KKC International Platform
November 15, 2022

Current Conditions and Outlook for theJapanese Economy and Monetary Policy
Sayuri Shirai

The Japanese economy is on a gradual recovery trend. After moving up and down following
the sharp fall from the 2020 COVID-19 crisis, economic activities have finally been gradually
recovering since the October-December quarter of last year. Economic activities have beenfurther expanding since this April, centered on services.
According to the most recent world economic outlook by the International Monetary Fund(IMF), the growth rate for next year is projected to be 1.6%, which is more or less the same as
the projected growth rate for this year. While negative growth is projected for Germany andItaly in Europe and the possibility of negative growth in the US cannot be denied, in Japan arecovery is likely to continue.
Nevertheless, the actual conditions of the Japanese economy are not strong. Japan’s real grossdomestic product (GDP) has yet to surpass the record high posted in 2018. With the abovementioned growth rates, it will just finally recover the 2018 level by 2023. Looking at real GDPin other major countries and regions since 2019, US real GDP has already greatly exceeded the2019 level, in part due to robust domestic demand, and it exhibited exceptional strength. The
present levels in the eurozone, the UK, and China do not differ greatly from 2019. Theweakness of the recovery in Japan stands out even more in comparison with these countries
and regions.
The drop in the potential growth rate to below 1% has an impact on the weakness of Japan’s
economic recovery. The Japanese economy is fragile against various economic crises, and alsolacks a strong rebound and dynamism. The factors contributing to these trends are the aging
of society with a declining birthrate (the decline in the working-age population and the decline
in total working hours) and the scant progress in the accumulation of capital stock withsluggish capital investment.

