## _pdp05

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---

### Abstract and main conclusion
- The paper examines the effects of quantitative easing implemented by the Bank of Japan (BoJ) since early 2001, focusing on inflation expectations and real asset prices.
- Quantitative easing has had smaller effects on nominal and real variables than desired, mainly because the BoJ has not succeeded in credibly communicating its policy intentions once the zero bound on short-term rates ceases to be binding.
- Key policy prescriptions emphasized:
  - Set clear goals for inflation or the price level.
  - Return to interest rate targeting as the main policy instrument when the zero bound is no longer binding.
  - Improve BoJ communication to pin down expectations and avoid instability during and after the transition out of quantitative easing.

### Introduction: rationale, outcomes, and transition challenges
- Rationale and immediate outcomes:
  - Quantitative easing was adopted in early-2001 to inject liquidity beyond the level needed to keep short-term interest rates at zero.
  - Outcome to date:
    - A deflationary spiral was avoided.
    - Spikes in short-term interest rates during periods of high temporary liquidity demand were averted.
    - The policy has not rapidly turned around deflation expectations or stimulated a rapid return to positive growth in nominal GDP.
- Attribution uncertainty:
  - Some recovery and easing of deflationary pressures (especially the CPI, but not the GDP deflator) have occurred, but it is difficult to disentangle monetary policy effects from external factors (e.g., Asia/China growth) and domestic restructuring.
- Transition challenge and risks:
  - Since quantitative easing began, high powered money has increased by more than 50 percent.
  - "If this increase persists, it will, if it is allowed to persist, eventually result in a very sizable increase in the price level."
  - The BoJ must manage the transition out of quantitative easing to avoid excessive inflation and potential banking system destabilization.
  - Suggested mitigation: the Ministry of Finance could exchange long-term bonds for short-term bonds to stabilize the relative supply of long- and short-term liquidity.
- Policy recommendation reiterated:
  - Move to interest rate targeting supplemented by a form of price level or inflation goal as the ultimate objective; manage communications carefully to minimize risks as deflation wanes.

### Monetary targeting, operations, and BoJ balance sheet
- Policy instrument and evolution:
  - Policy instrument: targeting “current accounts” of commercial banks at the BoJ; original target was 5 trillion yen.
  - Target evolution: target raised on eight occasions and stands at 30–35 trillion yen today.
- Magnitude and composition of base expansion:
  - The BoJ increased the monetary base by more than 50 percent since adopting quantitative easing; elsewhere in the text the monetary base increase is cited as roughly 60 percent.
  - Current account balances account for about 70 percent of the increase in the monetary base.
  - The increase in the monetary base has not produced parallel increases in broader monetary aggregates such as M2 and M3, which have stayed relatively stable.
- Main implementation channel:
  - Larger current account balances were achieved mainly through open market operations in government bonds.
- Selected BoJ balance sheet figures (in billions of Yen):
  - Assets: April 2001 = 112,326; Dec. 2001 = 117,508; Dec. 2002 = 125,126; Dec. 2003 = 131,369; Dec. 2004 = 144,547; Feb. 2005 = 151,409.
  - Of which: Govt. Securities: April 2001 = 64,164; Dec. 2001 = 75,591; Dec. 2002 = 83,124; Dec. 2003 = 93,503; Dec. 2004 = 95,026; Feb. 2005 = 99,469.
  - Bills Purchased: April 2001 = 8,707; Dec. 2001 = 20,714; Dec. 2002 = 28,042; Dec. 2003 = 23,843; Dec. 2004 = 36,073; Feb. 2005 = 37,765.
  - Liabilities: April 2001 = 107,219; Dec. 2001 = 112,476; Dec. 2002 = 119,989; Dec. 2003 = 126,107; Dec. 2004 = 139,259; Feb. 2005 = 146,121.
  - Of which: Bank Notes: April 2001 = 60,039; Dec. 2001 = 69,004; Dec. 2002 = 75,472; Dec. 2003 = 76,910; Dec. 2004 = 77,956; Feb. 2005 = 73,082.
  - Of which: Deposits: April 2001 = 18,047; Dec. 2001 = 22,511; Dec. 2002 = 27,269; Dec. 2003 = 36,281; Dec. 2004 = 38,297; Feb. 2005 = 38,905.
  - Bank Capital and Reserves: April 2001 = 5,107; Dec. 2001 = 5,032; Dec. 2002 = 5,137; Dec. 2003 = 5,261; Dec. 2004 = 5,287; Feb. 2005 = 5,287.
- Portfolio maturity note:
  - Average residual maturity of the BoJ’s bond portfolio is only around 2–3 years.

