Monetary and Economic Studies Vol.24, No.S-1 / December 2006

Financial Market Functioning and Monetary Policy: Japan's Experience

Naohiko Baba

This paper reviews the financial market functioning under the zero interest rate policy (ZIRP) and the subsequent quantitative monetary easing policy (QMEP) conducted by the Bank of Japan (BOJ). First, the estimation results of the Japanese government bond yield curve using the Black-Gorovoi-Linetsky (BGL) model show that (1) the shadow interest rate has been negative since the late 1990s, turned upward in 2003, and has been on an uptrend since then, and (2) the first-hitting time until the negative shadow interest rate hits zero again under the risk-neutral probability is estimated to be about three months as of the end of February 2006. Second, under the ZIRP and QMEP, the risk premiums for Japanese banks have almost disappeared in short-term money markets such as the market for negotiable certificates of deposit, while they have remained in the credit default swap market and the stock market. This result supports the view that market participants have positively perceived the BOJ's ample liquidity provisions in containing the near-term defaults of banks caused by the liquidity shortage.

Keywords: Bank of Japan; Term structure of interest rates; Zero lower bound; Zero interest rates; Quantitative monetary easing policy; Bank risk premium

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2006 Bank of Japan All Rights Reserved.

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