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October 31, 2005
Bank of Japan
Japan's economy continues to recover, having emerged from the temporary pause that began in the second half of 2004. Compared with the projection in the April 2005 Outlook for Economic Activity and Prices (the April outlook), overall economic activity has been more robust, because higher-than-expected domestic private demand has more than offset slightly lower-than-expected exports. The adjustments in production and inventory in IT-related sectors, which triggered the economy's temporary pause, appear to have run their course.
From the second half of fiscal 2005 through fiscal 2006, Japan's economy is likely to experience a sustained period of expansion at a pace slightly above its potential. This economic outlook rests on the following underlying assumptions and mechanisms. First, exports are likely to remain on the increase reflecting the continuing expansion of overseas economies. Second, the corporate sector is likely to continue to show strength. Corporate profits continue to increase, on top of three consecutive years of growth, and business fixed investment is likely to continue increasing as firms have mostly completed adjustments in excess production capacity and debt. Third, strong corporate performance is positively influencing the household sector via increases in wages and employment, as well as increases in dividends and stock prices. Against this backdrop, private consumption is expected to recover steadily. Finally, the extremely accommodative financial conditions are likely to support private demand. Firms' financing conditions have eased substantially, reflecting financial institutions' more active lending stance and the increased variety of financing channels available to firms. The accommodative financial conditions seem to be contributing to the increases in business fixed investment by small- and medium-sized enterprises (SMEs) and housing investment.
However, firms are still generally cautious in building up stocks of, for example, fixed capital, in view of the protracted period of low economic growth following the bursting of the bubble. While firms are beginning to make more efficient use of cash flow--not only paying off debts but also increasing capital investments and financing strategic partnerships--they still appear cautious about accelerating inventory and capital investments in response to increases in sales and production. As a result of such corporate behavior, economic recovery is likely to remain moderate, but at the same time the recovery is likely to be sustained as excessive build-up of stocks is being avoided.
Given this economic outlook, the environment influencing prices is likely to change gradually. The output gap is likely to continue narrowing moderately under the path of economic developments described above. Capacity constraints as perceived by firms in terms of capital stock and employment are currently at the strongest level in more than a decade. The decline in unit labor costs is likely to slow along with increases in wages, despite the fact that the rise in productivity would still tend to hold them down. Meanwhile, firms and households are gradually shifting up their expectations for inflation.
Regarding specific indices for inflation, the domestic corporate goods price index has deviated above the April outlook, recording relatively large increases on a year-on-year basis, due to rising prices of crude oil and other commodities. The index is likely to record a relatively large increase in fiscal 2005 and will probably continue increasing in fiscal 2006, albeit at a slower pace, with a caveat that the actual outcome will depend heavily on developments in crude oil and other commodity markets.
The consumer price index (excluding fresh food, on a nationwide basis) has generally moved in line with the April outlook, declining slightly on a year-on-year basis, reflecting persistent effects of special factors such as the decline in rice prices and the reduction in electricity and telephone charges. As the effects of these factors fall off, the year-on-year changes in the consumer price index will likely turn to zero percent or a slight increase toward the end of 2005. Thereafter, the year-on-year changes are expected to remain positive, in view of the gradually narrowing output gap and the weakening downward pressures from unit labor costs. This means that the year-on-year rate of change in the consumer price index is likely to be around zero percent in fiscal 2005 and a positive figure in fiscal 2006.
The outlook described above rests on the underlying assumptions and mechanisms mentioned earlier. It should be noted that there are following upside and downside risks to the outlook in the coming months.
The first is the path of crude oil prices. Crude oil prices have surged since 2004 and have recently recorded historical highs. One of the primary factors of this surge is increased global demand, reflecting developments such as high growth in emerging economies, and to that extent, high crude oil prices may be compatible with the expansion of the global economy. However, if crude oil prices rise further, due to, for example, supply-side constraints, the global economy may be adversely affected by a decline in real purchasing power in non-oil-producing countries, or rising concerns over increasing inflationary pressures worldwide with a concomitant rise in interest rates.
The second factor is the path of the global economy, including U.S. economic developments. In the United States, inflationary expectations have generally been contained, with the Federal Reserve continuing to raise the federal funds rate target at a measured pace. Financial conditions in the United States have remained accommodative, as evidenced by relatively low and stable long-term interest rates and historically tight credit spreads. The favorable financial conditions have supported buoyant spending by households, as house prices climbed higher. This, in turn, has supported economic expansion. Should this cycle be disrupted, due to, for example, unexpected changes in monetary accommodation in light of rising inflationary expectations, not only growth in the United States would slow, but the global economy could also be adversely affected, perhaps via a shift in the international flow of funds.
In the case of a major external shock, for example, an unexpected slowdown of overseas economies, economic growth in Japan may slow, notwithstanding the recent strength in domestic private demand.
