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April 27, 2007
Bank of Japan
Japan's economy is expanding moderately. Economic activity in fiscal 2006 seems to have been generally in line with the projection in the October 2006 Outlook for Economic Activity and Prices (hereafter the Outlook Report), although the pace of improvement in the household sector has been somewhat slow relative to the strength in the corporate sector. 2
From fiscal 2007 through fiscal 2008, the economy is likely to continue its sustained expansion with a virtuous circle of production, income, and spending in place. The year-on-year rate of growth in real GDP is likely to register around 2 percent, somewhat higher than the potential growth rate, for both fiscal 2007 and fiscal 2008.
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. The U.S. economy is likely to realize a soft landing, moving onto a sustainable growth path, although the pace of economic growth has recently been decelerating due mainly to ongoing adjustments in the housing market. Taken as a whole, overseas economies are expected to keep expanding, with momentum being gained across a wide range of economies. Second, strong corporate performance is likely to continue. With corporate profits continuing to be high, business fixed investment is likely to keep rising. However, in view of the capital stock cycle, the rate of growth in business fixed investment will likely fall gradually, since firms continue to be strict in their evaluation of investment profitability. Third, it is expected that the positive influence of the strength in the corporate sector will continue to feed through into the household sector slowly but steadily. Although firms, attentive to global competition and their greater exposure to the discipline of the capital market, are expected to continue to restrain labor costs, it is assumed that upward pressure on wages will increase gradually as labor market conditions tighten further through increases in the number of employees. In addition, strength in the corporate sector should filter through into the household sector via various other channels, for example, increased dividends. Against this backdrop, private consumption is likely to follow a moderate upward trend. And fourth, the extremely accommodative financial conditions are likely to continue to support private demand. The lending attitude of financial institutions has been positive, and the level of short-term interest rates has been very low relative to economic activity and price conditions.
Given this economic outlook, the environment surrounding prices can be summarized as follows. First, a higher level of resource utilization, namely in production capacity and labor, is being observed, and this is likely to rise further going forward. Estimates of the output gap suggest that supply and demand conditions will continue to tighten. Second, unit labor costs (labor costs per unit of output), although currently still declining, are likely to stop falling and start showing modest increases, reflecting gradual rises in wages. And third, the results of various surveys suggest that although inflation expectations in the private sector have shifted down due mainly to past falls in the prices of petroleum products, prices in general are still expected to increase moderately.
Looking at indices for inflation, the domestic corporate goods price index (CGPI) in fiscal 2006 was somewhat lower than the previous projection in October, reflecting declines in international commodity prices. As for the outlook, the CGPI is likely to maintain its upward trend, although this will be subject to future developments in prices of crude oil and other commodities as well as foreign exchange rates.
Movements in the consumer price index (CPI, excluding fresh food) are currently somewhat weaker than previously projected, mainly due to the fall in crude oil prices. Going forward, the year-on-year rate of change in the CPI is likely to be around 0 percent in the short run depending on developments in crude oil prices, but is expected gradually to rise in the longer run. To be specific, the rate of increase is projected to be slightly above 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008.
The outlook described above is the most likely projection based on the underlying assumptions and mechanisms mentioned earlier. It should be noted that the outlook is subject to the following upside and downside risks.
The first risk concerns developments in the global economy. In the United States, ongoing adjustments in the housing market have not so far spilled over into the wider economy, as evidenced by continued firmness in private consumption. Business fixed investment is expected to maintain its gradual upward trend reflecting the high corporate profits, although some leading indicators have been weak recently. However, if adjustments in the housing market turn out to be greater than expected or business fixed investment weakens, this may cause growth to decelerate further. With regard to the U.S. price situation, as a result of higher resource utilization, namely in production capacity and labor, as well as other factors such as developments in crude oil prices, it is possible that inflationary pressures may not subside. In such a case, there is a risk that, for instance, the reaction of financial markets to this situation could adversely affect the U.S. and global economies. In China, the economy continues to expand strongly, and it is possible that the growth rate may exceed expectations during the projection period depending on developments in fixed asset investments and exports. The global economy may also be influenced by international commodity prices, such as crude oil prices, depending on how these develop.
The second risk concerns supply and demand conditions for IT-related goods. Recent rises in inventories of IT-related goods in Japan seem to have resulted mainly from specific factors concerning products for the domestic market. Demand for IT-related goods, on a global basis, seems set to remain on a steady upward trend. However, if expected global demand is revised significantly downward in response to, for instance, deceleration in the global economy, supply and demand conditions may deteriorate, since the pace of increase in the global supply of IT-related goods has been rapid. Even in such a case, however, enhanced strength in the Japanese corporate sector, namely improvements in corporate profitability and firms' financial positions, may act as a cushion minimizing the impact on the overall economy.
The third risk concerns possible larger swings in financial and economic activity based on optimistic assumptions regarding, for example, financial conditions. Japan's current economic circumstances are such as potentially to encourage assertive financial and economic activity, with the financial positions of both firms and financial institutions improving and real interest rates remaining very low. Moreover, recent developments in asset prices, as seen in the increasingly distinct upward trend for land prices in major cities, may also cause such activity to accelerate. In this situation, if greater assertiveness should be based on optimistic assumptions regarding future profitability, such as favorable assumptions concerning the expected growth rate, financing costs, foreign exchange rates, and asset prices, the result could well be a misallocation of resources in the long run as agents become over-extended in financial markets or pour funds and other resources into inefficient economic activities. Such behavior may push up economic growth and asset prices in the short run, but may lead to later downward adjustments and hamper the sustainability of economic growth.
