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Outlook for Economic Activity and Prices (October 2007)

October 31, 2007
Bank of Japan

[The Bank's View] 1

Outlook for Economic Activity and Prices

Japan's economy is expanding moderately.  Economic activity in the first half of fiscal 2007 seems to have been generally in line with the projection in the April 2007 Outlook for Economic Activity and Prices (hereafter the Outlook Report).  The pace of improvement in the household sector, however, has remained slow relative to the strength in the corporate sector.

From the second half of fiscal 2007 through fiscal 2008, the economy is likely to continue its sustained expansion, although there are uncertainties regarding overseas economies and global financial markets.  A virtuous circle of growth in production, income, and spending is expected to remain in place.  The rate of real GDP growth in fiscal 2007 and fiscal 2008 is likely to register around 2 percent on average, somewhat higher than the potential growth rate.  The growth rate will be somewhat lower in fiscal 2007 and somewhat higher in fiscal 2008 due to a swing in housing investment.2

The outlook rests on the following underlying assumptions and mechanisms.  First, exports are likely to remain on the increase, reflecting continuing expansion of overseas economies.  Although the slowdown in U.S. economic growth could be protracted due mainly to the correction in the housing market, growth in other overseas economies is likely to remain high.  Thus, overseas economies, taken as a whole, are likely to keep expanding.  Second, strong corporate performance is expected to continue.  Business fixed investment is likely to keep rising, supported by high corporate profits.  However, since capital investment continued to increase at a rapid pace for the last several years, the rate of growth is likely to be lower than it was up until fiscal 2006.  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.  With the number of employees increasing, employee income is expected to rise moderately, and the positive effects via various other channels, for example, increased dividends, are likely to continue.  Wages have been somewhat weak, reflecting labor cost restraint by firms, especially small firms, in the face of greater exposure to global competition and capital market discipline, and increased materials prices.  The change in the composition of the workforce due to the retirement of the high-salaried baby-boomer generation and increases in part-time workers have also contributed to the weakness in wages.  However, with a further tightening of labor market conditions, upward pressure on wages is expected to increase gradually.  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 adverse effects of the U.S. subprime mortgage problem and the consequent volatility in global financial markets on Japanese financial conditions have been limited: the lending attitude of financial institutions has been positive; and the issuing environment for CP and corporate bonds has continued to be favorable.  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 labor and production capacity, 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 along with gradual rises in wages.  And third, the results of various surveys on inflation expectations continue to suggest that prices are expected to increase moderately.

Looking at indices for inflation, the domestic corporate goods price index (CGPI) in the first half of fiscal 2007 was higher than the previous projection in April, mainly reflecting rises in international commodity prices.  As for the outlook, the CGPI is likely to maintain its upward trend, 3 although this will be subject to future developments in prices of crude oil and other commodities as well as foreign exchange rates.  

Developments in the consumer price index (CPI, excluding fresh food) have been generally in line with the previous projection, and the year-on-year rate of change has been around 0 percent.  Fierce competition due partly to progress in deregulation has not allowed firms at the retail level to pass cost increases from higher materials prices on to consumers to the extent that has been possible at the wholesale level.  Going forward, 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.  The rate of increase is projected to be around 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008.

Positive and Negative Deviations

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 overseas economies.  In the United States, the economy is likely to realize a soft landing and move onto a sustainable growth path, even though the correction in the housing market is continuing.  Business fixed investment and private consumption are continuing their moderate upward trend, although the pace of increase is decelerating.  If, however, the housing correction intensifies or the negative effects of the disruptions in financial markets become unexpectedly widespread, private consumption and business fixed investment may fall below expectations through negative wealth effects, the credit tightening, and deterioration in business and consumer sentiment, and this may lead to further deceleration in growth of the U.S. economy.  The European economy is likely to continue to expand, but possible adverse effects on financial conditions of global financial market disruptions may pose a downside risk.  If these risks related to the U.S. and European economies were to materialize and have significant adverse effects, growth in other parts of the world may be hampered and this could cause global economic growth to be weaker than expected.

At the same time, it is also possible that inflationary pressures in the United States may not subside as a result of higher resource utilization as well as other factors such as developments in crude oil prices.  In China, the economy continues to expand strongly.  However, with signs of overheating, especially in fixed asset investment, the economic growth rate and the inflation rate may exceed expectations.  The strong growth of the global economy and geopolitical risks, among other factors, are causing crude oil and other international commodity prices to remain elevated, and the global economy and the price situation may also be affected depending on future developments in these prices. 

If overseas economies and global financial markets should follow the disruptive course mentioned above, Japan's economy may be adversely influenced through, for example, changes in exports and imports, corporate profits, and financial market conditions. 

Meanwhile, in Japan, adjustments are progressing gradually in inventories of IT-related goods, which have been high relative to shipments since last year.  However, if growth in overseas economies decelerates more than expected, supply and demand conditions for IT-related goods may deteriorate because their global supply has been increasing at a rapid pace.

The second risk concerns possible larger swings in financial and economic activity under continuing accommodative financial conditions.  As mentioned earlier, Japanese financial conditions are likely to remain extremely accommodative, despite the U.S. subprime mortgage problem and the consequent volatility in global financial markets.  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, developments in asset prices, such as 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 sales and profits, 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 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 the factors restraining wage growth were to remain strong, 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.  And second, considerable uncertainty surrounds developments in the prices of crude oil and other commodities, leaving the potential for movement in either direction. 

Conduct of Monetary Policy

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"). 4

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 growth in 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.  The recent volatility in global financial markets could be regarded as an example of laxity in risk evaluation under the continued benign global economic and financial environment being reversed by market forces of self-correction.  On the other hand, with uncertainties regarding overseas economies and global financial markets as referred to earlier, a significant change in their situation may adversely affect Japan's economy.  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, the Bank's basic thinking has been that (1) given the extremely accommodative financial conditions, the level of interest rates is to be raised if Japan's economy is to follow a path of sustainable growth under price stability, and (2) the pace of increase in interest rates should be determined in accordance with improvements in the economic and price situation without any predetermined view.  Weak inflationary pressures have given the Bank latitude in conducting monetary policy.  The actual interest rate adjustments have therefore been slow based on a thorough assessment, under the two perspectives, of the future path of the economy and prices and its likelihood, as well as both upside and downside risks.  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. 

  1. The text of"The Bank's View" was decided by the Policy Board at the Monetary Policy Meeting held on October 31, 2007.
  2. With the enforcement of the revised Building Standard Law in June 2007, applications for building permits became subject to a more stringent review.  As a result of this procedural change, delays in the submission of applications for building permits and construction starts have been evident.
  3. This outlook is based on the 2000-base CGPI.  From the December 2007 publication, the Bank will change the base year for the CGPI from the current 2000 base to the 2005 base.  This base-year change is likely to lower the year-on-year rate of increase in the index.
  4. The"understanding" reviewed in April 2007, 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.
  • Table
  1. 5The forecasts of the majority of Policy Board members are constructed as follows: each Policy Board member's forecast takes the form of a point estimate, namely the figure to which he or she attaches the highest probability. These forecasts are then shown as a range, with the highest and lowest figures excluded. It should be noted that the range does not indicate the forecast errors.
  2. 6The forecasts of all Policy Board members may be summarized as follows.
  • Table