It is a great privilege to be invited to speak at Columbia Business School today. I was told that

the Center on Japanese Economy and Business (CJEB), which is kindly hosting this

conference, is celebrating its 30th anniversary this year. The CJEB has long played a pivotal

role in promoting a better understanding of the Japanese economy and U.S.-Japan economic

relations. I would like to express my sincere appreciation to Professor Hugh Patrick, the

founder and long-time director of the CJEB and a leading expert on Japan's economy, and all

those related to the CJEB.

As you all know, Japan has long been mired in deflation. Deflation was once perceived to be

a phenomenon unique to Japan. Looking back to the late 1990s and 2000s, while Japan was

under low and stable inflation. In Europe, regional economic integration made substantial

progress with introduction of a common currency, the euro, in 1999, and the economy grew in

a stable manner. Meanwhile, emerging economies including China and commodity-exporting

countries continued to enjoy rapid growth. Only Japan seemed to be left behind in this tide of

global growth.

But then the global financial crisis struck in 2008. Major advanced economies suffered a

sharp deceleration in economic activity, but thanks to prompt and bold policy actions taken

by the authorities including central banks, the global economy was able to avoid another

Great Depression. However, even though eight years have passed since the start of the crisis,

measures called "quantitative and qualitative monetary easing," or QQE for short, we

launched three years ago. Today, I will discuss how Japan, as the "front runner" of deflation,

has fought against deflation and is overcoming it. While doing so, I will also explain the

theoretical background to the evolution of what is called unconventional monetary policy.

What is deflation? For those living in the United States, which has enjoyed moderate inflation

for an extended period of time, this might not be immediately obvious, so let me start with

this point.

the weighted averages of baskets of goods and services purchased by consumers. Put very

simply, deflation can be understood as a continuous decline in consumer prices.

What happens to the economy if prices as a whole decline continuously (Chart 1)? Looking at

the overall economy, suppliers of goods and services will see a decrease in sales and profits,

and firms with declining profits typically start to lay off employees or restrain their wages.

Employees that have been laid off or whose wages have declined experience a fall in their

income and restrain their spending due to uncertainty about their future. Such restraint in

spending leads to a further decline in the sale of goods and services, resulting in harsher

competition among firms. Firms therefore lower prices in order to compete, leading to a

reflecting this collapse. A key characteristic of Japan's deflation is that it has been moderate

but persistent. During the Great Depression in the United States, which is often cited as a

typical example of deflation, prices plunged by nearly 30 percent in total. Moreover, they fell

precipitously, dropping at an annual rate of almost 10 percent in 1931 and 1932. However,

deflation persisted only for four years. In contrast, Japan's consumer prices only fell by 4.1

percent in total in the 15 years from fiscal 1998 to fiscal 2012, which is equivalent to an

annual average rate of only 0.3 percent. Thus, while deflation was much milder, it lasted for a

decade and a half. Such prolonged deflation gave rise to the entrenched belief that prices and

wages will not rise in the future.

The biggest problem is that, under deflation, the value of cash gradually increases with the

passage of time, discouraging firms and households from spending. The nominal value of

cash remains unchanged and interest rates on deposits at banks are very unlikely to be

negative. (I will come back to this point later when I talk about negative interest rate policy.)

At the same time, prices of goods and services gradually decline, so that for consumers it is

better to wait now and buy later when prices are lower. For firms, instead of exploring new

business opportunities and investing in facilities or research and development, an easier way

to shore up corporate value is to cut costs such as wages, increase cash flow, and accumulate

cash in bank deposits. In Japan, all these phenomena have been widely observed since the

1990s.

about by the changes in the corporate sector, the government raised funds by issuing large

amounts of Japanese government bonds (JGBs) and increased fiscal spending such as public

works. Meanwhile, in the banking sector, deposits increased substantially while lending

decreased as a result of the financial surplus in the corporate sector. The banking sector, in

turn, invested these surplus funds in JGBs. Thus, under Japan's deflationary environment, a

peculiar flow of funds established itself, in which the corporate sector has a financial surplus,

the government sector has a financial deficit, and the banking sector expands its investment in

JGBs (Chart 2).

Another problem of moderate yet persistent deflation is that, as the belief becomes

expected to rise by 2 percent, the real interest rate is 1 percent. On the other hand, if the

nominal interest rate is again 3 percent, but prices are expected to fall by 1 percent, the real

interest rate is 4 percent. Obviously, financial conditions are more accommodative in the

former than the latter case. If people start to think that prices will steadily decline -- in the

economics jargon, "inflation expectations" fall into negative territory -- real interest rates will

remain high compared to nominal interest rates.

These considerations illustrate how moderate yet persistent deflation is like a harmful chronic

disease. It not only stymies the dynamism of the economy but also weakens the effectiveness

of monetary policy.

onward (Chart 3).

