This article is excerpted and translated from a speech given by Masaru Hayami, Governor of the Bank of Japan, to the Yomiuri International Economic Society in Tokyo on July 29, 1998.

September 11, 1998
Bank of Japan

I. Introduction

It is a great pleasure to be invited to the Yomiuri International Economic Society and to have the opportunity to talk to you today. This is my first public address since I was appointed Governor of the Bank of Japan four months ago, and therefore I would like to speak broadly about the problems and challenges facing the Bank.

The Japanese economy has been going through a difficult period since the second half of 1997. The failure of financial institutions including the Hokkaido Takushoku Bank and Yamaichi Securities in November had a very unsettling psychological effect on depositors and investors. The confusion was calmed relatively quickly as the Bank of Japan provided ample funds in the markets and the government took various countermeasures. The markets, however, remain wary of the credit risks of financial institutions and also firms, as indicated by the nervous movements in stock prices and market interest rates. In this situation, financial institutions reinforced their cautious lending stance. Meanwhile, consumer sentiment deteriorated rapidly, and business fixed investment started to show a clear decline, particularly in small and medium-sized firms.

The current economic downturn began in the spring of 1997, triggered by such fiscal factors as the raising of the consumption tax rate and by the turmoil in various Asian currencies and economies. While this was how the downturn began, I believe that the disturbances in the financial system caused the declining trend to become firmly established.

This situation has made me more than ever conscious of the very close relation between economic conditions and the financial system. The most important challenge for the Japanese economy at this moment is to achieve simultaneously both the revitalization of the financial system and the recovery of the economy.

Keeping in mind this close connection between economic and financial matters, I would like to explain the Bank's views and thinking regarding current issues related to Japan's financial system and monetary policy.

II. Financial System Issues

A. The Nonperforming Assets Problem and the Japanese Economy

I would like to start with the issues related to Japan's financial system.

Looking back on developments in the Japanese economy, it is quite true that the economy experienced various shocks during fiscal 1997, each of considerable magnitude. However, I cannot help being struck by how vulnerable to these shocks the economy was when I take into account the fact that, prior to the downswing, the economy had exhibited very clear signs of a recovery. For instance, it had achieved real growth rates of 2.8 percent and 3.2 percent during fiscal 1995 and 1996, respectively. Moreover, during the 1996 calendar year, the Japanese economy had recorded a growth rate of 3.9 percent, the highest rate of all the G7 countries.

It seems to me that the deterioration in the economy since fiscal 1997 proved that the preceding recovery was merely driven by favorable circumstances, and confirmed that the self-sustaining power of the economy was still very weak. The recovery from the beginning of 1996 was supported by such favorable factors as (1) steady expansion of the world economy, including the Asian economies; (2) a downward trend in the value of the yen; and (3) a sharp increase in domestic demand for information technology-related equipment and systems. The Bank of Japan remained uncertain as to whether the recovery was self-sustaining, and was highly conscious of the downside risk that might materialize if these favorable conditions dissipated. For this reason, the Bank opted to maintain the extremely easy stance of monetary policy it had adopted since September 1995.

The fact that the economic recovery continued on the surface but was never accompanied by a strengthening of the private sector was attributable to the severe structural adjustment pressures burdening the Japanese economy. At the center of these was the balance-sheet adjustment pressure on firms and financial institutions.

During the years of Japan's economic "bubble," some firms borrowed extensively from banks or issued an increased amount of bonds to finance massive real estate investments. With the collapse of the bubble, a plunge in real estate prices brought about a drastic depreciation of these firms' assets. On the other hand, bank loans and corporate bonds remained on their books at their original values, giving rise to a large gap between firms' assets and liabilities. Financial institutions experienced a similar imbalance as portions of their corporate lendings became nonperforming. This, which caused a major deterioration in the real capital base of firms and financial institutions, is the source of what is referred to as the balance-sheet adjustment pressure.

Firms and financial institutions plagued with the balance-sheet problem become more vulnerable to risks and find it difficult to venture into new business or extend new loans because of the contraction of their capital base. Under normal circumstances, a virtuous cycle can be expected in which firms enjoying rising profits will re-invest their earnings in new plant and equipment and the new investments in turn further boost profits. However, firms encumbered with balance-sheet problems will opt to use any additional profits to repay debts and write off nonperforming assets. Similarly, financial institutions cannot afford to take an active lending stance. As a result, it is difficult for self-sustained growth to ignite in an economy burdened with balance-sheet problems until the disposal of nonperforming assets has been completed.

