Japan’s monetary policy may have boosted economic performance through quantitative easing (QE), but only in the short term, when liquidity was needed. The authors research QE’s effects and whether countervailing forces in the economy may have mitigated the benefits of such a policy.

Although it did provide some stimulus to Japan’s economy, the efforts of the Bank of Japan (BoJ) to improve macroeconomic performance in the early 2000s through quantitative easing were not successful in raising aggregate demand to the point that it would overcome chronic deflation. The authors investigate the degree to which any economic stimulus was attributable to monetary authorities’ implementation of this policy tool.

In early 2001, Japan’s economy experienced lackluster performance, expressed in falling consumer prices and a weakened banking system. The prospect of another recession following the bursting of the internet bubble led the BoJ to implement quantitative easing. The three components of QE were changing the bank’s operating target to outstanding current account balances from the uncollateralized overnight call rate, increasing purchases of Japanese government bonds, and committing to maintain the policy response until the core Consumer Price Index ceased to fall. The exercise ran from March 2001 to March 2006 as liquidity issues eased and confidence in the banking system re-emerged.

It is not clear to what degree the BoJ QE policy yielded tangible benefits to the economy. The authors consider how it may have stimulated the economy through measures of bank lending. They find that the monetary policy positively increased bank liquidity and thus bank lending and that these positive effects flowed through to the economy. But banks reduced lending to one another, which muted the effectiveness of the stimulus. Quantitative easing is found to have been most effective during its initial years, when the banking system was weak, and most beneficial to those banks that were more liquidity constrained.

Central bankers, analysts, and portfolio managers will find the authors’ observations and conclusions an important contribution to historical perspective and source material for additional study on Japan’s banking sector and monetary policy.

A survey of the relevant literature on the topic, including a review of salient developments in Japanese banks’ liquidity positions during the QE implementation, accompanies the authors’ discussion of their novel methodology. Their approach considers the effects of quantitative easing on bank lending, which is achieved by using econometric methods that control for endogeneity to separate liquidity and lending effects. They use bank-level data on 138 banks contained in semiannual reports from the Japanese Bankers Association for the period September 2000–March 2009.

Using regression analysis, they focus on the relationship between loan growth and the liquidity ratio (the ratio of liquid assets—defined as the sum of cash deposits at the BoJ and other banks and call or short-term loans to other banks—to total bank assets), controlling for measures of bank financial strength and other features related to their lending prospects. The time period under review exceeds the full course of QE implementation to determine whether there is a difference in the liquidity and loan growth relationship between the periods with and periods without quantitative easing.

Indeed, the authors observe a marked decline in the relationship between the liquidity ratio and loan growth toward the end of the QE period. Specifically, for every 1.00% increase in liquidity, lending increased by 0.11% six months later; this relationship became negative and insignificant in the last years of QE. Increased liquidity that resulted from quantitative easing positively influenced the supply of credit to the economy, although this result was offset somewhat by the reduction of interbank deposits. Banks with weaker liquidity positions tended to benefit more from QE. The authors perform robustness checks to control for macroeconomic and financial developments that could affect loan demand over time and across banks, which confirm their results.