The third factor is the path of domestic private demand. The outlook rests on the assumption that corporate behavior will generally remain cautious. However, firms are increasingly enjoying an improvement in the investment climate, with a high level of return on assets comparable to that recorded during the bubble economy period, and with high capital ratios resulting from repayment of debt and the extremely low cost of corporate debt. Meanwhile, the stimulative effects of low interest rates are being amplified as the economy continues to recover. If firms become more confident about the economic outlook, they may embark on more active investment programs. If there are also stronger positive influences from the corporate sector to households via increases in employee income and dividend payments, household spending may increase. These developments would entail an acceleration of economic recovery.
As for price developments, there are both upside and downside risks to the outlook. The risks to real economic activity, mentioned above, would correspondingly impact prices, if they ever materialize. In addition, there are risks unique to prices. First is the uncertainty over developments in the prices of crude oil and other commodities. Depending on the direction of their fluctuations, general price levels may deviate either upward or downward. Second, although it appears that the impact of economic activity on prices has recently been weakening, a sustained narrowing of the output gap may cause a greater-than-anticipated increase in inflationary expectations. This can prompt firms to pass increases in costs, including past increases, onto sales prices, thus causing prices to deviate upward. Finally, the intensification of competition among firms, reflecting, for example, further deregulation, may cause downward deviation in prices.
The Bank has been providing extremely ample liquidity under the quantitative easing policy. The two pillars of the quantitative easing policy are: the Bank's provision of ample liquidity to the money market so that the outstanding balance of current accounts at the Bank substantially exceeds the amount of required reserves; and the Bank's commitment to continue with this ample provision of liquidity until the year-on-year rate of change in the consumer price index (excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis.
When there were strong concerns over the stability of the financial system, the ample provision of liquidity by the Bank, which met financial institutions' liquidity demand, stabilized financial markets and maintained accommodative financial conditions, and contributed to averting a contraction in economic activity. In financial markets, the Bank's ample provision of liquidity pushed short-term interest rates to practically zero percent. Longer-term interest rates have stably remained at low levels because the commitment by the Bank has led the market to expect that short-term interest rates will remain at zero percent when prices continue to decline slightly. Recently, however, concerns about financial system stability have subsided substantially. At the same time, with more market participants expecting that prices will stop declining and start rising, there is a shortening of the duration of the quantitative easing policy as expected by market participants. As a result, the policy commitment is gradually losing its influence on the formation of longer-term interest rates. Thus the stimulative effects of the quantitative easing policy on economic activity and prices are increasingly coinciding with the effects of short-term interest rates being at practically zero percent.
In the money market, where the Bank conducts its market operations, precautionary demand for liquidity has declined substantially, reflecting diminishing concerns over financial system stability. When demand for liquidity is extremely weak, measures adopted by the Bank in its market operations may, in some instances, hinder the natural formation of the yield curve and the efficient functioning of markets, even if the measures may enable the Bank to maintain a target balance of current accounts. Taking this into consideration, since May 2005, the Bank has allowed the outstanding balance of current accounts to fall temporarily short of the target range when demand for funds is judged to be extremely weak. Recently, with the improvement in the economic outlook, financial institutions are more actively bidding in the Bank's longer-maturity funds-supplying operations. Consequently, the maturity of funds-supplying operations, which has lengthened substantially since the beginning of 2005, may now be shortened without jeopardizing the Bank's ability to maintain the outstanding balance of current accounts within the target range. These developments are, to some extent, contributing to the reinvigoration of natural mechanisms for price formation in financial markets, which reflect underlying conditions of the economy and prices.
Assuming that developments would follow the projection described in this Outlook Report, the possibility of a departure from the present monetary policy framework is likely to increase over the course of fiscal 2006. Such a change would mean a reduction in the outstanding balance of current accounts toward a level in line with required reserves, and a shift in the main operating target for money market operations from the outstanding balance of current accounts to short-term interest rates. In reducing the outstanding balance of current accounts, the Bank will need to monitor financial market conditions carefully, because the quantitative easing policy has been in place for a long period of time. However, with strengthening expectations that prices will start rising, the effects of the quantitative easing policy are increasingly coinciding with the effects of short-term interest rates being at practically zero percent. Thus a change of the policy framework itself does not imply an abrupt change in terms of effects of policy. Conceptually, the course of monetary policy after the change of the framework will be a period of very low short-term interest rates followed by a gradual adjustment to a level consistent with economic activity and price developments.
The change of the policy framework as well as the level and time-path of short-term interest rates thereafter will depend on future developments in economic activity and prices as well as financial conditions. If it is judged that upward pressure on prices continues to be contained and the economy follows a sustainable and balanced growth path, this is likely to give the Bank latitude in conducting monetary policy through the entire process.
Given that the change of the current policy framework, as with the introduction of the quantitative easing policy, is unprecedented, it is essential to ensure that financial markets are able to perform pricing function smoothly, reflecting underlying conditions of the economy and prices. In order to realize sustainable economic growth and stable prices, the Bank will clearly explain its assessment of economic activity and prices as well as the thinking behind the conduct of monetary policy, and will endeavor to stabilize market expectations, while taking measures in an appropriate and timely manner in response to economic and financial developments.