Turning to the outlook for the inflation rate, it should be noted that there are uncertainties that could cause the rate to deviate either upward or downward from the projection. First, the sensitivity of prices to changes in the output gap seems to have declined due to factors such as the progress of economic globalization and deregulation, but the degree of decline is uncertain. In particular, if, despite continued economic expansion, wage growth were to remain low relative to the pace of productivity gains, downward pressure on prices would be expected to persist. On the other hand, greater upward pressure on prices is also a possibility if there is a significant change in inflation expectations or labor cost restraint by firms, following further, even moderate, increases in the utilization of resources such as production capacity and labor. And second, given factors such as geopolitical risks, considerable uncertainty surrounds developments in the prices of crude oil and other commodities, leaving the potential for movement in either direction.
The Bank assesses the economic and price situation from two perspectives and then outlines its thinking on the future conduct of monetary policy, taking account of the"understanding of medium- to long-term price stability" (the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term) (hereafter"understanding").
The"understanding" expressed in terms of the year-on-year rate of change in the CPI, takes the form of a range approximately between 0 and 2 percent, with most Policy Board members' median figures falling on one side or the other of 1 percent (see the Box).
The first perspective involves assessing the most likely outlook for economic activity and prices through fiscal 2008 with reference to the view of market participants regarding the future course of the policy interest rate -- a view that is incorporated in market interest rates. Examined from this perspective, Japan's economy is likely to continue its sustained expansion with a virtuous circle of production, income, and spending in place, as described earlier. The year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. Such developments can be regarded in line with the"understanding." In sum, Japan's economy is likely to realize sustainable growth under price stability.
The second perspective extends the time horizon and assesses the risks considered most relevant to the conduct of monetary policy, taking account of the cost incurred should risks materialize, even though the probability of such materialization may be low. From this perspective, it appears that, with the improved prospects for economic activity and prices, the stimulative effect of monetary policy may be further amplified. If, for instance, the expectation takes hold that interest rates will remain low for a long time regardless of developments in economic activity and prices, there is a medium- to long-term risk of larger swings and of inefficient allocation of resources as firms and financial institutions over-extend themselves. On the other hand, if the downside risks mentioned earlier should materialize, the improvement in the economic situation may stall. It is also possible that prices will continue not to rise despite the improvement in economic conditions. Nevertheless, the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity seems to have further decreased, since the strength of the corporate sector and robustness of the financial system have been enhanced.
Regarding the conduct of monetary policy since the termination of the quantitative easing policy in March 2006, the Bank has been gradually adjusting the level of interest rates in the light of developments in economic activity and prices. Adjustments were made in view of the outlook for the economy and prices, with the Bank judging that sustained economic growth would continue with a virtuous circle of production, income, and spending in place, and that consumer prices would be likely to increase moderately in the long run in line with the"understanding." With inflationary pressures weak, the pace of adjustment has been slow and the accommodative financial conditions ensuing from very low interest rates have been maintained. The Bank's basic thinking in this regard will remain the same in the conduct of future monetary policy. In sum, while confirming that the Japanese economy remains likely to follow a path of sustainable growth under price stability in light of the"understanding" and assessing relevant risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation.
In March 2006, the Bank announced, in the publication of"The Bank's Thinking on Price Stability," that the"understanding of medium- to long-term price stability" (the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term) (hereafter"understanding") will be, in principle, reviewed annually. Since about a year has now passed since this announcement, a review has been conducted.
The results can be summarized in the three points given below.
The basic understanding stated in"The Bank's Thinking on Price Stability" was reaffirmed as follows:
(1)Price stability is a state where various economic agents including households and firms may make decisions regarding such economic activities as consumption and investment without being concerned about the fluctuations in the general price level.
(2)Given that the effects of monetary policy take time to work through the economy and that the volatility of output may actually be amplified when attempts are made to absorb every short-term change in prices resulting from various shocks, the Bank should forecast developments in economic activity and prices from a sufficiently long-term viewpoint and strive to realize price stability over the medium to long term.
In examining the"understanding," the following points were considered: (1) measurement bias in the CPI; (2) the"safety margin" that acts as a buffer against the risk of falling into a vicious circle of declining prices and deteriorating economic activity; and (3) the level of inflation perceived by households and firms as consistent with price stability. As for the first point, it was judged that measurement bias remains insignificant even after taking account of last year's rebasing of the index. Regarding the second point, the"safety margin," the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity seems to have further decreased, since the strength of the corporate sector and robustness of the financial system have been enhanced. Finally, on the third point, the level of inflation perceived by households and firms as consistent with price stability is unlikely to have changed much, since changes in the inflation rate have been small.
Based on the above considerations, it was agreed that the"understanding" should be expressed as follows: The"understanding," expressed in terms of the year-on-year rate of change in the CPI, takes the form of a range approximately between 0 and 2 percent, with most Policy Board members' median figures falling on one side or the other of 1 percent.