Quantitative easing works: Lessons from the unique experience in Japan 2001-2006

The current financial crisis has now led most major central banks to rely on quantitative easing. The unique Japanese experience of quantitative easing is the only experience which enables us to judge this therapy's effectiveness and the timing of the exit strategy. In this paper, we provide a new empirical framework to examine the effectiveness of Japanese monetary policy during the “lost” decade and quantify the effect of quantitative easing on Japan's activity and prices. We combine advantages of Markov-switching VAR methodology with those of factor analysis to establish two major findings. First, we show that the decisive change in regime occurred in two steps: it crept out from late 1995 and established itself durably in February 1999. Second, we show for the first time that quantitative easing was able not only to prevent further recession and deflation but also to provide considerable stimulation to both output and prices. This positive effect is reached through the interest rate factor. These results remain valid even when fiscal policy is simultaneously taken into account in the analysis. If Japanese experience is any guide the quantitative easing policy must be seen as a symptomatic treatment; it must be accompanied with a dramatic restructuring in the financial framework. The exit from quantitative easing must be postponed and decided within a clear program and according to clear numerical objectives.