### Effects on inflation expectations and observed evidence
- Inflation expectations:
  - Contrary to a simple quantity-theory prediction, inflationary expectations deteriorated for a full year after quantitative easing was launched.
  - Recent improvements in inflationary expectations have been modest and are "only barely positive," so they are not significantly reducing real interest rates via inflation expectations.
- Observed mismatch vs. quantity theory:
  - If prices and output were proportional to the monetary base and quantitative easing were expected to be permanent, long-term expectations about the future price level should have increased dramatically; this did not materialize.
  - The data leave open the possibility that, although quantitative easing fell short of desired effects, outcomes could have been worse under a less aggressive policy stance.

### Theoretical interpretations: liquidity trap and intertemporal expectations
- Keynesian liquidity trap interpretation:
  - At zero interest rates, money and short-term government bonds are perfect substitutes; buying short-term government bonds is irrelevant for spending decisions.
  - Empirical pattern in Japan: commercial banks have built up sizable idle cash balances in current accounts at the BoJ instead of holding short-term government bonds.
  - Figure 4 (Real Monetary Base/GDP vs. Call Rate, 1980–2004) is at least suggestive of a liquidity trap: as the short-term interest rate declined and the monetary base increased, banks and individuals increased cash holdings with little effect on price level, aggregate demand, or output.
- Modern intertemporal view:
  - Aggregate demand depends on current and expected future real interest rates in intertemporal-stochastic-GE frameworks.
  - Monetary policy can be effective in a liquidity trap if it changes expectations about future interest rates and inflation at the date when the zero bound is expected to cease being binding.
  - Increasing expected future money supply lowers expected future real rates and can stimulate demand today even when short-term rates are zero.
  - Committing to keep nominal interest rates lower in the future for any given price level is equivalent to committing to a higher future money supply; such commitment can be stimulative.
  - The BoJ’s announcement that it would keep interest rates low for a substantial period is consistent with this strategy and may have contributed to the gradual improvement in inflationary expectations.
- Limits on effectiveness:
  - Quantitative easing is ineffective if the public expects future money supply to revert to a constant value, or expects the central bank to follow a Taylor rule, or anticipates discretionary reneging once the zero bound ceases to bind.
  - The Keynesian liquidity trap is a true trap only when the central bank cannot move expectations; otherwise quantitative easing can work by altering expected future policy and money supply.

### Asset purchase channels and foreign exchange intervention
- Portfolio channel hypothesis:
  - Expanding the monetary base by purchasing assets other than short-term government bonds may change prices of those assets.
  - In a general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant.
  - Long-term interest rates depend on expectations of future short-term interest rates and a risk premium; neither depends on quantity of long-term bonds or on the monetary base at zero interest rates.
  - Open market operations buying long-term bonds without providing a credible indication about the duration of quantitative easing are unlikely to be effective.
- Unsterilized foreign exchange intervention:
  - Unsterilized intervention expands base money and can depreciate the currency only if it changes expectations about future interest rates.
  - If open market operations in foreign exchange leave expectations unchanged, they are unlikely to have much economic effect.

### Liquidity-channel considerations
- Liquidity-channel hypothesis:
  - Increasing the monetary base provides private sector with liquid assets, potentially expanding aggregate demand if agents are liquidity constrained.
- Counterargument:
  - At zero interest rates, bonds and money are perfect substitutes; a sensible definition of overall liquidity should include both money and government bonds.
  - Quantitative easing that purchases government bonds leaves this broader liquidity aggregate unchanged.
  - For liquidity-increasing operations to be effective, they must transfer wealth from the public to the private sector (for example, direct cash transfers or wealth transfers from non-liquidity-constrained to liquidity-constrained agents) — effectively fiscal policy rather than monetary policy.