Sound economic development requires a certain degree of risk-taking by the private sector. Sound risk-taking requires that the nonperforming-asset problem be solved and balance sheets be put back in good health.

It is particularly important to enhance the functions of the financial markets where such risk-taking activities are carried out. An essential function of the financial markets is to mediate between savings and investments and, during the process, to distribute the various risks inherent in the economy smoothly among investors, firms, and households. If the markets fail to fulfill this function properly, firms will not be able to raise the necessary funds and capital, and business opportunities will be wasted. Therefore, to induce the risk-taking activity essential for the economy to grow satisfactorily, it is necessary for Japan's financial markets to attain the capacity to offer a diverse range of financial products and services to investors and fund-raisers, which will lead to, among other things, expansion of the direct financing markets. Japan's financial Big Bang is designed to establish a competitive framework, which is indispensable for nurturing such markets. In order for market functions to be upgraded as intended by the Big Bang, first it is necessary to solve as soon as possible the nonperforming loan problem of financial institutions, which are the key market players.

B. Keys to the Prompt Solution of the Nonperforming-Asset Problem

Next I would like to move on to describe the progress made in the disposal of nonperforming loans by Japan's financial institutions.

Significant steps have been taken toward creating a full-fledged framework for the disposal of nonperforming loans, such as the announcement of the Comprehensive Plan for Financial Revitalization, the so-called Total Plan, in early July by the government and the ruling Liberal Democratic Party. I ardently hope that the new administration will take form very soon and that it will waste no time in showing leadership in revitalizing the financial system by implementing the measures contained in the Total Plan. Then the next challenge will be to make maximum use of the framework to achieve speedy disposal of nonperforming loans. I believe there are three keys to successfully carrying out this process.

The first is full disclosure of nonperforming loans, a very important prerequisite for forwarding the disposal.

It is quite true that, over the past few years, disclosure of the nonperforming loans of financial institutions has been expanded. For instance, the new disclosure standards applied from the fiscal year ended March 1998 are comparable to the United States' SEC standards. Unfortunately, however, skepticism persists in both the domestic and overseas markets that there are still substantial amounts of loans not subject to disclosure but may in fact be bad loans. Regarding this point, the data released by the Financial Supervisory Agency on July 17 showed a total of approximately 29.8 trillion yen in "risk management loans" for all Japanese banks as of March 1998.¹ It should be pointed out, however, that according to the self-assessment of assets made by financial institutions for the purpose of appropriate write-offs and provisioning, all Japanese banks have a total of 6.1 trillion yen in Category III, exposures where banks have serious concerns about ultimate collection, and 65.8 trillion yen in Category II, exposures requiring risk management on a one by one basis. There is no doubt that Category II contains a number of credit exposures on which, if they are properly managed, the banks will not incur losses. Hence, it is not appropriate to regard all these assets as nonperforming. For instance, Category II includes loans to firms whose credit risks have come to require special attention because of business cycle factors. In many cases, these loans start generating profits for financial institutions once the economy enters a recovery phase and corporate performance improves.

In any case, however, the ambiguity that remains about the massive amount of self-assessed credit exposures is apparently exacerbating the anxiety of the markets. It is a crucial deficiency for financial institutions, whose very existence is based on credibility and trust, not to be able to gain the confidence of the market. I find it very frustrating to see this situation unrectified fully seven years after the collapse of the "bubble" economy. It is essential that each financial institution promptly make every possible effort to regain its credibility in the markets.

In this respect, I have taken the position that it is desirable to expand the scope of disclosure, and that one possible way of doing this is for individual financial institutions to voluntarily disclose their self-assessment figures. There have been some negative responses to this approach on the grounds that an undifferentiated disclosure of Category II loans under an ambiguous definition may invite misinterpretation by the markets. However, my point is not to promote a uniform, formalistic disclosure of all Category II loans. What I am saying is that it is very important for the financial institutions to provide useful information, which the markets can use as a basis for making judgments, through their own creative approaches to winning the confidence of the markets. Financial institutions should voluntarily show the markets their assessment of credit risk exposures and demonstrate that they are taking appropriate measures to dispose of nonperforming loans by giving convincing explanation. I believe this is highly important to speedily restore both customers' and markets' confidence in not only individual financial institutions, but also the entire Japanese financial system. We are living in an age when domestic and international markets make judgments on the business performance of firms and financial institutions. In this environment, one should not forget that the more accurate and adequate information is made available, the more confidently the markets can form their judgments.