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The output gap which measures the difference between the actual economic activities and its
potential output has been in negative territory since 2019, suggesting that insufficient demand
relative to production capacity is continuing. Although real consumption continues togradually recover, it remains below the pre-COVID level. In particular, food consumption has
been dropping since the COVID-19 crisis, and while the consumption of durable consumer
goods sharply increased at one point from stay-at-home demand, it is presently decreasing
rapidly. Services are finally improving from a rather depressed level, and a gradual recovery is
expected to continue in the service industry including tourism and entertainment.
Why is inflation low in Japan?
Global inflation rates are greatly rising. The main reason is the surge in energy prices, followedby the increase in food prices. These reflect the sharp increases in commodity prices since2021, the war in Ukraine, China’s tight COVID policy, etc.
The rate of inflation in the United States has decreased somewhat from July this year with thedrop in gasoline prices, but it remains high at 7.7%. The labor market remains tight as
employment continues to rise and the number of job openings remain significantly large.
Companies especially in the services sector where demand is picking up continue to raise theirsales prices to maintain profits.
Meanwhile, in Europe, the spike in energy prices is the overwhelming cause of inflation, andcurrency depreciation has also resulted in high inflation. The rate of inflation in the eurozone
has most recently been around 10%, and the rates in Germany and Italy in particular, whichhave greatly depended on Russian gas, reached 10.4% and nearly 12%, respectively. Theinflation rate in the UK is also above 10%. While inflation will gradually decline in the Europe
in the near future, it will take more time for inflation to subside compared with the UnitedStates. In any case, it is likely to take 2–3 years before it returns to the 2% inflation in the USand Europe.
In contrast to the US and Europe, the rate of inflation in Japan is presently at a lower level of3%. The “inflation rate excluding fresh foods” and the “inflation rate excluding fresh foods andenergy” which the Bank of Japan (BOJ) use as reference indicators are 3.0% and 1.8%,respectively. This shows that energy is the main cause of inflation in Japan. The depreciationof the yen which has been advancing since the beginning of the year is also pushing up importprices and accelerating inflationary pressure.
Looking at the relation between corporate goods prices and consumer prices for food andpetroleum products, petroleum products prices have been passed onto consumer prices fromrelatively early on to some extent. Food prices also see some passing of higher wholesale foodprices onto retail prices but with some lag.
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Then, why is the rate of inflation in Japan so low compared with the US and Europe? Most of
the world’s central banks focus on “core inflation rates” which exclude the price fluctuationsof all food and energy, all which are easily impacted by international commodity prices. In theUS and Europe, even looking at these indices, the inflation rates are above 5%, and price rises
are spreading across a wide range of items. In contrast, in the case of Japan, the inflation ratefor services is just 0.2% and is hardly rising at all. The “Western-type core inflation rate” which
excludes all food products (including both fresh foods and other food products) and energy isjust 0.9% well below the BOJ’s 2% inflation target. This makes it very different from inflation in
the US and Europe.
Services prices are low because they are hardly rising at all aside from the food service industry.
Companies in the service industry must be suffering from the sharp rise in electricity bills, but
the prices of many items including rent, education, health and welfare services, andcommunications charges are not rising. In as much as overall services prices are not risingacross the board as they are in the US and Europe, Japan’s household burden is relatively
moderate except for low-income households.
While global energy prices and food prices remain at a high level, they have declined
substantially from their peak levels. That impact should gradually appear as a decline in theinflation level in Japan as well from around the spring of 2023.
Yen depreciation and US monetary policy
The pressure for the depreciation of the yen is largely caused by the interest rate differential
between the US and Japan and the overall rise in the dollar index, as well as the deteriorationof Japan’s trade balance. According to a purchasing power parity basis, the depreciation of theyen is excessive.
The November 2, 2022 meeting of Federal Open Market Committee (FOMC) of the FederalReserve maintained the interest rate hike of 75 basis points for four consecutive meetings,
raising the policy interest rate (the federal funds rate) to 3.75–4.0%. The long-term yields
picked up after Federal Reserve Chair Jerome Powell pointed out at the press conference that
“we may ultimately move to higher levels than we thought at the time of the Septembermeeting”. However, when the subsequent announcement that the October unemployment
rate had risen slightly to 3.7% and the October inflation rate of 7.7% had been lower thanwhat market expected, markets now view that the pace of interest rate hikes will slow down.
The US dollar index declined somewhat as well. The present market outlook on the policy rateis that the interest rate will be raised by 50 basis points in the next December FOMC meeting
and will be raised toward 5.0-5.25% by September 2023, and then maintain that level for therest of the year.
3Because US inflation rate and long-term interest rate trends are difficult to predict, US stock
prices and the yen-dollar exchange rate will continue to be unstable for the time being. There
are increasing market concerns that the US economy may fall into negative growth in 2023 if
the policy interest rate is lifted to 5% or higher. This means that the inversion in the US
government bond yield curve will advance further. An inverted yield curve is the phenomenon
whereby the long-term and short-term interest rates are reversed because while short-term
rates rise sharply from monetary tightening, long-term rates do not rise as much as the shortterm rates, reflecting concerns over a recession. Because the 10-year yield gap between theUS and Japan has a greater impact on the yen-dollar exchange rate than the gap in the policyrates, there is a possibility that the depreciation pressures on the yen will weaken once theterminal rate of the policy rate becomes clearer in 2023.
Is the BOJ an outlier?
Domestic and foreign media often describe the BOJ’s monetary policy as an “outlier.” They
point out that while many central banks are raising interest rates, only Japan is maintaining a
low interest-rate policy. To be sure, excluding China—which has a similar inflation rate to Japanand implemented two interest-rate cuts this year—the situation in Japan is unique.
However, as stated above, Japan’s Western-style core inflation rate has been below 2%. Also,
the rise in long-term inflation expectations is not enough to be of any concern. Whilehousehold and corporate long-term inflation expectations have risen substantially, those on
three year or five year ahead are lower than those for one year ahead. Market based longterm inflation projections (such as break-even inflation rate, inflation swap rate, etc.) are well
below 2%.
In other words, inflation trends in Japan are unlikely to be strong enough to require interestrate hikes aiming at suppressing domestic demand in order to lower inflation as comparedwith the US and Europe. So long as monetary policy judgment is made based on price stability,
BOJ’s decision to maintain the low interest rate policy may not be unusual. If the inflation ratein Japan were to rise much further and core inflation were to largely surpass 2%, the likelihoodof examining adjustments in monetary policy would probably increase.
The future of the BOJ’s monetary policy
The BOJ has adopted measures to enhance policy flexibility. In 2018, a target range of plus orminus 0.2% was explicitly introduced for 10-year interest rates, and in 2021 this was expanded
to plus or minus 0.25%. Boosting flexibility by expanding the leeway somewhat further isconsistent with the policy line implemented thus far. Rather than increasing interest rates, the4goal is to enhance policy flexibility. Having some modulation in monetary policy in line withbusiness cycles could make it more effective and improve the functions of bond markets.
However, because there is presently a high level of uncertainty regarding US inflation rates andthe terminal rate of US policy rate hikes, and because interest rates are rising globally, the BOJ
is thought to be cautious about taking action. In Japan as well, the 30-year interest rate hasrisen since the beginning of the year and it has presently reached around 1.5%, showing thefirst clear rising trend since 2013. As enhancing flexibility under such conditions could resultin an additional increase in ultra-long interest rates, unless there is a substantial change ininflation conditions, the BOJ is likely to maintain the current conditions. The BOJ is believed tomaintain the status quo for the time being regarding when it will enhance flexibility, but if US
monetary tightening and the bond market settle down in 2023, that might become thesituation for seeking out the timing. On that occasion, it is conceivable that the BOJ mightmake a decision carefully while maintaining close dialog with the market.

Sayuri Shirai is a professor at Keio University and a former policy board member of the Bankof Japan.
Keizai Koho Center (Japan Institute for Social and Economic Affairs, KKC) has served
as a bridge for the Japanese business community to interact with its key stakeholders insideand outside Japan. With a wide range of its domestic and international programs, KKC hasdeveloped a worldwide network encompassing businesses leaders, lawmakers, government
officials, journalists, university scholars, and school teachers.
The KKC International Platform is a forum to discuss new developments,changes, and challenges of Japan and the international society.
The views expressed in the essays on the KKC International Platform are solely those of theauthors.

Keizai Koho Center
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