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April 28, 2006
Bank of Japan
Japan's economy continues to recover steadily. Exports and production continue to increase. Business fixed investment also continues to increase against the backdrop of high corporate profits. Household income continues to rise moderately, reflecting improvements in employment and wages, and private consumption is on an increasing trend. With steady increases continuing in domestic and external demand, economic activity in fiscal 2005 seems to have been stronger than the projection in the October 2005 Outlook for Economic Activity and Prices. Consequently, the conditions of persistent oversupply have been dispersed and the output gap seems now to have closed.2
From fiscal 2006 through fiscal 2007, Japan's economy is likely to experience a sustained period of expansion, with domestic and external demand and also the corporate and household sectors well in balance. Given that the current recovery of the economy has already lasted for over four years and is likely to mature, the growth rate is likely to slow gradually toward the potential growth rate. The forecast is around 2.5 percent for fiscal 2006 and around 2 percent for fiscal 2007.
The 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, corporate performance is likely to continue to be strong. Corporate profits increased for the fourth consecutive fiscal year since 2002, and in fiscal 2006, the ratio of firms' current profits to sales will remain at levels exceeding the peak marked during the bubble era of the late 1980s. With regard to resource utilization, the capacity utilization rate is rising and firms are more often experiencing constraints arising from insufficient labor. In this environment, the March Tankan (Short-Term Economic Survey of Enterprises in Japan) indicated that in many industries business fixed investment plans for fiscal 2006 are relatively strong for the time of year. The plans are likely to be revised upward in subsequent surveys. Firms, conscious of increasing global competition, have been generally cautious about increasing business fixed investment and have not built up large capital stocks. Over the next two years, however, the growth rate of business fixed investment is at some point expected to fall off, in view of the capital stock cycle, reflecting the long economic recovery. Third, the positive influence of the strength in the corporate sector on the household sector is likely to become more evident. Strong corporate performance is benefiting the household sector via increases in employment and wages as well as increases in dividends and rising stock prices. Against this backdrop, private consumption is expected to continue increasing steadily. Housing investment is likely to experience a moderate uptrend, partly supported by the view that interest rates will only rise from current levels, as land prices are starting to rise particularly in central Tokyo. Household spending will be the main driving force behind firm domestic private demand and firm household spending in turn will feed back to the corporate sector, with the likelihood of a virtuous circle being maintained. Fourth, the extremely accommodative financial conditions are likely to continue to support private demand. As financial institutions adopt more proactive lending postures and as the demand for credit in the private sector stops declining, the year-on-year rate of increase in the amount outstanding of lending by private banks is on the rise. Short-term real interest rates are falling. In particular, these financial conditions may also be contributing to increases in business fixed investment by small firms and housing investment.
Given this economic outlook, the environment for prices is likely to change gradually. First, a higher level of resource utilization is being observed. The MarchTankan indicated that firms are perceiving the strongest capacity constraints in terms of capital stock and employment in more than a decade. The output gap has closed, and actual output is likely to gradually exceed potential output. Second, although unit labor costs (labor costs per unit of output) continue to decline due to increases in productivity, the rate of decline has been on a narrowing trend as a result of wages starting to increase. Given the tighter supply and demand balance of labor in a relatively wide range of industries and the likely slowing rate of productivity increases as the economic recovery matures, unit labor costs are expected to stop declining and start increasing slightly in the future. Third, results of various surveys show that firms and households are gradually shifting up their inflation expectations for both the short term and the medium to long term.
Looking at various indices for inflation, the domestic corporate goods price index in fiscal 2005 exceeded the October projection, recording the largest increase on a year-on-year basis since early 1990, reflecting higher international commodity prices and the weaker yen in the second half of 2005. While the prices of crude oil and other commodities and foreign exchange rates will influence it significantly, the index is likely to continue increasing through fiscal 2007.
The consumer price index (CPI; excluding fresh food, on a nationwide basis) has generally moved in line with the October projection, with the year-on-year changes turning positive toward the end of 2005 followed by larger increases since the beginning of 2006. In recent years, the rate of increase in the CPI may have become less sensitive to changes in the output gap. As explained below, the views on the mechanisms underlying this development will have a bearing on the outlook for the inflation rate. Accordingly, there are uncertainties, but the year-on-year rate of increase in the CPI is likely to gradually rise to around the middle of the range between zero and 1 percent in fiscal 2006 and to slightly below 1 percent in fiscal 2007. 3
The outlook described above is the most likely projection based on the underlying assumptions and mechanisms mentioned earlier. It should be noted that there exist the following upside and downside risks to the outlook in the coming months.
The first risk is the growth path of the global economy. The outlook assumes that the economies of Japan's major trading partners continue to expand at a pace close to their potential growth rates. Therefore, depending on developments in their economies, Japanese exports and production may move either upward or downward from their expected trajectory. One of the factors supporting the ongoing expansion of the global economy is the durability of stable financial conditions and generally subdued inflationary pressures due at least in part to the appropriate conduct of monetary policy by central banks. Any changes to the picture may adversely affect the global economy, accompanied by shifts in international capital flows and repricing in financial markets. Global economic developments may also be influenced by international commodity prices, including crude oil prices, which have remained at elevated levels reflecting, for example, the higher level of geopolitical risks.
