The central bank sets a target level for the interest rate and then controls it on a daily basis, injecting money into the financial system or withdrawing money from the system as needed to keep the interest rate at the targeted level.
Under quantitative easing, the BoJ stopped targeting the level of the overnight call rate, which had already been lowered to zero in an effort to end deflation and stimulate the Japanese economy. Instead, the BoJ set the level of its current account as the operating target and raised the target level of its current account to $250 to $300 billion, which was far in excess of the roughly $40 billion level needed when the operating target was the overnight call rate at zero percent.
Operationally, the quantitative easing policy required the BoJ to purchase trillions of yen of financial securities, including about $120 billion per year of Japanese government bonds in an operation known as “Rinban.” The BoJ also purchased asset-backed securities and equities, and extended the terms of its commercial bill purchasing operation up to 12 months. The combined effect of these operations was to effectively flood the Japanese financial system with excess liquidity.
The BoJ also explicitly pre-committed to maintain the quantitative easing regime at least until year-on-year changes in the consumer price index excluding fresh foods (the core CPI) became positive in a stable manner. With quantitative easing tied to the core CPI, the BoJ’s explicit commitment to its policy regime was much stronger than the Fed’s commitment to maintain easy monetary policy for a “considerable period” or its commitment to being “patient” in raising rates.
Q: Why did the BoJ decide at the March 8-9 meeting to end the quantitative easing policy?
Masanao: Quantitative easing worked; the Japanese economy is recovering and core consumer prices are rising. Before the BoJ’s March meeting, the year-on-year change in Japan’s core CPI had been positive for three consecutive months, and the core CPI has now increased for four consecutive months. Most importantly, BoJ policymakers expect a sustained recovery and continued increases in core consumer prices, fulfilling the conditions laid out in the commitment to maintain quantitative easing.
Q: How did the quantitative easing policy help to revive Japan’s economy?
Masanao: The BoJ’s pre-commitment to quantitative easing was an important element of the policy’s success. The market was able to expect that the BoJ’s zero interest rate policy would continue for months or even years by just looking at core CPI prints, allowing not only money market rates but also two-year and even longer rates to stay close to zero. The effect of the BoJ’s pre-commitment strategy was also evident in stabilizing the banking system and tightening credit market spreads in general. The availability of term financing at a level close to overnight financing rates enhanced borrowers’ credit. In other words, the quantitative easing policy made easy money available for many borrowers in Japan.
Excess liquidity in the financial system was another key element of the quantitative easing policy. The BoJ officially downplays the role of excess liquidity, concluding that excess liquidity only helped to stabilize the banking system and did not stimulate the economy. I doubt this conclusion.
It is true that bank lending did not improve until recently despite the excess liquidity provided by the BoJ. But bank lending did finally improve. It just took a long time for excess liquidity to work because the banking system was weak and the corporate sector was busy cleaning up its balance sheet. The BoJ just needed to wait for the banking sector to become healthier before the liquidity started to work.
I also believe that assets that the BoJ purchased in large size, i.e., money market instruments and JGBs, benefited by reducing their risk premium.
