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Outlook and Risk Assessment of the Economy and Prices

(October 2003)

October 31, 2003
Bank of Japan

[The Bank's View]1

Standard Scenario for the Economy and Prices

Looking forward, Japan's economy is expected to gain cyclical momentum for a recovery in the second half of fiscal 2003, and it will continue to recover during the course of fiscal 2004. Overall economic activity deviates slightly above the standard scenario presented in the"Outlook and Risk Assessment of the Economy and Prices" (April 2003).

Overseas economies, the U.S. and East Asian economies in particular, are expected to grow relatively fast against the background of a recovery in IT-related demand. Based on the expected recovery overseas, exports and production will increase. Corporate profits are likely to increase partly due to restructuring efforts, and business fixed investment will be likely to continue following an uptrend.

Since there still remain structural impediments such as excess debt and labor, the pace of recovery is most likely to be moderate. Although household income stops declining, it will not yet show clear signs of improvement as companies continue to restrain labor costs. As a result, private consumption will remain generally flat. It should be noted that the GDP deflator has been declining faster than other price indexes, and this tendency is intensifying. The growth rate of real GDP is likely to be calculated at a higher value to the extent of this tendency.

The above pace of recovery suggests that the output gap will narrow marginally from fiscal 2003 to 2004. Nevertheless, given that the current output gap is still wide, downward pressures on prices are somewhat likely to remain. The consumer price index (CPI) will continue to register small declines in fiscal 2003 and 2004.

Risk Assessment

It is possible that the economy deviates either above or below the standard scenario if the following risk factors materialize.

The first risk factor stems from developments in overseas economies. While uncertainties surrounding overseas economies are ebbing away, Japan's economy may deviate either above or below the standard scenario, depending on such factors as the outlook for the U.S. labor market, the global demand for the IT-related goods, and the growth rate of East Asian economies.

The second risk factor is the financial market development. Although financial markets reflect the development of real economy over the medium- to long-term, they fluctuate due to various factors in the short-term. Depending on how stock prices, long-term interest rates and foreign exchange rates or a combination of these three move, they could influence economic activity.

The third risk factor focuses on the progress in the disposal of nonperforming loans (NPLs) and financial system developments. The disposal of NPLs is making steady progress. The outstanding amount of NPLs, particularly at large banks, is declining, and provisioning is increasing. Concerns over the financial system are subsiding as stock prices rise. Under such circumstances, risks that the financial system problem adversely affects corporate finance and economic activity are receding. However, they still remain as a significant risk factor.

The fourth risk factor is the development in domestic private demand. The standard scenario assumes a recovery path, centering on large manufacturers. The economy may deviate either above or below the standard scenario, depending on the extent that the recovery spreads to nonmanufacturers, small- to medium-sized companies, and households, as well as the firms' prospects for future demand.

Overcoming Deflation and Conduct of Monetary Policy

In order to extricate Japan from deflation and to put its economy back on a sustainable growth path, Japan needs not only a cyclical recovery but also households and companies having higher expectations for growth. Structural problems such as excess debt, excess labor and financial system weakness need to be addressed. In this regard, some of the large manufacturers have been solving the problems of excess debt and labor. These problems, however, still remain in the nonmanufacturing sector and small- to medium-sized companies. Japan also needs to make further progress in the disposal of NPLs and the enhancement of financial system stability.

The Bank of Japan has adopted quantitative easing since March 2001. This policy contributes to ensuring financial market stability and maintaining the accommodative environment for corporate finance, thereby firmly supporting the real economy. In the financial and capital market, long-term interest rates have picked up while stock prices have risen. The financial positions of firms are improving slightly, and the accommodative funding environment is generally maintained.

The Bank of Japan aims at putting Japan's economy back on a sustainable growth path by firmly maintaining the quantitative easing policy based on clear and concrete commitment with reference to the CPI. Under the condition that financial intermediaries have not regained full strength, the Bank will reinforce the transmission mechanism of monetary policy by improving the function of credit markets such as bank lending, commercial paper and corporate bonds, thereby making the effect of monetary easing permeate the entire economy.

  1. The Bank's View was determined by the Policy Board at the Monetary Policy Meeting held on October 31, 2003.

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The whole report including the background will be published at 2:00 p.m. on Tuesday, November 4.