Monetary Policy Responses to Bubbles in Japan and the US

David E. Weinstein Columbia University Consultant FRBNY NBER 1

Quick Overview • Data and History – What Happened?

– Comparing the Policy Response in the US and Japan • Understanding Monetary Policy in a Deflationary Environment 2

Both Japan and the US have Suffered Similar Declines in Equity Prices

Relative Movements in Nikkei 225 in dollars and S&P 500

1.6

1.4

1.2

1 0.8

0.6

0.4

0.2

0 Nikkei in Dollars S&P 3

How Does Current Crisis Compare with Japanese Crisis?

• Japanese Stock Market Peaked in December of 1989 • US Market Peaked in October of 2007 – One can define that month as “Month 0” in both countries to do comparisons 4

The Decline in the S&P was Greater than that of the Nikkei

Relative Movements in Nikkei 225 in dollars and S&P 500 (12/89 =1 for Japan 10/07 =1 for US)

1.20

1.00

0.80

0.60

0.40

0.20

0.00

-70 -65 -60 -55 -50 -45 -40 -35 -30 -25 -20

Months Relative to Peak

-15 -10 -5 0 5 10 15 Nikkei S&P 5

In Japan Stocks Fell Before Housing, but in the US Housing Prices Fell First

Movements in Housing Price Indexes (Peak Year = 1)

1.10

1.00

0.90

0.80

0.70

0.60

0.50

Case-Shiller 10 City Index OFHEO Japan Commercial Real Estate Japan Residential Real Estate 0.40

0.30

0.20

-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Years Relative to Stock Market Peak

7 8 9 10 11 12 13 14 15 The fact that housing continued to rise for years after stocks began their decline may have reduced the sense of urgency in Japan 6

Growth and Inflation Slumped in Japan 7

Policy Timeline • Feb 12, 1999: Introduction of Zero Interest Rate Policy (ZIRP) • April 13, 1999: Governor announced commitment to maintain ZIRP until deflationary concerns dispelled • August 11, 2000: Termination of ZIRP: call rate target raised to 25 basis points • March 19, 2001: Introduction of Quantitative Easing (QE) policy – Includes commitment to maintain QE (and hence ZIRP) until deflation over – Specific quantitative criterion: until y-o-y increase in core CPI positive in a stable manner 8

Some Basic Ideas about Monetary Policy in a Deflationary Environment • The ISLM model is a bad way to think about policy because it assumes prices are fixed • If prices are falling, the real interest rate will be above the nominal rate – Consumers have an incentive to delay purchases until prices fall • If interest rates are zero, bonds and cash become perfect substitutes – Economic agents will be indifferent between holding additional government bonds (paying an interest rate of zero) and cash (also paying an interest rate of zero) – As a result, additional expansions in the money supply (e.g. quantitative easing) ceases to be effective 9

Source: Woodford Monetary Policy 1990-2008 10

Inflation Rates were Comparable but Declined More Rapidly in the US

Inflation in Japan and the US

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25

Months Relative to Stock Market Peak

30 35 40 45 50 55 60 Japanese Core Inflation US Core Inflation 11

Fed Cut Interest Rates Much More Rapidly than BOJ

Interest Rates in Japan and the US

9 8 7 6 5 2 1 4 3 0 -45 -42 -39 -36 -33 -30 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60

Months Relative to Stock Market Peak

Japanese Call Rate Federal Funds Rate 12

As a Result Real Interest Rates fell Much More Sharply in the US

Real Interest Rates in Japan and the US

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

-45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60 -1.0

-2.0

Months Relative to Peak

Japanese Real Int.

US Real Int.

13

What Can be Done if we enter deflation?

• Government must try to alter inflationary expectations – If agents expect inflation and interest rates are zero, they will have an incentive to spend • How to do this?

– Inflation Target or Price Level Target • Problem is commitment but “Open Mouth Operations” can help – Devalue Currency • Raises Import prices and generates inflation – Fiscal Policy • Higher deficits are likely to force a central bank to monetize some of the debt and generate a higher inflation rate 14

Were Explicit commitments effective in changing expected future path of interest rates? (Woodford) • BOJ (Okina and Shiratsuka) argues that Gov. Hayami's announcement in April 1999 did further lower implied forward rates – However, BOJ gave many signals that it was eager to abandon ZIRP • In fact, BOJ abandoned ZIRP as soon as real growth appeared, despite continuing deflation • Term structure data suggest imminent tightening expected even before the abandonment, but definite shift upward in implied forward rates around this time • Recovery aborted soon after: due to signaling effect of abandonment of ZIRP?

15

Conclusions • US situation today bears striking similarity to Japan’s situation in 1989 – Declines in equity and housing markets were, if anything, larger than in Japan • US policy response looks very different – Much faster interest rate cuts by Fed – US has negative real interest rates – Japan never did – Much faster rate of bank bailouts and fiscal policy • Will this be enough?

– Major test of modern economic theory – Other policy options remain 16