The Introduction of a New Framework for the Conduct of Monetary Policy

March 9, 2006
Bank of Japan

The Bank of Japan Law stipulates the principle of monetary policy as "contributing to the sound development of the national economy" "through the pursuit of price stability." Based on this principle, the Bank is pursuing an appropriate course of monetary policy. At the Monetary Policy Meeting held today, the Bank decided to introduce a new framework for the conduct of monetary policy, as well as to review its thinking on price stability.

1. A New Framework for the Conduct of Monetary Policy

(1) Clarifying Price Stability

The Bank of Japan will review its basic thinking on price stability, and disclose a level of inflation rate that its Policy Board members currently understand as price stability from a medium- to long-term viewpoint, in their conduct of monetary policy ("an understanding of medium- to long-term price stability," see infra). Board members will conduct monetary policy in the light of such thinking and understanding.

(2) Examining Economic Activity and Prices from Two Perspectives

In deciding the conduct of monetary policy, the Bank of Japan will examine economic activity and prices from two perspectives explained below.

The first perspective is examining, as regards economic activity and prices one to two years in the future, whether the outlook deemed most likely by the Bank of Japan follows a path of sustainable growth under price stability.

The second perspective is examining, in a longer term, various risks that are most relevant to the conduct of monetary policy aimed at realizing sustainable growth under price stability. More specifically, for example, the Bank of Japan may examine risk factors that will significantly impact economic activity and prices when they materialize although the probability is low.

(3) Outlining the Current View on Monetary Policy

The Bank of Japan will, in the light of deliberations from the two perspectives described above, outline the current view on monetary policy, and, as a rule, disclose it periodically in the Outlook for Economic Activity and Prices.

2. The Bank's Thinking on Price Stability

Price stability is a state where various economic agents including households and firms may make decisions regarding such economic activities as consumption and investments without being concerned about the fluctuations in the general price level.

Price stability is an indispensable prerequisite for realizing sustainable growth, and the Bank of Japan is responsible for realizing price stability through an appropriate conduct of monetary policy. In this regard, given that the effects of monetary policy take time to work through the economy and that volatility of output may actually be amplified when attempts are made to absorb every short-term change in prices resulting from various shocks, the Bank strives to forecast developments in economic activity and prices from a sufficiently long-term viewpoint and to realize price stability over the medium to long term.

The basic indicator for the evaluation of price developments is a price index that covers goods and services consumed by households and which the public at large is accustomed to. In particular, the consumer price index is important in the light of its favorable attributes including timeliness.

Price stability is, conceptually, a state where the change in the price index without measurement bias is zero percent. Currently, there seems to be no significant bias in the Japanese consumer price index. If there is a risk of falling into a vicious cycle of declining prices and deteriorating economic activity, depending on the weight attached to the risk, the accommodation of slight inflation may be deemed consistent with an understanding of price stability in the conduct of monetary policy.

In the case of Japan, the average rate of inflation over the last few decades is lower than major overseas economies. Japan has also experienced a prolonged period of low rates of inflation since the 1990s. Consequently, the rate of inflation at which households and firms perceive price stability seems to be low, and economic decisions may be guided by such a low inflation environment. The conduct of monetary policy must take account of such possibilities.

In today's Monetary Policy Meeting, there was a discussion of the level of inflation rate that each Policy Board member currently understands as price stability from a medium- to long-term viewpoint, in the conduct of monetary policy ("an understanding of medium- to long-term price stability"). While there was a range of views, reflecting the differences in the relative weight attached to factors affecting the understanding of price stability, it was recognized that the level was somewhat lower than that in major overseas economies. It was agreed that, by making use of the rate of year-on-year change in the consumer price index to describe the understanding, an approximate range between zero and two percent was generally consistent with the distribution of each Board member's understanding of medium- to long-term price stability. Most Board members' median figures fell on both sides of one percent. Given that the understanding of medium- to long-term price stability may change gradually reflecting developments such as structural changes in the economy, as a rule, Board members will review it annually.

Notice:As for the Bank'sthinking on price stability, background noteswere released on March 10.