Reflecting on Japan's "Transcendental" Monetary Policy

In this article, I review the monetary policy adopted by the Bank of Japan (BOJ) in recent years. The BOJ is Japan's central bank and is responsible for implementing monetary policy. Traditional monetary policy operates under the assumption that interest rates remain above zero, and seeks to influence economic trends by adjusting these rates. Raising interest rates tends to slow down economic activity and curb inflation (inflation is defined as the simultaneous rise in the prices of various goods and services). Conversely, lowering rates stimulates the economy but can accelerate inflation. This approach to influence the economy is now commonly referred to as conventional monetary policy.

However, Japan has been in a zero-interest rate environment since the end of the 1990s, which renders conventional monetary policy infeasible. This is because there was no room left to lower interest rates despite continuing economic stagnation. In an effort to overcome these challenges, the BOJ developed a set of alternative tools known collectively as unconventional monetary policy. Except for a few brief intervals, these measures have been in place since 1999. Notably, in 2013, the BOJ launched a massive initiative known as "quantitative and qualitative monetary easing," often referred to as "transcendental monetary easing."

In March 2024, the BOJ ended this series of unconventional monetary policies and returned to conventional monetary policy in the form of manipulating interest rates. In December, it published a comprehensive assessment of previous policies titled Review of Monetary Policy from a Broad Perspective. I was one of eight scholars who had the honor of contributing commentary to the review at the end of this report. In this article, I draw upon that experience to examine the BOJ's unprecedented monetary easing; specifically, an overview of the policies, the effectiveness of the policies, and remaining challenges.

The unprecedented monetary easing that was implemented by the BOJ involved injecting an extraordinary amount of money into the economy. But I am afraid this deceptively simple explanation just confuses the reader: the term "money" is so overused and yet so vague that it creates misunderstanding among readers. Therefore, I would like to provide a more technical explanation.

The BOJ conducts transactions with private banks. These banks purchase and hold large amounts of government bonds (debt securities issued by the state). The BOJ undertakes monetary easing by purchasing these bonds from them. However, the BOJ does not pay in cash. Each commercial bank has a current account with the BOJ. The BOJ credits the bank's account by the corresponding amount when the BOJ purchases these bonds.

From the perspective of a commercial bank, it merely exchanges its government bonds for reserves in its BOJ account. The bank's total asset size does not change due to this transaction. In that sense, the bank does not have more "money" (defined as the total sum of its assets) than before. That said, reserves held at the BOJ account are highly liquid--the bank can withdraw and use its reserves at any time. In that sense, the bank has more "money" (defined as the component of its overall asset that can be used at any time) due to this transaction. Thus, when we say that the BOJ is increasing the supply of money, it is effectively reshuffling the composition of bank assets.

Although reserves at the BOJ current account are convenient, they earn almost no interest. Of course, banks recognized this disadvantage of excess reserves and, in normal times, prefer to earn interest by lending them out to corporations. More lenders mean lower interest rates. That's how traditional monetary policy works.

However, from 1999 onward, Japan entered an era of zero interest rate. In such a situation, even if banks were to lend out their reserves to companies, they would earn very little. Consequently, even if banks' reserves with the BOJ account were to increase, they would not be motivated to lend those reserves. The increased amount has simply accumulated in the BOJ accounts and remained untouched. Ultimately, the BOJ's unprecedented monetary easing is a policy to significantly increase the money being hoarded by banks with no intended use.

One may wonder--is there any benefit to increasing money that is merely left unused in the BOJ accounts? In 2013, when the policy was first launched, the BOJ declared its intent to raise the inflation rate to 2% within two years. In retrospect, it's clear that this target was not achieved. Nonetheless, many researchers believe the policy had at least some effect, although opinions vary on the extent.

Many researchers acknowledge that when the policy was first introduced, it created optimism in the market which led to rising stock prices and a weaker yen, which had a positive effect on the economy. In my opinion, the policy had its greatest impact in the 2020s, when the world began to experience rising prices and inflation encroached on Japan. At this point, an ordinary central bank in a normal situation would have halted monetary easing and raised interest rates. On the contrary, the BOJ held back and continued with its unprecedented monetary policy, which led to a weaker yen and accelerated inflation in Japan.

The resulting inflation has been tough on households and remains unpopular. Moreover, the overall economy has only seen modest improvement. Even so, I find it remarkable that, twelve years after the BOJ first pledged to generate inflation, it now has a chance to make good on that promise.

From these experiences, I think that such policies are most effective when there is a strong belief among the public that the policy is getting close to the exit. If people are anxiously anticipating an end to the policy and then the BOJ signals that the same policy will continue for the time being, people will be surprised and react strongly. On the other hand, I have yet to encounter any credible evidence that demonstrates the effectiveness of continuing such policies for an extended period of time.

The entity most benefited from the BOJ's unprecedented monetary easing might have been the Japanese government. As is widely known, it has issued vast amounts of government bonds. In other words, the government is borrowing heavily from the public. Ordinarily, someone so deeply in debt would eventually struggle to find lenders. Similarly, Japan risks its future and, sooner or later, its bonds may stop attracting buyers.

Until now, however, the BOJ's large-scale purchases have delayed that moment of reckoning for bonds sold by the Japanese government. At times, the BOJ even bought nearly all of the newly issued bonds in a single month. I do not believe that the BOJ acted intentionally to uphold the Japanese government. Furthermore, the government has said that it does not intend to rely on support from the BOJ. Still, few people could plausibly deny that some politicians, deep in their subconsciousness, might be implicitly expecting support from the BOJ.

Now that the BOJ has ceased large-scale purchases of government bonds, the real test lies ahead. Importantly, just because the BOJ bought these bonds, it doesn't mean the overall public-sector debt (government + BOJ) has magically disappeared. In reality, government liabilities labeled as "bonds" have simply been swapped for BOJ liabilities labeled as "reserves at current account." Since last year, each time the BOJ raises interest rates, it increases the interest payments that accrue to commercial banks that hold current accounts. These are also public-sector expenditures. In order to confidently declare that the era of unprecedented monetary easing has ended well, it is necessary for Japan's political leaders to successfully navigate the challenges that lie ahead.