level and corporations were concerned about liquidity due to the financial system crisis. The zero interest rate policy was effective in dispelling them. On this point, the situation in 2001 was different. Since the liquidity constraint was small, additional effects are limited in terms of lowering interest rates.

Next, We will take a look at the effects on money supply and bank lending. The growth rate of monetary base (year on year comparison), which is the total of currency in circulation and the outstanding balance of the current accounts at the Bank of Japan, rose from an average of about 7% in 1999-2000 to 14% in September 2001. But, the growth of money supply (M2 + CD) was only about 2~3% and lending by private banks (excluding special factors, such as liquidation of credits) decreased about 2%. On the other hand, the government bonds held by private banks have more than doubled from the level at the end of 1998 (Figure 1-2-7). This suggests that, despite the Bank of Japan' s unprecedented scale of monetary easing measures, there was not enough lending by banks as corporations' appetite for new funds had remained low and banks' tolerance for risk had been much lower due to the excessive debts and the problem of non-performing loans as will be described in Section 2, Chapter 2. As for the exchange rate (yen-dollar rate), the yen has been on a downward trend since the beginning of 2001, although it turned slightly higher temporarily after additional monetary easing measures were implemented in August. Since exchange rate moves in response to relative changes in domestic and overseas financial and economic developments, Japan' s monetary easing itself has an effect of depreciating the yen. However, since the U.S. economy also slowed down and the country adopted monetary easing steps during the period, the yen' s unilateral decline has been checked.

What else can be taken as monetary policy?

Since nominal interest rate does not fall below zero percent and has little room to go down further, the effect on bank lending of the Bank of Japan' s quantitative monetary easing policy has so far been limited. The steps that should be studied as further monetary policy would be (1) further increases in outright purchases of long-term government bonds (further quantitative easing) and (2) introduction of "inflation targeting" policy to set the target for medium- and long-term inflation rate. Inflation targeting is a policy to set a specific target for inflation rate with the aim of stabilizing prices in the medium and long terms. It is different from "reflationary policy" of deliberately generating higher inflation.

As for the problem of who should set the price target, there are three ways: the central bank (example: Sweden), the government (U.K.), and on agreement between the central bank and the government (New Zealand, Canada).

• (1) Effects expected from further quantitative easing and setting an inflation target From the standpoint of promoting the two measures, the following effects can be expected. First, as for further quantitative easing, if the Bank of Japan further increases its purchases of long-term government bonds, interest rates on longer term-instruments will be prodded to fall. Moreover, as banks' lending stance becomes positive, it is expected to eventually lead to an increase in bank lending. In order to promote drastic disposal of non-performing loans smoothly, it is important to prevent asset prices, such as land prices, from declining further. Further quantitative easing is expected to have the effect of supporting asset prices(25). Next, as for setting an inflation target, if the Bank of Japan makes clear its stance to make utmost efforts to stabilize prices, it is expected to increase the transparency of monetary policy and help to dispel the deflation expectation. If the deflation expectation is dispelled, real interest rates will decline and positive effects on business investment can be expected. The Bank of Japan has already announced that it will continue the quantitative easing policy targeting the current account balance at the BOJ (until the CPI posts an annual increase of zero percent or more on a stable basis). However, the Bank of Japan has failed to reveal policy instruments to achieve a zero-percent or more increase and the policy channel that it will take after the CPI has achieved such an increase. Furthermore, the Bank has yet to set medium- and long-term price targets (for example, aiming at an annual increase of 0~2 %). Therefore it is not guaranteed that the effects expected above will be fully achieved.
• (2) Negative views on further quantitative easing and setting an inflation target Some argue against these measures, saying that they are not effective and produce ill effects. Among the cautious views of further quantitative easing are the following: (a) Its positive effect on lending is limited or uncertain. To begin with, no monetary easing measures will lead to an increase in investment/lending to promising fields, unless non-performing loans are drastically disposed of and corporations complete the adjustment of their balance sheets. (b) There are concerns that if the Bank of Japan increases outright purchases of long-term government bonds, the government may lose its fiscal discipline and that this, in turn, may produce ill effects, such as the risk of a sharp rise in interest rates and a sharp decline in prices of government bonds (the possibility of the balance sheets of the Bank of Japan and financial institutions holding long-term government bonds deteriorating). As for setting an inflation target, the following problems are pointed out. (a) If prices go up in the future, inflation may accelerate and overshoot the target. (b) Nominal interest rates on long-term instruments may rise by discounting the target and, as a result, real interest rates on long-term instruments may not decline and the target may lose its effect of spurring the economy. (c) With the Japanese economy plagued with structural problems, it is difficult to raise both the expected price level and real price level unless clear means to achieve them are presented. If the target is not achieved, the credibility of monetary policy will decrease(26).
• (3) Positive views on further quantitative easing and setting an inflation target With regard to concerns and limits concerning further monetary easing and inflation targeting, people who are in a position to promote these measures think in the following ways: First, as for the argument that further monetary easing does not lead to an increase in lending and investment, it is true that the positive effects may not be large. Still, we can expect a certain level of effect on real interest rates. We can also expect some effects on lending increases and exchange rates, though the effect may not be clear. Under the current severe economic situation, it is necessary to study and adopt every possible means. As for the argument that further monetary easing will lead to a loss of fiscal discipline and, as a result, may have the side-effect of raising interest rates sharply, it can be said that such a risk has decreased, as the government has taken large steps toward promoting fiscal reforms.

As for concerns that introducing an inflation targeting policy may accelerate inflation, such concerns cannot be justified for the time being, as the Japanese economy is in a severe situation plagued by economic downturn and deflation. Moreover, if confidence in monetary policy is restored through implementation of inflation targeting, people will not have expectations of excessive inflation and, as a result, acceleration of inflation can be avoided. As for the argument that inflation targeting raises long-term nominal interest rates but that long-term real interest rates may not decline, it is true that long-term nominal interest rates will rise if medium- and long-term expectations of inflation are discounted. However, a long-term interest rate is an average value of expected future short-term interest rates. Since short-term interest rates will be kept at a low level until the target is achieved by monetary easing measures, a rise in long-term nominal interest rates will be limited and, as a result, the long-term real interest rates (nominal interest rates - inflation expectations (deflation expectations) are highly likely to fall. Setting an inflation target is also a policy to prevent inflation from rising above the target. So, if people have confidence in monetary policy, inflation expectations will not rise above the target and, therefore, a sharp rise in long-term nominal interest rates can be avoided(27). As for the argument that inflation targeting policy may lower confidence in monetary policy as it lacks the means to achieve the target, it can be responded to in the following ways: As for the means, it is effective through the above-mentioned further monetary easing and people' s inflation expectations. Since the potential growth of the Japanese economy is high in the medium and long terms, providing the maximum support to smoothly realize the potential by monetary measures, even for a short term, will lead to increasing confidence in monetary policy.

We have just described grounds for arguments for and against further monetary easing and setting an inflation target. Monetary policy is not a cure-all to bring about a complete recovery of the economy. However, given the facts that the Japanese economy is now weak overall and that promotion of structural reforms is expected to intensify downward pressures on the economy in the short term, it is believed that the Bank of Japan is now in the stage where it should positively consider further measures to ease deflationary pressures. Weathering such short-term deflationary pressures and securing the medium- and long-term growth potentials of the economy projected by the government will make monetary policy consistent with government policies and this, in turn, will win confidence in monetary policy.

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