The second key to the disposal of nonperforming loans is to remove bad loans from balance sheets as soon as possible by selling off the loans themselves or the collateral real estate.

This is related to the issue of disclosure which I discussed just now. No matter how rational the methods, valuation of nonperforming loans unavoidably involves some degree of uncertainty. For instance, it is possible that a deterioration in the market conditions will cause the proceeds from the actual sale of collateral real estate to fall short even of a fairly conservative estimate made when loan-loss reserves were set aside. Hence, in order to improve the reliability of the balance-sheet information of financial institutions, it is desirable to identify the amount of potential losses as early as possible.

Various institutional changes are being steadily implemented to develop an environment more amenable to the liquidation of real estate and other assets. It is notable that the Total Plan contains numerous important measures for promoting greater liquidity, such as establishment of a Temporary Council for Coordinating Real Estate-Related Rights, the introduction of due diligence procedures for real estate appraisal, and the creation of a servicer system. Using these new arrangements to separate nonperforming loans from the balance sheet will facilitate a more accurate judgment of the strength and market value of financial institutions, and will thereby open the way to the next step, which is to formulate new management strategies.

The third key is making effective use of public funds to promote the smooth solution of the nonperforming-loan problem without causing disruption and unwanted side effects during the process.

What is most important is to protect the depositors of failed financial institutions. The two financial system-related laws enacted in February 1998 provide for the use of a maximum of 30 trillion yen in public funds. 17 trillion yen of the 30 trillion yen has been earmarked for the Special Account of the Deposit Insurance Corporation for the full protection of depositors.

The other 13 trillion yen has been made available to the new Financial Crisis Management Account of the Deposit Insurance Corporation for such purposes as enhancing the capital base of financial institutions. Of this total, 1.8 trillion yen has already been injected into 21 banks at the end of March following deliberations by the Financial Crisis Management Examination Board. The Total Plan also proposes the establishment of public bridge banks to continue providing loans to sound borrowers of failed financial institutions. A portion of the 13 trillion yen for the Financial Crisis Management Account will go into the capital of the bridge bank holding company, to be known as the Heisei Financial Revitalization Corporation. I believe that the fund can also be effectively used in various other situations. For example, if a financial institution falls into capital inadequacy as a result of thorough disposal of nonperforming loans, or if such a financial institution merges with another financial institution, the fund may be used to protect borrowers from being affected by an extreme deterioration in the institution's lending capacity. Of course, it is essential to prevent moral hazard when using public funds, and due accountability and adequate measures will be required of financial institutions drawing on these funds. As discussion of these matters proceeds, I very strongly hope that disposal of nonperforming loans will accelerate, leading to an early recovery of the financial intermediary functions.

1. "All Japanese banks" refers to the member banks of the Federation of Bankers Associations of Japan (Zenginkyo).

C. The Role of the Bank of Japan

Given its position as the central bank, the Bank of Japan will seek to make the maximum possible contribution to the process of disposing of nonperforming loans.

The primary role of the Bank is to safeguard the stability of the financial system by providing adequate liquidity to prevent hindrance of settlements in the financial markets.

For example, the Bank has provided uncollateralized loans, or "special loans" (tokuyu), under Article 38 of the Bank of Japan Law of 1997 (Article 25 of the former Bank of Japan Law) as needed to ensure that the failed financial institutions are able to repay deposits smoothly. Currently, the outstanding balance of these special loans amounts to approximately 2.7 trillion yen.

The Bank acted decisively to supply the markets with considerate amounts of reserves when the market's growing concern over the credit risks of financial institutions exerted upward pressures on interest rates. When markets were particularly tense at the end of last year and again in June this year, the Bank's provision of reserves exceeded the amount required under the reserve requirement system by a daily average of 3-4 trillion yen.

It is only when smooth withdrawal of deposits and unimpeded settlement of funds are secured that the anxiety of depositors and the markets is removed, restoring confidence in the stability of the overall financial system. The Bank has worked to achieve this because it is responsible for maintaining the smooth operation of the payment and settlement systems, and it will continue to do its utmost to avoid any problems emerging in this area.

