The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of Japan 2006 published on 20 July 2006.
The new monetary policy framework announced following the end of quantitative easing…
Inflation turned positive in the first quarter of 2006, with the core consumer price index (the OECD definition, which excludes food and energy) rising by 0.2% year on year. However, the continued decline in other price measures, notably the private consumption and GDP deflators, suggests that some deflationary pressures remain. In March 2006, the Bank of Japan ended the quantitative easing policy introduced in 2001, which had supported the economic expansion by keeping the short-term interest rate at zero and long-term rates at low levels, while forestalling financial-sector instability by providing enormous liquidity to banks. With the end of quantitative easing, the central bank unwound the run-up in reserves since 2001 and then started to move away from a zero short-term interest rate with a 0.25% hike in July 2006. The Bank plans to continue purchasing long-term government bonds at an unchanged rate, which is likely to help maintain financial-market stability. The Policy Board also announced that 0 to 2% is its understanding of what constitutes price stability in the medium to long term, the first time that it has specified an inflation range.
Deflation is coming to an end
Year-on-year percentage change
1. Japanese core CPI excludes fresh food only, while the OECD core CPI excludes food and energy products.
Source: OECD Economic Outlook 79 database, Ministry of Internal Affairs and Communications and Cabinet Office.
…should be revised to ensure a definitive end to deflation
The exit strategy from quantitative easing and zero interest rates is a special challenge for the Bank of Japan. While the announcement of the Board Members’ understanding of price stability enhances transparency, the fact that the inflation range will be reviewed each year makes it less useful as a guide for market expectations over the medium term. The framework announced in March also allowed considerable flexibility to the Bank in moving away from zero interest rates in order to limit long-term risks. Given uncertainty about the rate of potential growth and the size of the output gap as the economy emerges from deflation, the Bank should be cautious in raising interest rates. It needs to be sure that inflation is sufficiently positive to minimise the risk that a negative shock could push Japan back into deflation. Although the Bank ended the zero short-term interest rate in July, waiting until inflation moves further above zero – such as a 1% rate of increase in the core consumer price index – before raising interest rates further would also support the expansion. This suggests that the Bank should review the understanding of price stability and increase the lower end of the range to give an adequate buffer against deflation, as the zero floor is too close to deflation for comfort. Such an approach to monetary policy would reduce market expectations of interest rate hikes, which helped to drive up the long-term interest rate from 1.6% when the quantitative easing policy ended in March to 2% in May, accompanied by exchange rate appreciation. Avoiding a premature rise in long-term interest rates while the GDP deflator is still declining is also important for progress in fiscal consolidation.
Further reform of the banking sector is essential to a sustained economic expansion
Avoiding a substantial, premature rise in the long-term interest rate would also be beneficial to banks, whose holdings of long-term government bonds increased significantly during the quantitative easing period. Maintaining the improved financial health of banks is important to sustain the upward trend in bank lending, which recently turned positive for the first time since 1996. There has been considerable progress in reducing the non-performing loans of the major banks. The supervisory authorities should maintain pressure on the banking sector to strengthen its capital base and encourage the regional banks to continue reducing non-performing loans. While regional banks play an important role in lending to small and medium-sized enterprises, the government should avoid moral hazard that would create additional non-performing loans. In addition, the profitability of the banking sector would be improved by scaling back the role of public financial institutions. Perhaps the top priority is the privatisation of Japan Post, the largest financial institution in the world. The authorities should achieve a complete divestiture of the government’s holdings in Postal Savings and Postal Life Insurance by 2017 at the latest. A level playing field with private financial institutions should be established before restrictions on the activities of Postal Savings and Postal Life Insurance are removed. The rationale for public financial institutions, whose lending amounts to almost one-fifth of that of private financial institutions, should be carefully examined and their activities should be reduced and subjected to clear budget constraints. Such an approach would reduce unfair competition with private financial institutions, while helping to cut wasteful government spending.
The share of public financial institutions in total loans has risen since 1990
Source: Bank of Japan.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded. It contains the OECD assesment and recommendations but not all of the charts included on the above pages.
The complete edition of the Economic Survey of Japan 2006 is available from:
For further information please contat the Japan Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat's report was prepared by Randall Jones, Tadashi Yokoyama and Taesik Yoon under the supervision of Willi Leibfritz.