Can Japan's Monetary Policy Overcome the Dilemma It faces?
-Suggestions Offered by Estimation of the Equilibrium Interest Rate -

Japan’s monetary policy faces a dilemma in the second term of the Bank of Japan Governor Kuroda, and the second term of the framework that he has instituted. The realization of the 2% price stability target will take time; however, a further strengthening of monetary easing in order to prioritize the early achievement of this target will increase concerns over secondary effects. On the other hand, the hasty normalization of monetary easing or a change in the policy framework will create instability in the monetary environment and slow down Japan’s economic recovery.

One key to overcoming this dilemma is whether or not the effects of monetary easing increase in the future without a change in the policy. If the performance of the economy improves, the economic stimulus effect of monetary easing will become stronger even if the operational target for the policy interest rate remains the same for the time being. If the benefits of the monetary easing policy increase in magnitude, the problem of secondary effects may be relatively mitigated. In this paper, the authors estimate the equilibrium interest rate (also known as the natural rate of interest), a neutral interest rate level that neither stimulates nor restrains the economy, and examine whether or not the effects of monetary easing will increase in the future.

The results of these estimates, based on multiple models, suggest that Japan’s equilibrium interest rate has recently commenced an upward trend. The same trend could also be inferred from the potential growth rate, corporate capital investment and other economic indicators. If this steady increase in Japan’s equilibrium interest rate continues into the future, the policy effects, i.e. the benefits of monetary easing, can also be expected to increase.

Ryuzo Miyao
Professor, Graduate School of Economics, The University of Tokyo
Mototsugu Shintani
Professor, Research Center for Advanced Science and Technology, The University of Tokyo