I mentioned earlier that 30 trillion yen in public funds has been made available for financial system measures. Under the scheme, the Deposit Insurance Corporation can obtain funds up to 20 trillion yen through (1) Bank of Japan loans, (2) private financial institution lending, and (3) bond issuance, all of these guaranteed by the government with the aforementioned public funds. Accordingly, the Bank has in fact already provided the Deposit Insurance Corporation with liquidity. Following the principle that the Bank's funds must not be used to cover the losses of financial institutions and must not go beyond the limits of providing temporary liquidity, the Bank is utilizing such schemes to ensure the stability of the financial system.

The second role of the Bank of Japan is to undertake on-site examinations of financial institutions. While such examinations are conducted under bilateral contracts with individual financial institutions, they are given an explicit legal standing under the new Bank of Japan Law.

As I mentioned earlier, to solve their nonperforming-loan problems, financial institutions today are required to undertake loan-loss write-offs and provisioning in accordance with appropriate self-assessment of their assets, and to voluntarily expand the scope of their disclosure. As part of this process, it is very important to increase the objectivity of disclosed information to enhance its credibility in the markets. For this purpose, the Bank of Japan and the Financial Supervisory Agency will cooperate in conducting intensive inspections and examinations of 19 major banks.

The third role of the Bank of Japan derives from a somewhat different viewpoint. It is to implement, where possible, measures to contribute to smooth corporate financing in a situation where the lending attitude of financial institutions is increasingly cautious. As I previously explained, financial institutions have adopted a more cautious lending stance because nonperforming loans have significantly impaired their real capital base. The most effective way to achieve a more accommodative lending stance is therefore to promote increased management efficiency and strengthen financial institutions' capital bases. Injection of public funds stands as a ready tool for achieving this purpose, and as I stated earlier, the Bank of Japan is committed to supporting these initiatives through the supply of requisite liquidity.

But our efforts do not stop here. In its conduct of money market operations, the Bank of Japan has implemented several measures to facilitate the raising of funds by the corporate sector. Last autumn, following the failure of several financial institutions, market anxiety mounted, causing the CP market to temporarily cease to function. The Bank responded to this situation by significantly expanding its CP buying operations to promote an early recovery of the market to normal functioning, and thereby gave indirect support to firms' CP financing.

CP issuance is generally limited to large firms. However, it is conceivable that, if CP buying operations revitalize this market, large firms might shift their funding to CP from bank loans, and as a result, financial institutions might be given more room to meet the financing needs of smaller firms. Thus, I believe that the Bank's action can indirectly have favorable effects on lending from financial institutions to small and medium-sized firms.

I have tried to illustrate how the Bank's market operations can contribute to invigorating the financial markets. The Bank remains committed to implementing carefully considered operations, including maintaining flexible CP operations, particularly toward the end of the semiannual settlement in September, when seasonal corporate demand for funds heightens.

It is also vitally important for the Bank to constantly review its money market operations means, and the collateral involved, in accordance with innovation in financial technology. Last year, the Bank of Japan launched market operations in the "repo" market. In the autumn of this year, the Special Purpose Companies (SPCs) Act is scheduled to be enacted to prepare an environment for facilitating the issuance of asset-backed securities (ABS) and asset-backed CP (ABCP). The Bank of Japan must review and update its market operations methods to reflect such ongoing changes and diversification of financial transactions. Not only is this indispensable for attaining greater sophistication in market operations, but these efforts will promote further development of the financial markets, and through this contribute to smoother corporate financing.

As I have outlined, the Bank's response to the issue of corporate financing consists of short-term actions and also measures requiring medium- to long-term consideration. The Bank intends to take both approaches to help advance financial market functions.

III. Current Monetary Policy Management

A. The Current Condition of the Japanese Economy

Thus far, I have explained the key points for the early disposal of nonperforming loans, which is a prerequisite to the recovery of confidence in the financial system, and the role to be played by the Bank of Japan in this process. At the same time, the stability of the economy itself is an essential factor as an environment in which smooth disposal of nonperforming loans can be promoted. For instance, should business conditions further deteriorate, decreased cash flows of firms and lower real estate prices would heighten the probability of an increase in nonperforming loans. At the outset of my remarks today, I mentioned that there is a very close relation between economic conditions and the financial system. Not only does a weak financial system delay and obstruct an economic recovery, it must also not be forgotten that a worsening of business conditions could hinder the solution of the nonperforming-loan problem.

