3.THE ZERO INTEREST RATE POLICY (ZIRP)
Essentially, because a central bank is a creature, so to speak, of market developments,
central banks tend to respect the market mechanism. The BOJ is no exception. In the
early 1990s, it promoted deregulation of the money market and changed its policy
target from a regulated interest rate (the official discount rate) to a market rate (the
overnight call market rate). In July 1991, it also repealed directly regulated measures
such as window guidance, under which the BOJ directly controlled increases in the
lending of individual banks. As financial liberalization is by now virtually complete in
Japan, a change in monetary policy must of necessity be market-based. Confronted,
however, with a situation in which interest rates have reached the zero bound and the
market risks malfunctioning due to rising credit risk, monetary policy is forced to
explore new options.6
Before the BOJ implemented the ZIRP, the policy rate had remained at a low
level of 0.25%. Subsequently, in February 1999, the BOJ decided to adopt the ZIRP
(Figure 4). This was the only measure left in terms of further monetary easing;
technically, the zero interest rate was achieved by creating excess reserves. With the
creation of these, the monetary base was expected to expand.
According to meeting transcripts released 10 years later, the BOJ was concerned at the time about whether the money market would function under the zero interest rate.7
Although transactions continued, a dramatic decline in volume took place.
The BOJ Governor, Masaru Hayami, at the time the ZIRP was adopted described
the policy as “not normal”.8 This could be taken to refer to a situation in which
transactions did not take place and interest rates diminished in the market. As already mentioned, the BOJ established the main tools of monetary operations using the market mechanism. Nevertheless, an ironic effect of the policy was to affect market functioning.
During the ZIRP period, Governor Hayami announced that he would continue
the policy until deflationary concern was eliminated. This roughly describes the
“duration effect,” which was referred to subsequently as “forward guidance.” The ZIRP was already equipped with two essential standard policy measures of unconventional policy: ample provision of liquidity and forward guidance.
It appears that no decisive conclusion has been reached as to the ZIRP’s effectiveness in promoting economic recovery. The economy posted a slight recovery in 2000, but it is fair to say that this reflected the IT boom in the United States. On the other hand, the ZIRP had a much clearer effect in promoting financial stability, and it can be said that the ZIRP was a very strong tool in this regard.9
The overnight call rate, as the policy rate of the BOJ, is measured as a weighted average of actual transactions in the market. The zero interest rate was attained by conducting all transactions at the zero interest rate. Thus, no transaction was allowed to be conducted above this rate. This meant that since the BOJ provided zero-cost credit to any bank that held eligible collateral, any risk premium would diminish. This gave a great deal of support to troubled banks.