The Japan Premium and the first stage of the monetary transmission mechanism

This chapter investigates the breakdown of the interest rate channel and the first stage of the monetary transmission mechanism. Frictions leading to elevated money market risk premia are typically associated with financial crises, as they may seriously impact the ability of central banks to conduct conventional monetary policy. For Japan, this became evident during the Japanese banking crisis – when the strains in the interbank market triggered the so-called Japan Premium. The market turmoil that started in August 2007 came to have a similar effect, albeit on an international scale. Both episodes resulted in significant central bank and government intervention to rescue the financial system – in other words, to restore the functioning of the first stage of the monetary transmission mechanism. This chapter shows how the functioning of the first stage of the monetary transmission mechanism no longer tells a consistent story. Using money market benchmarks and the covered interest rate parity as a lens, the chapter critically examines a string of distinct, but closely interconnected, assumptions and misperceptions underpinning theoretical assumptions. By doing so, it not only sheds some fresh light on current financial market ‘puzzles’ but also on the Japan Premium during the 1990s.