Let us now take a look at the current condition of the Japanese economy. The economy is now at a stage where a weakening of final demand, reflecting anemic private consumption and business fixed investment, is clearly exerting a negative influence on production, corporate profits, and employment and income conditions. Industrial production, affected by ongoing inventory adjustment, marked its third consecutive quarterly decline in the April-June quarter. The outlook for the July-September quarter is also gloomy, as the Bank's interviews with industry sources suggest a strong possibility that the slide will continue. The contraction in production activity, together with weak price developments, has created very harsh conditions for corporate profits. Employment adjustment pressure is also mounting rapidly, particularly in small and medium-sized firms. As a result, Japan's unemployment rate has risen to its highest level since such figures were first compiled in 1953.

In other words, we see at present a negative interaction between production, income, and expenditure. What would this situation have led to in the absence of policy countermeasures? In my view there would have been a real possibility of the Japanese economy falling into a vicious cycle of a further expansion of the output gap leading to declining prices and then to squeezed corporate profits--namely, a deflationary spiral.

In actuality, the government introduced in April a comprehensive economic package in excess of 16 trillion yen, and the supplementary budget for fiscal 1998, which embodied the package, is now being implemented. Parallel action was taken to strengthen the financial system. As I mentioned earlier, in February the government adopted emergency measures to stabilize the financial system, which allowed for the use of a maximum of 30 trillion yen in public funds. In early July, the government and the ruling LDP unveiled the details of the Total Plan. The effects of the special income tax cuts and additional public works contained in the comprehensive economic package will begin to appear in the second half of this year. This leads us to expect that the risk of the economy sinking into a deflationary spiral will be contained, at least for the time being. However, as the level of economic activity is already very low, we are left with little choice but to conclude that the measures will have a limited impact on private demand and that, therefore, they are unlikely to place the economy promptly on a path of self-sustained recovery. My judgment is that, although a deflationary spiral will be averted for the time being, considerable uncertainty remains as to the prospects for the economy after the effects of the comprehensive economic package have played themselves out.

B. Monetary Policy for the Immediate Future

Given these economic conditions, the Monetary Policy Meeting of the Bank of Japan Policy Board convened yesterday decided to keep monetary policy unchanged for the immediate future. I will leave the details of the Board's discussions to the minutes to be published at a later date, but in brief, the majority view expressed in yesterday's meeting was that (1) the risk of the economy slipping into a deflationary spiral would be averted for the immediate future by the effects of the government's comprehensive economic package; (2) therefore, it would be better to maintain the current easy monetary policy rather than to further reduce interest rates from their already extremely low levels; and (3) the Board should closely monitor the unfolding impact of the comprehensive economic package, as well as the influence of progress in discussions on various financial system revitalization measures and tax system reforms on corporate and household confidence.

As you all know, the Bank of Japan has maintained the official discount rate at a historic low of 0.5 percent and has encouraged the uncollateralized overnight call rate to remain, on average, slightly below the official discount rate for nearly three years since September 1995. With interest rates extremely low, there is very little room left to lower them any further. Given this constraint, we constantly face the following two questions in managing monetary policy.

The first question is, "How effective can a further interest rate reduction be in stimulating the economy?" Currently, corporate and household confidence is very weak. Under such conditions, a minor cut in interest rates, resulting in only a slightly lower cost of capital and only a small improvement in the financial position of firms, would naturally have only a limited effect on active corporate behavior such as business fixed investment. For the effects of monetary easing to be certain, there needs to be a sizable decrease in interest rates. But given the present extraordinary low interest rate levels, we face the dilemma of having scarcely any room left for a significant cut.

Of course, it can be argued that as long as there is some positive effect, no matter how small it might be, interest rates should be lowered immediately if economic conditions are deteriorating. This brings me to the second question that must be considered: "Are there no negative aspects to a further interest rate cut?" For instance, lower interest rates will reduce households' interest income. We then face the question whether consumer confidence, already low, would be further undermined.