In the United States, if higher resource utilization coupled with, for example, the impact of the past rises in crude oil prices leads to higher inflationary expectations, responses in financial markets may bring about a fall in the economic growth rate. In addition, given that past rises in housing prices have contributed to the growth of private consumption, any sharp adjustment in housing prices may lead to lower growth rates. Meanwhile, the Chinese economy continues to expand robustly. Although there is a risk of repercussions from the robust economic growth, there still is a possibility that this growth will accelerate during the projection period, depending on developments in fixed asset investment and private consumption.
The second risk is the possibility of inventory adjustments. Levels of inventory are still relatively low even though the economy is already in the fifth year of recovery. However, given the projected slowdown in the growth rate, there are factors that may trigger inventory adjustments during the projection period. For example, although the demand for IT-related goods is likely to continue increasing, lower-than-expected growth in demand may trigger inventory adjustments, given that the supply of these goods is increasing at a very fast pace, including in the high-value-added products sector where Japanese firms have a competitive edge. When the adjustments actually occur, however, the impact of inventory adjustments on economic activity may not be pronounced, reflecting, for example, the fact that Japanese firms have on the whole completed adjustments in excesses in employment and production capacity as well as the high level of corporate profits.
The third risk is a further acceleration of business fixed investment. The outlook assumes that the growth in investment will gradually slow as the economic recovery matures gradually. If firms accelerate investment, there may be a positive impact on overall growth for a while. On the other hand, such acceleration may lead to an excessive build-up of capital stock which may precipitate an economic slowdown.
Looking at corporate finances, current conditions point to an acceleration in investment. Firms are less encumbered by debt, and levels of return on assets are comparable to those recorded during the bubble era of the late 1980s. Real interest rates are extremely low as well. Developments in asset prices such as land and stocks are also contributing to increasing private demand. Meanwhile, if financial markets price in the changing state of the economy, it may contribute to preventing large swings in economic activity.
Turning to developments in the inflation rate, factors causing the rate to deviate either upward or downward from the projection warrant attention. The first factor is the impact of the emerging positive output gap (i.e., actual output exceeding potential output). The weaker sensitivity of the rate of increase in the CPI to changes in the output gap is a tendency observed not only in Japan but also worldwide. This reflects developments such as deregulation, advances in information and telecommunication technology, and the deepening of economic globalization. Additionally, in Japan unit labor costs were able to fall considerably as productivity increased against the backdrop of a relatively low rate of resource utilization. However, assuming that demand gradually exceeds supply following the closing of the output gap, the rate of increase in wages and prices may accelerate at some point accompanied by an upward shift in the expected rate of inflation. The second factor is the path of the prices of crude oil and other commodities. There are substantial uncertainties in this regard. The third factor is the impact of an increase in the potential growth rate. An increase in the potential growth rate gives rise to downward pressure on prices from the supply side, whereas it may give rise to upward pressure on prices from the demand side via improvement in expectations of future income. The potential growth rate of the Japanese economy seems to be on an uptrend recently, after experiencing various structural adjustments. Nevertheless, given that it is difficult to observe such changes in real time, there is also uncertainty in this regard.
The Bank of Japan decided to terminate the quantitative easing policy at the Monetary Policy Meeting held on March 8 and 9, 2006. The Bank decided to change the operating target of money market operations from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call rate. The new target for the uncollateralized overnight call rate was set at effectively zero percent.
Under the new guideline for money market operations, the volume of short-term funds-supplying operations by the Bank is decreasing. Accordingly, the outstanding balance of current accounts at the Bank is declining gradually. So far, the short-term money market remains stable and there is gradually more activity being seen in the interbank market. The Bank will continue to closely monitor conditions in the short-term money market, in reducing the outstanding balance of current accounts toward a level in line with required reserves.
The objective of the monetary policy of the Bank is stipulated as contributing to the sound development of the national economy through the pursuit of price stability. To this end, the Bank is pursuing an appropriate course of monetary policy. In the new framework for the conduct of monetary policy released on March 9, 2006, the Bank announced that it would assess economic activity and prices from two perspectives, taking account of the"understanding of medium- to long-term price stability," and that, in the light of this assessment, it would outline its current view on monetary policy.
Looking at the outlook deemed most likely by the Bank for economic activity and prices two years into the future (the first perspective), Japan's economy is likely to continue expanding with balanced domestic and external demand. The year-on-year rate of increase in the CPI (excluding fresh food, on a nationwide basis) is expected to rise gradually through fiscal 2007 as the output gap becomes slowly positive, indicating excess demand, and downward pressures from declining unit labor costs weaken. In sum, Japan's economy is likely to achieve sustainable growth under price stability.
Turning to the risks that are most relevant to conducting monetary policy, looking over a longer time horizon and taking account of the cost incurred when risks materialize, however improbable they might be (the second perspective), it can be seen that the stimulus from monetary policy to economic activity and prices may be amplified against the backdrop of improving corporate profitability and a turnaround in price developments. In this situation, given that the output gap has closed, there is a risk in the medium to long term of larger economic swings, resulting in large fluctuations in the rate of inflation. Meanwhile, even if economic activity is less robust and the inflation rate lower than expected, the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity has become smaller, since the Japanese financial system has regained stability and the economy has now cast off excesses in production capacity, employment, and debt.
With regard to the future course of monetary policy, as a result of the assessment of economic activity and prices from the two perspectives described above, it seems probable that the accommodative financial conditions ensuing from very low interest rates will be maintained for some time following a period in which the uncollateralized overnight call rate is at effectively zero percent. Through and beyond this stage, the Bank will adjust the level of interest rates gradually in the light of developments in economic activity and prices.