Simply put, when the central bank becomes a large buyer of specific assets as a non-economic agent, supply of those assets to the private sector is smaller than it otherwise would be.

Altogether, the recovery in the banking system, the sustained low rates and the reduction in risk premiums have led to rising business activity and investment. In turn, the expansion in the corporate sector is driving real wages higher, supporting the consumer sector. External demand from the U.S. and China also aided Japan’s recovery, but the BoJ’s quantitative easing policy played a large role in helping to stimulate internal demand.

Q: What do you expect from the BoJ now that the central bank has ended quantitative easing?

Masanao: With the end of quantitative easing, the BoJ’s policy framework will be less transparent but more flexible. The BoJ shifted gears back to targeting the overnight call rate and will need to substantially reduce excess liquidity in its current account to around $40 billion before starting to hike policy rates from the current zero percent. The outright purchase of Japanese government bonds under the Rinban program will also have to be scaled back at some stage in the future.

Future policy decisions will now be based on two perspectives the BoJ recently outlined. The first perspective is the outlook for prices and economic activity one to two years into the future, with an “understanding” that medium- to long-term price stability means an inflation rate of 0% to 2%. The second perspective is an examination of longer-term risks that are most relevant to monetary policy aimed at generating sustainable growth with price stability.

This two-perspective framework is both good news and bad news. The good news is that the new framework will give the BoJ flexibility in monetary policy that is based on an “understanding,” not a “target,” of price stability, while still ensuring some degree of transparency. The bad news is that the BoJ may end up tightening monetary policy too early, and by too much, under the new framework.

Q: Why do you worry the BoJ might tighten too much and too soon?

Masanao: I have three concerns. First, I think the 0% to 2% range for the inflation rate is too low. The lower the level of price stability is, the faster the BoJ is likely to hike rates to prevent inflation risks.

Second, when addressing a forward-looking approach, the BoJ already seems too concerned about an asset price bubble at this stage. Right after the end of quantitative easing, the BoJ released a document titled, “The Bank’s Thinking on Price Stability,” that explained the lagged effect monetary policy has on general prices and detailed the Bank’s own experience during Japan’s asset price bubble in the late 1980s. I think this illustrates that the asset bubble that arose during the 1980s and then popped, leading to the long period of stagnation in Japan’s economy, remains a traumatic experience for the BoJ. It is true that land prices have already seen double-digit growth in primary areas of the large cities in Japan. But I think it is way too early to worry about an asset price bubble and its future negative impact on the real economy.

And third, the BoJ does not believe that its outright purchase of Japanese government bonds under the Rinban operation had an impact in reducing risk premiums in long-term bonds, which suggests that the Rinban operation may be scaled back sooner than later. I worry that the BoJ might be overconfident in downplaying the role of the Rinban. The Japanese government bond market, unfortunately, is much too spoiled to properly function without the BoJ’s kindness as the “buyer of last resort.”

But I still trust that the BoJ took as the most significant lesson of the last decade that the risk for the central banks is extremely asymmetric when the economy is only at mild inflation or disinflation. More than any other central bank, the BoJ understands the lack of policy tools that are immediately effective when the economy slips into deflation. Japan’s economy is no doubt recovering. But it is only just emerging from deflation. Let’s not forget it.

Q: Thank you, Tomoya, we look forward to speaking with you again as the BoJ’s new policy regime develops.