There is also the issue of whether lower interest rates would trigger an additional depreciation of the yen, and if so, whether that would be a problem. Under normal circumstances, a weaker yen acts as a channel for transmitting the impact of monetary easing, working positively on the economy. However, depending on the state of market sentiment, the possibility cannot be denied that a depreciation of the yen could, by provoking falls in other Asian currencies against the US dollars and causing a drop in stock prices in tandem, amplify people's anxieties.

To summarize, with today's extremely low interest rates, it is probable that the effects of a further cut in interest rates would not be sufficiently large and, in addition, the side effects of the action might not be negligible. These are essential points that the Board has had to consider in its discussion of monetary policy in the past few months. They do, however, lie beyond the domain of our past experience, and moreover, the effects and side effects of the policy action can vary depending on the prevailing circumstances. Hence, I believe that it would be inappropriate to come to any firm conclusion. The decisions to leave monetary policy unchanged while economic conditions grew progressively harsher each month were based primarily on the judgment that the positive effects of fiscal policies should soon appear. But at the same time, the Board could not escape the question of how to judge the balance between the positive and negative outcomes of an interest rate reduction under the current conditions.

C. The So-Called "Adjusted Inflation"

In this unusual monetary policy environment, arguments have recently been put forward in some quarters for so-called "adjusted inflation." What is meant by this term varies from one user to another, while the question remains whether the term "adjusted inflation" is an appropriate expression of the ideas put forward. Let me outline what I believe to be the essence of the arguments, with "monetary expansion" and "inflation targeting" also in mind. (1) In the current situation, there is limited room for further reductions in nominal interest rates. (2) It is real interest rates--that is, nominal interest rates minus expected rate of inflation--rather than nominal interest rates that actually affect investment decisions. (3) Therefore, the Bank of Japan should adopt a clear stance of allowing a certain level of inflation, raising inflation expectations and thereby lowering real interest rates. (4) The Bank of Japan could indicate its pro-inflation stance by pledging itself to the expansion of monetary aggregates such as money supply or monetary base, or by setting an inflation target. It should be noted, however, that regarding the question of tolerance of inflation, there is a considerable difference between "adjusted inflation," which advocates an active raising of price levels, and "monetary expansion" and "inflation targeting," both of which simply emphasize the avoidance of deflation.

There are a wide variety of opinions on this topic both in academic and business circles. At the Bank of Japan, we are also discussing these proposals, but at present we do not have a consensus on all pertinent issues. Having expressed this reservation, I would like to introduce three specific issues which I believe to be of special importance.

My first point relates to the Bank of Japan Law, which explicitly states that the Bank's monetary policy should "be aimed at contributing to the sound development of the national economy through the pursuit of price stability." In this context, "price stability" refers to "the absence of inflation or deflation." It is commonly understood that expectations of inflation or deflation are very difficult to sweep away once they become lodged in people's minds. It is therefore quite unacceptable for a central bank to declare war on inflation at one time and to promote it at another. After all, it is essential that the central bank adhere at all times to the single policy objective of averting inflation or deflation, in order to win the public's confidence in monetary policy. If the "adjusted inflation" policy proposal aims, under certain circumstances, at creating a certain level of inflation, then it must be said that this constitutes an untenable option.

But I would like to take this opportunity to state clearly that the Bank does not desire deflation. I ask you to remember that the Bank has for nearly three years now maintained interest rates at extremely low levels for the purpose of avoiding a deflationary spiral.

My second point concerns the relation between a "lowering of interest rates" and "monetary expansion," which is often cited as an effective means of increasing people's inflation expectations. We would usually expect that a lowering of interest rates, as it worked its way through the economy, would boost corporate demand for funds, and in turn lead to increased monetary aggregates such as bank lending and money supply. In fact, under the Bank of Japan's "very easy" monetary policy, the monetary base--equivalent to the sum of cash and reserve deposits of financial institutions held at the central bank--has recently attained an annual growth rate of nearly 10 percent, helped by a significant increase in banknotes. This also works the other way round. When there is upward pressure on money market interest rates, the Bank of Japan responds by supplying ample funds--that is, "through monetary expansion"--to contain the pressure on interest rates.

