The Bank of Japan (BoJ) responded by reducing overnight interest rates from a peak of more than 8 percent in early 1991 to ½ a percent by the fall of 1995.2 Most studies of this period suggest that policy was generally appropriate given economic forecasts at the time, but too tight relative to the actual outcomes.3 Economic forecasts for Japan – both by the official community and by private sector agents – were consistently more optimistic than the actual outturns. It is noteworthy that as late as January 1995 – on the eve of deflation – 10-year Japanese Government Bond (JGB) yields were still at 4.7 percent. With the benefit of hindsight, we now understand that the disinflationary consequences of the asset price bust and financial stress where vastly more powerful than was widely realized at the time. As we later saw in the U.S., the forces of contraction and disinflation operated through many different channels – not just directly on household wealth, for example, but also through the impact of the asset price bust on the health of financial intermediaries and the supply of credit to households and businesses. Over time, the Japanese banking system came under mounting stress. This was a slowmotion crisis, as the assets were mainly loans that were not marked-to-market. Accounting practices and regulatory forbearance allowed banks to delay charging off bad loans and recapitalizing at the cost of impairing the availability of credit to new potential borrowers. A full-blown banking crisis finally materialized in 1997.
The evolution of policy in Japan, in turn, has been informed, in part, by the experience of the U.S. and other nations. So what have we learned to date? Let me highlight six key points. First, and most importantly, managing expectations is critical in the execution of monetary policy at the zero bound. This includes expectations about the central bank’s objectives for inflation and the economy, and expectations about how the central bank will use its tools in the future to achieve these goals. Second, in managing expectations, good communication is essential. Expectations will not be well anchored when communications are muddled or inconsistent, or when a central bank acts in ways that are not consistent with its guidance. Third, actions speak louder than words alone. Thus, there is an important role for asset purchases that ease financial conditions to support growth and keep inflation expectations well anchored. Fourth, the policy instruments interact so that policy as a whole exceeds the sum of its parts. Fifth, at the zero lower bound, risk management becomes extremely important. In particular, because the costs of getting stuck in a liquidity trap with chronic deflation are high, a central bank should put substantial weight on avoiding this outcome. Sixth, the constraints imposed by the zero bound limit what monetary policy can accomplish by itself. This increases the importance of complementary fiscal, financial, and structural policy actions. Credible fiscal policies, actions to ensure a healthy financial system, and structural reforms that lift the potential for growth are very important.