To start with, in 1999, the Bank adopted a "zero interest rate policy," in which the overnight

money market rate was guided close to 0 percent. In 2001, the Bank switched its main

operating target from the overnight money market rate to current account balances held by

financial institutions at the Bank of Japan, which are equivalent to what in the United States

are usually called "reserve balances." Under the policy, which lasted from 2001 to 2006, the

Bank provided large amounts of liquidity, so that reserve balances eventually reached several

multiples of required reserves. To the best of my knowledge, this was the world's first

quantitative easing. At the same time, the Bank committed itself to continuing with the policy

financial system was relatively small. CPI inflation, which had been positive since 2006, fell

back into negative territory. Against this backdrop, the Bank introduced another policy

initiative in 2010 which we called "comprehensive monetary easing." Under this policy, the

Bank purchased large amounts of JGBs, focusing in particular on those with maturities of up

to three years, pushing down interest rates on such JGBs to close to 0 percent. In addition, to

reduce risk premiums, the Bank also -- though to a lesser extent -- purchased private-sector

debt such as corporate bonds and commercial paper (CP), as well as equity financial products

such as exchange-traded funds (ETFs) and real estate investment trusts (REITs). Moreover, in

order to encourage lending by financial institutions, the Bank introduced special long-term

lending facilities with a low interest rate, which are similar to the Funding for Lending

Japan's economy from falling into a 1930s-style deflationary spiral of sharply falling prices

and economic contraction. However, none of these monetary policy measures were

sufficiently strong to overcome deflation. Why was this the case?

To understand the reasons, we should start with the mechanisms through which monetary

easing affects the economy. A key concept in this context is the so-called "natural rate of

interest," which is the real interest rate at which the economy neither accelerates nor

decelerates. Monetary easing aims to push real interest rates in financial markets below the

natural rate of interest through a lowering of the policy rate and/or increase in the supply of

funds in order to stimulate economic activities such as business fixed investment and housing

policy under deflation faced two major challenges. The first was that real interest rates

remained high. Nominal short-term interest rates -- the policy tool of traditional monetary

policy -- already were close to 0 percent after the introduction of the zero interest rate policy

in 1999. This means that short-term interest rates already faced the so-called "zero lower

bound" in the sense that nominal interest rates cannot be lowered below 0 percent. At the

same time, with the economy stuck in a deflationary equilibrium, inflation expectations

remained low. As a result, real interest rates -- that is, nominal interest rates minus inflation

expectations -- remained high.

The second major challenge that made it more difficult to overcome deflation is the decline in

has been under 1 percent (Chart 4). Given that, as mentioned, the potential growth rate likely

is a key determinant of the natural rate of interest, it is likely that the latter also followed a

declining trend.

As a result, Japan was trapped in a situation in which the zero lower bound on nominal

interest rates and the decline in inflation expectations made it difficult to reduce real interest

rates just at a time when lower real interest rates were warranted due to the decline in the

natural rate of interest. This situation can be easily grasped by comparing Japan's estimated

potential growth rate and real interest rates as approximated by the yields on 10-year JGBs

minus actual inflation (Chart 5). Given these challenges, Japan was unable to find an

challenge has been to simultaneously devise monetary policy measures to substantially lower

real interest rates. It has been widely argued that monetary policy is no longer effective and

that economic policy should center on strategies to promote growth. However, as I hope my

explanation so far has made clear, tackling deflation is not a choice between monetary policy

or a growth strategy: both are necessary. In this context, the government's initiative to

enhance Japan's economic growth as well as growth-oriented efforts by the private sector are

of vital importance. At the same time, the Bank of Japan has to accomplish its mission as the

central bank.

Bank of Japan. This followed the Federal Reserve's announcement of a similar longer-run

inflation goal a year earlier in January 2012.

stability target, in March 2013. The following month, in April, we introduced a new policy

initiative, QQE. We designed QQE to overcome the limitations of previous policies. QQE

consists of two major elements (Chart 6). First, QQE seeks to raise inflation expectations and

hence drastically change the deflationary mindset that has taken hold among the public

through the Bank's strong commitment to achieving the price stability target of 2 percent at

the earliest possible time. Second, through massive JGB purchases by the Bank, QQE exerts

room for further declines in nominal interest rates. When QQE was initially introduced, the

Bank's operational guideline was to purchase JGBs so that the Bank's holdings of JGBs

would increase at an annual pace of about 50 trillion yen. The pace was accelerated in

October 2014 to about 80 trillion yen a year and this guideline continues to this day. Given

that Japan's nominal GDP is about 500 trillion yen, JGB purchases of about 80 trillion yen

correspond to about 16 percent of Japan's GDP. As a result of such purchases, the ratio of the

Bank's balance sheet to nominal GDP has risen from 35 percent at the end of March 2013 to

77 percent at the end of December last year and will continue expanding. The equivalent ratio

in the case of the Federal Reserve, after three rounds of large-scale asset purchases (LSAPs),

is 25 percent as of end-December last year. This comparison should give you a good sense of