### Empirical evidence on announcements, yields, and portfolio effects
- Effects on expectations and markets:
  - Figure 3 evidence: expectations did not react strongly to the adoption of the quantitative easing policy framework; a full year later, inflationary expectations continued to worsen and are still only barely positive.
  - Bernanke and others (2004): find no significant effect on 5-year yields around announcements of higher current account targets.
  - Equity market reaction: on six occasions of “surprise” increases in current account targets, the Nikkei 500 rose between 3 and 6 percent.
    - Interpretation: markets may have interpreted higher current account targets as indication that the BoJ would keep monetary policy loose for a substantial period.
- Portfolio channel evidence:
  - Yields on long-term bonds declined around announcements that the BoJ planned to step up purchases of longer-maturity JGBs (Bernanke and others, 2004).
  - No-arbitrage VAR-based model estimation suggests reductions in long-term interest rates cannot be explained solely by expected future short rates; residual may be due to a portfolio channel.
  - Alternative explanations include signaling of future monetary easing and inelastic institutional demand for long-term bonds.
  - Caveat: reduction in long-term JGB yields did not translate into a similar reduction in long-term borrowing costs for firms.

### Exit risks as Japan exits deflation and contracts base money
- Size of base expansion:
  - Monetary base has expanded by more than 50 percent since adoption of quantitative easing.
- Necessity to contract:
  - As the economy recovers, the BoJ will need to contract the base to prevent excessive inflation because, in the long run, the price level is roughly proportional to the monetary base as interest rates return to equilibrium.

- Disruption in short-term interest rates:
  - Monetary targeting at positive interest rates can lead to considerable volatility in short-term interest rates due to instability and unforecastability of money demand.
  - Recommendation: as the economy recovers, the BoJ should resume using the nominal interest rate as the policy instrument rather than targeting the monetary base or current accounts.

- Disruption in expectations:
  - Market may interpret a shift toward interest rate targeting as signal of tighter future policy or faster rate increases.
  - Large changes in monetary base required during recovery may lead to large and erratic movements in expectations if markets cannot interpret them.
  - Two pillars for a successful transition strategy:
    - Clear goals for the evolution of inflation or the price level.
    - A clear target for the policy variable — the nominal interest rate.

- Disruption in long rates and portfolio channel risk:
  - Long-term interest rates depend partly on expected path of future short rates; managing expectations is critical to prevent excessive volatility in long yields.
  - BoJ holds significant amounts of long-term government bonds; contracting the base by selling long-term bonds would change relative supply and could raise long-term yields.
  - Mitigation: Ministry of Finance could stand ready to exchange long-term bonds held at the BoJ for short-term government bonds to keep relative supply stable and avoid portfolio disruption.
  - Even if portfolio channel importance is doubtful, such an arrangement would be almost costless to eliminate the risk.

- Balance sheet losses and banking sector vulnerability:
  - Unexpected interest rate increases may cause capital losses for banks and individuals holding government bonds.
  - Commercial banks hold considerable government bonds; increases in yields cause capital losses, but economic expansion accompanying rate increases should increase value of other bank assets. Net effect ambiguous; some banks might suffer losses.
  - IMF FSSA (2003) selected stress results (loss measured as percentage of equity):
    - Equity price stress: 20 percent decline in prices → City Banks 44%, Credit Cooperatives 3%, Regional Banks 9%, Life Insurance 45%
    - Interest rate stress: 100 bp increase in yields → City Banks 33%, Credit Cooperatives 72%, Regional Banks 22%, Life Insurance 38%
    - Credit risk stress: 3 percent credit loss on loan book → City Banks 93%, Credit Cooperatives 35%, Regional Banks 45%, Life Insurance 10%
  - Historical context:
    - 2002: Japanese equity prices fell by more than 20 percent while long-term yields declined by nearly 100 basis points (bp).
    - Looking ahead, long-term yields could rise by 200 bp with substantial effects on banks and especially credit cooperatives.
  - Fiscal backstop:
    - Losses on government bond holdings by banks correspond to gains for the government; Ministry of Finance would in principle have the resources to compensate banks for losses.
  - Importance of expectations management:
    - Losses accrue only with unexpected interest rate movements; shifting from a quantity target to an interest rate target helps markets forecast future rates and minimizes unexpected losses.