My point is that a "reduction in interest rates" and "monetary expansion" are basically two sides of the same coin. Therefore, if we should opt for "monetary expansion" at some point in the future, we must acknowledge that the action would, at least temporarily, bring about a further decline in short-term interest rates from their current levels. We might see the overnight call rate come down close to zero percent. There are some proposals for "monetary expansion" as an alternative to the lowering of interest rates to avoid the various side effects of lower interest rates. This, however, is simply impossible. Thus, if a lowering of interest rates is problematic because it may have an adverse effect on consumer confidence and the yen's exchange rate, then we must realize that "monetary expansion" will give rise to exactly the same problems.

The third and last point concerns the assertion that "monetary expansion" or "inflation targeting" can have a more pronounced impact than an "interest rate cut" in that they can work on people's medium-term expectations. Some academic circles, represented by Professor Krugman, claim that even in cases where the nominal interest rate stands at zero percent and therefore cannot be lowered any further, the public's expected rate of inflation will rise if the central bank announces a medium-term commitment to monetary expansion, or if it establishes a specific inflation target. Those taking this position argue that the increase in inflation expectations will stimulate the economy by lowering real interest rates.

However, even if a central bank sets a goal of expanding the money supply or raising the inflation rate, by what means could such goals be achieved when there is so little room for a further decline in interest rates? True enough, it might be possible to increase the monetary base by purchasing large quantities of government bonds and other securities. From that point on, however, there would be tremendous uncertainties. For instance, how much growth can we expect to see in corporate demand for borrowing when there is very little room left to lower lending rates? Similarly, how positive a stance can we expect of financial institutions in regard to stepping up their lending activity when the financial intermediary functions are so weak?

Nevertheless, the Bank of Japan will continue to study and examine the arguments on "monetary expansion" and "inflation targeting," as they involve highly important issues concerning policy objectives of the central bank and the formation of medium-term expectations. However, it cannot be denied that significant uncertainties remain with regard to the relation between the objectives, namely a certain level of money stock growth or rate of inflation, and available means for achieving them. These arguments, in the end, bring us back to our initial problem that there is little room for further interest rate declines.

D. Macroeconomic Policy

While I have discussed some important aspects of "adjusted inflation", I would like to suggest that if we interpret "adjusted inflation" policy to mean "implementation of measures to stimulate aggregate demand," then this would be a policy which the Japanese economy vitally needs today. Considering the general environment for monetary policy which I have discussed, however, I believe that the primary economic policy responses available at this time are inevitably (1) direct demand creation measures centered on fiscal policy, and (2) confidence building measures, including financial system stabilization and structural reforms of the economy.

From this perspective, the comprehensive economic package, the Total Plan, and the ongoing discussions on tax system reforms are very timely indeed, and I strongly hope that steady progress will be made in these areas. It should be noted, however, that if the government is to abide by the framework of the Fiscal Structural Reform Act as it stands now, it is quite likely that the initial fiscal 1999 budget will be restraining in comparison to the total fiscal 1998 budget which included a large-scale supplement. This would not be a problem if the private sector has gained by then enough momentum for a self-sustained recovery. But if it has not, then the economy would be put at the risk of deteriorating again in fiscal 1999, even if downward momentum has been stopped temporarily by the effects of the comprehensive economic package in the second half of this fiscal year.

Needless to say, from a medium- to long-term perspective, improving the efficiency of the fiscal system, or fiscal consolidation, constitutes one of the most important challenges facing Japan today. From this viewpoint, the basic spirit of the Fiscal Structural Reform Act must be fully respected. However, taking into consideration the substantial uncertainties which cloud the prospects for the Japanese economy in fiscal 1999, I earnestly hope that both the new administration and the Diet deliberate thoroughly on the immediate issues that I mentioned, while constantly keeping in mind the medium-term goal of achieving fiscal soundness.

IV. Conclusion

As I have stated, the task of the Bank of Japan is becoming more challenging than ever before in terms of both the financial system and monetary policy.

As you all know, nearly four months have passed since the new Bank of Japan Law came into effect in April. The law states that the Bank's role is to contribute to the sound development of the national economy through "pursuit of price stability" and "maintenance of the stability of the financial system." I believe that these twin missions are given to the central bank specifically because of the close, indeed inseparable, relation between the economy and the financial system. It seems to me that the importance of this relation has never been so clear as today.

We, as the central bank of this country, are committed to making every effort to achieve swiftly and simultaneously the revitalization of the financial system and the recovery of the economy. In closing, I would like to ask for your support and cooperation.

Thank you very much for your kind attention.