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Outlook and Risk Assessment of the Economy and Prices

(October 2000) *

  • As determined by the Policy Board at the Monetary Policy Meeting held on October 30, 2000.

October 31, 2000
Bank of Japan

Outlook of economic and price developments

The Policy Board of the Bank of Japan believes Japan's economy will continue to trace a gradual recovery mainly led by private demand during fiscal 2000 and 2001. Prices overall are expected to remain stable. Because of various structural adjustment pressures, including balance sheet problems and continuing restructuring at firms and financial institutions, expansion of the economy is unlikely to be vigorous. The present recovery pattern led by the corporate sector, with the household sector lagging, is expected to continue for a while.

Following is the outlook for demand over the next 12 months or so. Based on currently available information, public investment is expected to increase into the first half of fiscal 2001 reflecting the execution of projects included in the recently announced 'Policy Package for New Economic Development toward the Rebirth of Japan.' Net exports (real exports minus real imports) will come to a temporary pause due to the completion of inventory restocking activity in East Asian economies, but will return to a moderate upward trend after entering fiscal 2001. Business fixed investment will remain on a rising trend centering on information and communications related sectors. Under such circumstances, while corporate profitability will likely continue to improve, in view of continuing restructuring it will take more time than in past recovery phases for such an improvement to spread to household income. As a result, the pace of recovery in personal consumption will be slow.

On the financial front, despite the moderate recovery of the economy, commercial bank lending is expected to remain sluggish and growth in money supply is likely to be contained against the following background. First, firms continue to suppress liquidity on hand. While they once pursued active funding as a precautionary measure during the period of financial system instability from the autumn of 1997 through the autumn of 1998, they have since moved toward gradually curtailing accumulated liquidity on hand as concern over such instability has waned. In addition, financial restructuring with a view to gaining better market evaluation, including ratings, has also been a factor behind accelerated loan repayments by firms. Second, since corporate cash flow has been at a high level reflecting improved profitability, and outlays for fixed investment and other business activity have been within cash flow, improved economic activity is unlikely to immediately stimulate corporate demand for funds.

Regarding prices, evaluation of the output gap is of critical importance. Taking into account a decline in the economic value of capital stock and widening mismatching in the labor market reflecting recent rapid structural changes in the economy, potential supply growth is likely slowing down. Considering the slower growth in potential supply and the outlook for demand described above, the output gap is expected to narrow moderately.

The development of price indexes is affected by cost factors in addition to the output gap. With an improvement in domestic supply/demand conditions and the rise in crude oil prices, domestic wholesale prices are expected to be broadly stable for the time being. However, they may somewhat weaken as the declining trend of prices of machinery and other equipment continues due to technological innovation.

On the other hand, consumer prices (excluding perishables) are expected to be somewhat weak reflecting the past rise of the yen and the streamlining of distribution systems. Going into fiscal 2001, it is expected that the lagged effect of higher crude oil prices and improved domestic supply/demand conditions on the one hand and continuing downward pressure from the supply-side on the other will be roughly balanced.

As such, the outlook for inflation as a whole is around zero or slightly negative. Given that corporate profitability continues to increase and employment and wages are moderately improving, Policy Board members do not consider such an outlook will be a trigger suppressing economic activity.

Risk assessment

As a standard scenario, the Policy Board believes the economy will continue to mark a moderate recovery while prices remain broadly stable. Nevertheless, in the conduct of monetary policy, both upside and downside risks need to be borne in mind, even if their probability may be low.

The outlook assumes that the world economic growth will be sustained, albeit at a slightly decelerating pace. Among the factors which deserve attention in this regard, the first is the prospect for worldwide IT-related demand. Needless to say, the recent expansion of the world economy, particularly the U.S. economy, has been partly underpinned by the surge in worldwide IT-related demand. Thus, careful attention should be paid to the possibility that supply/demand conditions for IT-related goods might ease as related investments increase in a number of countries, and especially to the effect on East Asian economies that depend on the production of IT-related goods to a significant degree.

The second factor is the effect of higher crude oil prices. It is thought that the direct impact on Japan's economy and prices will not be substantial for the time being. However, considering such underlying factors as a worldwide increase in oil demand against only a modest increase in supply, it cannot be denied that inflation risk might materialize in some countries or regions. If this does transpire and subsequent monetary tightening triggers a substantial slowdown in the growth of the world economy, there will be a risk of increasing downward pressure on Japan's economy.

The third factor concerns the development of international financial and foreign exchange markets. To the extent that the recent expansion of the world economy has been supported by a surge in IT-related demand and resulting overly bullish expectations for growth, it is necessary to be aware of the possibility that international capital flows might change if there is a reversal of such demand and a revision of expectations. Should this occur, Japan's economy will most likely be affected through any reaction in overseas economies, and international financial and foreign exchange markets.

With regard to risks pertaining to the outlook for the economy and prices, in addition to overseas factors, domestic ones also need to be taken into account. One risk is related to the effects of balance sheet adjustment and restructuring at firms and financial institutions. These effects have already been factored into the standard scenario presented at the outset and it should also be noted that since such adjustment and restructuring lay the foundation for economic growth over the medium to long term, it is not appropriate to view them only as a downside risk to the economy. Nevertheless, the possibility should be borne in mind that the effects stemming from such developments might further adversely affect the economy in the short run. At present, while carefully evaluating the credit risk of borrowers, financial institutions continue to be more active in extending loans to sound companies. Such a lending attitude is expected to be maintained as long as the economy continues to trace a moderate recovery. If, however, financial institutions should be exposed to an increase in the non-performing loans that need to be disposed of, due to the development of asset prices and corporate bankruptcies, then their risk-taking ability might be reduced.

Another risk is that uncertainties felt by the public with respect to the future might increase for some reason. While there are a variety of direct sources of such uncertainties ranging from job insecurity to post-retirement concerns, structural problems facing the economy and financial system lie in the background. Therefore, there is a possibility that triggered by, for example, the pace of economic recovery being less than anticipated, the public might become more aware of these structural problems, and their uncertainties with respect to the future might further intensify.

On the other hand, the possibility should also be considered that the pace of economic recovery might turn out to be faster than assumed in the standard scenario. In this regard, it should be noted that due to the prolonged stagnation of the economy corporate perceptions of growth prospects are likely extremely bearish. But, should such growth prospects over the medium term be revised upward, business fixed investment might increase significantly. If crude oil prices further rise under such a situation, upward pressure on prices may increase in the future.

Forecasts of the Majority of Policy Board Members

Table : Forecasts of the Majority of Policy Board Members (Y/y % change)
  Real GDP Domestic WPI CPI (excluding perishables)
Fiscal 2000 +1.9 to +2.3 0.0 to +0.1 -0.4 to -0.2
  • Note: The forecasts of Policy Board members are based on the assumption that there will be no change in monetary policy. Forecasts of the majority of Policy Board members are shown as a range with the highest and lowest figures excluded. If there are multiple highest and/or lowest figures, only one from either end is excluded. The forecasts of all Policy Board members are as follows:
Table : Forecasts of the Majority of Policy Board Members (Y/y % change)
  Real GDP Domestic WPI CPI (excluding perishables)
Fiscal 2000 +1.5 to +2.3 0.0 to +0.2 -0.5 to -0.1