### Communications, credibility, and target choice
- Communications and credibility around exit:
  - Absent clear communication, the BoJ risks confusing markets, which might interpret a change in framework as an indication of premature or excessive rate increases and thereby undermine recovery.
  - Limited effectiveness of quantitative easing may be due to insufficiently credible communications about the BoJ’s inflation or price level objectives for the period when the zero bound ceases to bind.
  - One risk is that inflationary expectations could prematurely pick up, prompting an earlier and sharper-than-desired increase in policy rates.
  - If the Bank credibly communicates its long-term goal for inflation or prices, the risk of unwarranted increases in inflationary expectations and policy rates is much reduced.
  - Historical note: Sweden, Japan, and the United States moved from a deflationary situation into modest inflation during the 1930s without sharp movements in expectations.

- Price level targets versus inflation targets:
  - Advantages of announcing price level goals over inflation goals, especially with low interest rates:
    - Price level goal incorporates an "automatic stabilizer": a credible price level goal commits the government to undo deflation with subsequent inflation.
    - Higher inflationary expectations are helpful when the zero bound is binding because they lower real interest rates and increase demand.
    - In the exit phase, a credible price level goal helps by associating higher inflation with expected disinflation, reducing inflationary expectations and increasing real interest rates, thus diminishing overheating risk.
  - Risk and mitigation:
    - One risk is overheating and inflation overshooting the target during exit.
    - To avoid implying a commitment to actual deflation after overshoot, there are advantages to announcing a price level target with a trend rate of growth of prices.
    - Svensson (2001) suggests advantages to a temporary price level targeting regime as practiced in Sweden during the 1930s.

### Policy recommendations and practical measures
- As economic slack is reduced, the BoJ should:
  - Resume targeting short-term interest rates instead of current accounts or base money.
  - Complement an interest rate target with clear inflation and/or price level goals to anchor expectations and avoid bumpy adjustments as interest rates return to more normal levels.
- To guard against portfolio-channel disruptions in long-term yields:
  - Ministry of Finance could buy back long-term bonds held by the BoJ and replace them with short-term debt to offset potential adverse portfolio effects of contracting the monetary base.

*Prepared by Gauti Eggertsson and Jonathan D. Ostry; April 2005.*

### Section 1

### _pdp05 - Section 1

### Abstract and main conclusion
- The paper examines the effects of quantitative easing implemented by the Bank of Japan (BoJ) since early 2001, focusing on inflation expectations and real asset prices.
- Quantitative easing has had smaller effects on nominal and real variables than desired, mainly because the BoJ has not succeeded in credibly communicating its policy intentions once the zero bound on short-term rates ceases to be binding.
- Key policy prescriptions emphasized:
  - Set clear goals for inflation or the price level.
  - Return to interest rate targeting as the main policy instrument when the zero bound is no longer binding.
  - Improve BoJ communication to pin down expectations and avoid instability during and after the transition out of quantitative easing.

### Introduction: rationale, risks, and transition issues
- Quantitative easing was adopted in early-2001 to inject liquidity beyond the level needed to keep short-term interest rates at zero.
- Outcome to date:
  - A deflationary spiral was avoided.
  - Spikes in short-term interest rates during periods of high temporary liquidity demand were averted.
  - The policy has not rapidly turned around deflation expectations or stimulated a rapid return to positive growth in nominal GDP.
- Uncertainty over attribution:
  - Some recovery and easing of deflationary pressures (especially the CPI, but not the GDP deflator) have occurred, but it is difficult to disentangle monetary policy effects from external factors (e.g., Asia/China growth) and domestic restructuring.
- Transition challenge:
  - Since quantitative easing began, high powered money has increased by more than 50 percent.
  - If this increase persists, it "will, if it is allowed to persist, eventually result in a very sizable increase in the price level."
  - The BoJ must manage the transition out of quantitative easing to avoid excessive inflation and potential banking system destabilization.
  - Suggested mitigation: the Ministry of Finance could exchange long-term bonds for short-term bonds to stabilize the relative supply of long- and short-term liquidity.
- Policy recommendation reiterated:
  - Move to interest rate targeting supplemented by a form of price level or inflation goal as the ultimate objective; manage communications carefully to minimize risks as deflation wanes.

### Monetary targeting in Japan: operations and statistics
- Policy instrument: targeting “current accounts” of commercial banks at the BoJ; original target was 5 trillion yen.
- Target evolution: target raised on eight occasions and stands at 30–35 trillion yen today.
- Magnitude of base expansion:
  - The BoJ increased the monetary base by more than 50 percent since adopting quantitative easing; elsewhere in the text the monetary base increase is cited as roughly 60 percent.
  - Current account balances account for about 70 percent of the increase in the monetary base.
- Relationship with broader aggregates:
  - The increase in the monetary base has not produced parallel increases in broader monetary aggregates such as M2 and M3, which have stayed relatively stable.
- Main implementation channel:
  - Larger current account balances were achieved mainly through open market operations in government bonds.
- BoJ balance sheet (selected figures from Table 1, in billions of Yen):
  - Assets: April 2001 = 112,326; Dec. 2001 = 117,508; Dec. 2002 = 125,126; Dec. 2003 = 131,369; Dec. 2004 = 144,547; Feb. 2005 = 151,409.
  - Of which: Govt. Securities: April 2001 = 64,164; Dec. 2001 = 75,591; Dec. 2002 = 83,124; Dec. 2003 = 93,503; Dec. 2004 = 95,026; Feb. 2005 = 99,469.
  - Bills Purchased: April 2001 = 8,707; Dec. 2001 = 20,714; Dec. 2002 = 28,042; Dec. 2003 = 23,843; Dec. 2004 = 36,073; Feb. 2005 = 37,765.
  - Liabilities: April 2001 = 107,219; Dec. 2001 = 112,476; Dec. 2002 = 119,989; Dec. 2003 = 126,107; Dec. 2004 = 139,259; Feb. 2005 = 146,121.
  - Of which: Bank Notes: April 2001 = 60,039; Dec. 2001 = 69,004; Dec. 2002 = 75,472; Dec. 2003 = 76,910; Dec. 2004 = 77,956; Feb. 2005 = 73,082.
  - Of which: Deposits: April 2001 = 18,047; Dec. 2001 = 22,511; Dec. 2002 = 27,269; Dec. 2003 = 36,281; Dec. 2004 = 38,297; Feb. 2005 = 38,905.
  - Bank Capital and Reserves: April 2001 = 5,107; Dec. 2001 = 5,032; Dec. 2002 = 5,137; Dec. 2003 = 5,261; Dec. 2004 = 5,287; Feb. 2005 = 5,287.
- Portfolio maturity note:
  - Average residual maturity of the BoJ’s bond portfolio is only around 2–3 years.

### Effects on inflation expectations and observed data
- Inflation expectations:
  - Contrary to a simple quantity-theory prediction, inflationary expectations deteriorated for a full year after quantitative easing was launched.
  - Recent improvements in inflationary expectations have been modest and are "only barely positive," so they are not significantly reducing real interest rates via inflation expectations.
- Observed mismatch:
  - If prices and output were proportional to the monetary base and quantitative easing were expected to be permanent, long-term expectations about the future price level should have increased dramatically; this did not materialize.
  - The data leave open the possibility that, although quantitative easing fell short of desired effects, outcomes could have been worse under a less aggressive policy stance.

### Keynesian liquidity trap interpretation
- Classic liquidity trap insight:
  - At zero interest rates, money and short-term government bonds are perfect substitutes; buying short-term government bonds is irrelevant for spending decisions.
  - Empirical pattern in Japan: commercial banks have built up sizable idle cash balances in current accounts at the BoJ instead of holding short-term government bonds.
- Empirical suggestion:
  - Figure 4 (Real Monetary Base/GDP vs. Call Rate, 1980–2004) is at least suggestive of a liquidity trap: as the short-term interest rate declined and the monetary base increased, banks and individuals increased cash holdings with little effect on price level, aggregate demand, or output.

### Modern intertemporal view of the liquidity trap
- Mechanism for effectiveness:
  - In intertemporal stochastic general equilibrium frameworks, aggregate demand depends on current and expected future real interest rates.
  - Monetary policy can be effective in a liquidity trap if it changes expectations about future interest rates and inflation at the date when the zero bound is expected to cease being binding.
  - Increasing expected future money supply lowers expected future real rates and can stimulate demand today even when short-term rates are zero.
  - Committing to keep nominal interest rates lower in the future for any given price level is equivalent to committing to a higher future money supply; such commitment can be stimulative.
- BoJ communication:
  - The BoJ’s announcement that it would keep interest rates low for a substantial period is consistent with this strategy and may have contributed to the gradual improvement in inflationary expectations.

### When is quantitative easing effective versus irrelevant?
- Conditions under which quantitative easing is ineffective:
  - If the public expects future money supply to revert to a constant value, any current increase will be expected to be reversed (Krugman, 1998).
  - If the public expects the central bank to follow a Taylor rule, increases in the monetary base will be reversed when inflation or output gaps close, rendering quantitative easing ineffective (Eggertsson and Woodford, 2003).
  - If the central bank is discretionary and minimizes a standard loss function (inflation and output gap) without commitment, it will have incentives to renege on inflationary promises once the zero bound ceases to bind (Eggertsson, 2004).
- Implication:
  - The Keynesian liquidity trap is a true trap only when the central bank cannot move expectations; in other circumstances, quantitative easing can work by altering expected future policy and money supply.

*Prepared by Gauti Eggertsson and Jonathan D. Ostry; April 2005.*

### Section 2

### _pdp05 - Section 2

### B. Long-Term Bond Purchases and Foreign Exchange Intervention
- Portfolio channel hypothesis: expanding the monetary base by purchasing assets other than short-term government bonds may change prices of those assets.
- Empirical/theoretical tensions:
  - Eggertsson and Woodford (2003): in a general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant.
  - Long-term interest rates depend on expectations of future short-term interest rates and a risk premium; neither depends on quantity of long-term bonds or on the monetary base at zero interest rates.
  - Open market operations buying long-term bonds without providing a credible indication about the duration of quantitative easing are unlikely to be effective.
- Unsterilized foreign exchange intervention:
  - Unsterilized intervention expands base money and can depreciate the currency only if it changes expectations about future interest rates.
  - If open market operations in foreign exchange leave expectations unchanged, they are unlikely to have much economic effect.

### C. Quantitative Easing and the Liquidity Channel
- Liquidity-channel hypothesis: increasing the monetary base provides private sector with liquid assets, potentially expanding aggregate demand if agents are liquidity constrained.
- Counterargument:
  - At zero interest rates, bonds and money are perfect substitutes; a sensible definition of overall liquidity should include both money and government bonds.
  - Quantitative easing that purchases government bonds leaves this broader liquidity aggregate unchanged.
  - For liquidity-increasing operations to be effective, they must transfer wealth from the public to the private sector (for example, direct cash transfers or wealth transfers from non-liquidity-constrained to liquidity-constrained agents) — effectively fiscal policy rather than monetary policy.

### D. Policy Implications (from theoretical discussion)
- Quantitative easing needs to alter public expectations about the future course of money and interest rates beyond the period in which the zero bound is binding to be effective.
- Japan’s experience:
  - Quantitative easing has not had particularly noticeable effects on inflationary expectations and the speed of economic recovery, though identifying the counterfactual is difficult.
  - Gradual recovery in output and inflationary expectations and avoidance of widespread financial instability provide limited positive evidence.
- Transition risks:
  - If strong irrelevance propositions hold, transition to positive interest rates is straightforward: BoJ can contract the monetary base, allow rates to rise, and secure a balanced recovery.
  - If expectational, portfolio, or liquidity effects are empirically important, the BoJ may face serious challenges mopping up excess liquidity.

### V. Some Empirical Evidence on the Effects of Quantitative Easing
A. Empirical Evidence on the Effect of Quantitative Easing on Expectations
- Inflationary expectations:
  - Figure 3 evidence: expectations did not react strongly to the adoption of the quantitative easing policy framework; a full year later, inflationary expectations continued to worsen and are still only barely positive.
- Announcements of higher targets for current account balances:
  - Hypothesis: higher targets signal longer duration of quantitative easing and a higher targeted price level, raising inflationary expectations and implied forward rates if credible.
  - Bernanke and others (2004): find no significant effect on 5-year yields around announcements of higher current account targets.
  - Equity market reaction: on six occasions of “surprise” increases in current account targets, the Nikkei 500 rose between 3 and 6 percent.
    - Interpretation: markets may have interpreted higher current account targets as indication that the BoJ would keep monetary policy loose for a substantial period, i.e., keep interest rates low even after deflationary shocks subside.

B. Empirical Evidence on the Portfolio Channel
- Evidence that yields on long-term bonds declined around announcements that the BoJ planned to step up purchases of longer-maturity JGBs (Bernanke and others, 2004).
- No-arbitrage VAR-based model estimation suggests reductions in long-term interest rates cannot be explained solely by expected future short rates; residual may be due to a portfolio channel.
- Alternative explanations:
  - Purchases of long-term bonds could signal future monetary easing (expectations channel).
  - Inelastic demand from institutions with strong preference for long-term bonds could make BoJ purchases affect prices by altering relative supply.
- Caveat:
  - Reduction in long-term JGB yields did not translate into a similar reduction in long-term borrowing costs for firms; if long rates are decoupled from broader interest structure, investment and economic activity effects may be limited.

### VI. Will Contracting Base Money Cause Problems as Japan Exits Deflation?
- Monetary base has expanded by more than 50 percent since adoption of quantitative easing.
- As the economy recovers, the BoJ will need to contract the base to prevent excessive inflation because, in the long run, the price level is roughly proportional to the monetary base as interest rates return to equilibrium.

A. Disruption in Short-Term Interest Rates
- Monetary targeting at positive interest rates can lead to considerable volatility in short-term interest rates due to instability and unforecastability of money demand.
- Recommendation: as the economy recovers, the BoJ should resume using the nominal interest rate as the policy instrument rather than targeting the monetary base or current accounts.

B. Disruption in Expectations
- Market may interpret a shift toward interest rate targeting as signal of tighter future policy or faster rate increases.
- Large changes in monetary base required during recovery may lead to large and erratic movements in expectations if markets cannot interpret them.
- Two pillars for a successful transition strategy:
  - Clear goals for the evolution of inflation or the price level.
  - A clear target for the policy variable — the nominal interest rate.

C. Disruption in Long Rates
- Long-term interest rates depend partly on expected path of future short rates; managing expectations is critical to prevent excessive volatility in long yields.
- Portfolio channel risk:
  - BoJ holds significant amounts of long-term government bonds; contracting the base by selling long-term bonds would change relative supply and could raise long-term yields.
  - Mitigation: Ministry of Finance could stand ready to exchange long-term bonds held at the BoJ for short-term government bonds to keep relative supply stable and avoid portfolio disruption.
  - Even if portfolio channel importance is doubtful, such an arrangement would be almost costless to eliminate the risk.

D. Balance Sheet Losses
- Unexpected interest rate increases may cause capital losses for banks and individuals holding government bonds.
- Commercial banks hold considerable government bonds; increases in yields cause capital losses, but economic expansion accompanying rate increases should increase value of other bank assets (equity prices up, credit risk down). Net effect ambiguous; some banks might suffer losses.
- Stress test results from IMF FSSA (2003) indicate credit risk is dominant for bank equity vulnerability. Selected stress results (loss measured as percentage of equity):
  - Equity price stress: 20 percent decline in prices → City Banks 44%, Credit Cooperatives 3%, Regional Banks 9%, Life Insurance 45%
  - Interest rate stress: 100 bp increase in yields → City Banks 33%, Credit Cooperatives 72%, Regional Banks 22%, Life Insurance 38%
  - Credit risk stress: 3 percent credit loss on loan book → City Banks 93%, Credit Cooperatives 35%, Regional Banks 45%, Life Insurance 10%
- Historical context:
  - 2002: Japanese equity prices fell by more than 20 percent while long-term yields declined by nearly 100 basis points (bp).
  - Looking ahead, long-term yields could rise by 200 bp with substantial effects on banks and especially credit cooperatives.
- Fiscal backstop:
  - Losses on government bond holdings by banks correspond to gains for the government; Ministry of Finance would in principle have the resources to compensate banks for losses (though realization may be difficult in practice).
- Importance of expectations management:
  - Losses accrue only with unexpected interest rate movements; shifting from a quantity target to an interest rate target helps markets forecast future rates and minimizes unexpected losses.

### VII. Policy Suggestions
- As economic slack is reduced, BoJ should:
  - Resume targeting short-term interest rates instead of current accounts or base money.
  - Complement an interest rate target with clear inflation and/or price level goals to anchor expectations and avoid bumpy adjustments as interest rates return to more normal levels.

*Source: _pdp05 - Section 2*

### Section 3

### _pdp05 - Section 3

### Communications and credibility around exit from the zero bound
- Absent clear communication of this sort, the BoJ runs the risk of confusing the market, which might interpret the change in the policy framework as an indication that the BoJ intends to raise interest rates prematurely or excessively, and so undermine the recovery.
- The limited effectiveness of quantitative easing in the past may be due to insufficiently credible communications about the BoJ’s inflation or price level objectives for the period in which the zero bound on short-term interest rates ceases to be binding.
- One risk is that inflationary expectations could prematurely pick up, prompting an earlier and sharper-than-desired increase in policy rates to guard against an overshooting of inflation.
- To the extent that movements in inflationary expectations are not justified (e.g., the market misreads the policy stance of the BoJ), this may cause an unnecessary economic slowdown.
- If the Bank credibly communicates its long-term goal for inflation or prices, the risk of unwarranted increases in inflationary expectations and, likewise, policy rates, is much reduced.
- Historical note: Sweden, Japan, and the United States moved from a deflationary situation into modest inflation during the 1930s without sharp movements in expectations (see, for example, Kumar and others, 2003, for a discussion).

### Price level targets versus inflation targets
- There are some advantages to announcing price level goals over inflation goals, especially in periods with low interest rates, although under normal circumstances the trade-off is perhaps less clear cut.
- One advantage of a price level goal is that it incorporates an “automatic stabilizer.” If the central bank announces a price level goal that is credible, the government commits itself to undo any deflation with subsequent inflation.
- Higher inflationary expectations are helpful when the zero bound is binding (to lower real interest rates and increase demand); a credible price level goal therefore helps when the zero bound is binding.
- A similar argument applies to the exit phase from the zero bound: if the BoJ has a credible price level goal, higher inflation would be associated with expected disinflation, thus reducing inflationary expectations and increasing real interest rates; those expectations would thus reduce demand growth and so diminish the chance of overheating.
- One risk is that the economy will overheat in the exit phase and inflation will overshoot the goal set by the central bank.
- To avoid the possibility that overshooting implies a commitment to actual deflation in a price level targeting regime, there are some advantages to announcing a price level target with a trend rate of growth of prices, as argued by Svensson (2001).
- Historical practice: Svensson (2001) suggests advantages to a temporary price level targeting regime as practiced in Sweden during the 1930s.

### Portfolio channel and long-term interest rates; policy recommendation
- As pointed out in the last section, there may be some dangers stemming from an increase in long-term interest rates due a portfolio channel.
- As the economy recovers, it is expected that the Bank of Japan will need to liquidate a large number of long-term government bonds. This will increase the supply of long-term bonds in the market which may increase yields on those assets.
- Although the magnitude and importance of this channel is open to question, it is prudent to guard against it.
- Policy recommendation: A straightforward way of doing this would be for the Ministry of Finance to buy back all long-term bonds held by the BoJ and replace them with short-term debt. This would offset any potential adverse portfolio effect that a contraction of the monetary base could imply.

*Source: _pdp05 - Section 3*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp05.pdf_