Ryuzo Miyao: Japan's economy and monetary policy
Speech by Mr Ryuzo Miyao, Member of the Policy Board of the Bank of Japan, at the 2014
Autumn Annual Meeting of the Japan Society of Monetary Economics, Tokyo, 18 October
2014.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
It is a great honor to be invited to the 2014 Autumn Annual Meeting of the Japan Society of
Monetary Economics. Both the Bank of Japan and I have been deeply indebted to the
Society over the years.
In the four and a half years since I took office as a Policy Board member of the Bank - how
time flies - the global economy has faced strong headwinds caused mainly by the sovereign
debt crisis in Europe, the fiscal cliff in the United States, and the Great East Japan
Earthquake in Japan. Central banks in advanced countries have adopted their own
unconventional monetary policy, stepping further into uncharted territory. The Bank of Japan,
for its part, introduced quantitative and qualitative monetary easing (QQE) in April 2013 and
has been conducting further aggressive monetary easing.
I am aware that there are various views and opinions in academia about the initiatives by the
Bank and other major central banks. Discussions and research have been actively
underway. As a central banker who came from academia, I too have been asking myself the
following questions.
First, economic recovery has been driven by consumption in Japan for about the past two
years. Why consumption, and why now? What is the driving force behind this? Can such
recovery be sustained? Second, contrary to what many people had expected, the rate of
increase in the consumer price index (CPI) has been rising steadily since 2013. What is the
driving force for that? Firms increasingly have been passing on costs to sales prices, but why
is this happening now? Third, views are divided among those in academia with regard to the
effects of the unconventional monetary policy, such as the purchases of Japanese
government bonds (JGBs). How should we respond to skeptical views about the policy
effects, stating, for example, that (1) the policy by itself does not produce any effects in
ordinary times, but it appears effective only because some market participants believe so;
and (2) such policy will only cause a temporary asset price bubble, and thus make the
economy unstable?
In finding my own answers to these questions, I realized that such answers critically depend
on an assessment of the potential strength of the supply side of the economy; namely, its
growth potential, profitability, and capacity to generate income. Needless to say, it is
essential to accurately gauge the situation on the supply side of the economy in discussing
the mechanism of economic recovery and its sustainability, as well as the effects and
challenges of monetary policy.
Bearing that in mind, I have emphasized in my past speeches that the main feature of the
current economic recovery in Japan is that it has been primarily driven not by exports, like in
typical recovery phases in the past, but by consumption and nonmanufacturing activities, and
that the driving force has been the heightened strength of the supply side from the standpoint
of several aspects.1 Specifically, in the corporate sector, various positive efforts have been
made in and outside Japan, and these have bolstered nonmanufacturers' profitability as well
as manufacturers' ability to make profits through globalization; firms' demand for labor has
generally risen and the employment and income situation has continued to improve; and the
household labor supply has been increasing, with voluntary labor force participation by
women and the elderly.
The Bank has been conducting QQE, in order to achieve the price stability target of
2 percent. As I will address in detail later, if the potential strength of the economy heightens,
the 2 percent price stability target will be achieved more smoothly in a well-balanced manner,
with a sustainable economic recovery, and price stability will be maintained. Moreover, with
the heightened strength of the economy, monetary policy will be more effective while
potential negative side effects - such as financial imbalances - will likely be suppressed. If
the decisive measures promote further effects, a virtuous cycle may start to operate that
encourages positive efforts of firms and households as well as a structural transformation in
the economy, which would further heighten the strength of the economy.
Today, I would like to reexamine the improvements on the supply side of Japan's economy.
Based on that, I will then address some issues regarding monetary policy. At the end of my
speech, I will touch upon points to keep in mind regarding Japan's economic and price
developments.
I. Recent developments in economic activity and prices and improvements on
the supply side
A. Continued moderate recovery in Japan's economy
Japan's economy has continued to recover moderately as a trend, although some weakness,
particularly on the production side, has been observed, due mainly to the effects of the
subsequent decline in demand following the front-loaded increase prior to the consumption
tax hike. Real GDP for the April-June quarter of 2014 fell substantially at a rate of 7.1 percent
on an annualized quarter-on-quarter basis. However, this decline followed the front-loading
of demand in the January-March quarter, for which real GDP had grown significantly at a rate
of 6.0 percent (Chart 1). To exclude such fluctuations, when we compare real GDP for the
January-June period of 2014 with that for the July-December period of 2013, the annualized
growth rate was 1.0 percent. Therefore, on average, Japan's economy has continued to grow
at a pace above its potential and the recovery trend has been maintained.
Japan's output gap has continued to improve as a trend. The Bank's estimated figures for the
output gap turned positive in the January-March quarter of 2014 and were close to 0 percent
in the April-June quarter. Thus, the output gap has generally disappeared. The weighted
average of the production capacity DI and employment conditions DI in the September 2014
Tankan (Short-Term Economic Survey of Enterprises in Japan) also confirms this
improvement (Chart 2).
Next, I will move on to price developments. The year-on-year rate of increase in the CPI (all
items less fresh food, excluding the direct effects of the consumption tax hike) has
strengthened its uptrend from 2013 and has improved to around 11⁄4 percent recently. This
uptrend can also be confirmed by the CPI figures for all items excluding food and energy
(Chart 3). These developments reflect the improving trend in the output gap mentioned
earlier and a rise in inflation expectations. The medium- to long-term inflation expectations
according to Consensus Forecast, for example, have turned to a rising trend from 2013
(Chart 4).
The main feature of the recent economic recovery is that it is driven by consumption and
nonmanufacturing activities, and this trend can still be observed (Chart 5). The typical pattern
of past recovery phases, driven by exports, can be clearly observed in the expansionary
phase of 2002 to 2008, but exports have subsequently been more or less flat in the longer
run. Business fixed investment has been increasing moderately, albeit with fluctuations, but
the pace has been gradual in comparison with the expansionary phase in the mid-2000s. In
contrast, consumption has consistently followed an increasing trend, albeit with various
effects, and has posted even higher growth since the start of 2012. Consumption expenditure
for the April-June quarter of 2014 saw a large drop of 19 percent on an annualized
quarteron-quarter basis, reflecting the effects of the decline in demand following the front-loaded
increase prior to the consumption tax hike; however, after smoothing out the fluctuations,
consumption expenditure for the period of January-June 2014 compared with that of
JulyDecember 2013 declined by a much slower pace of 0.8 percent. Private consumption has
remained resilient as a trend with the employment and income situation improving steadily,
and the effects of the decline in demand following the front-loaded increase have been
waning on the whole, albeit unevenly. It deserves special mention that consumption - which
has been posting increasingly higher growth - has been the driving force of economic
recovery over the past two years or so without being accompanied by notable increases in
exports and business fixed investment, which had previously been the driving factors of
economic recovery.
At the same time, it is evident that the current economic recovery has also been driven by
nonmanufacturing activities (Chart 6). Looking at economic developments since 2012 - when
the effects of the earthquake disaster mostly dissipated - the level of nonmanufacturing
activities has continued to increase, while that of manufacturing activities has turned to a
pick-up after having dropped. Although the decline in demand following the front-loaded
increase prior to the consumption tax hike has recently been somewhat large, it seems the
improvement in nonmanufacturing activities is being maintained as a trend.
B. Improvements on the supply side
The fact that the economy has continued to recover, mainly in consumer demand, reflects
improvements in the various aspects of the supply side; in other words, the potential strength
of the economy.
In the corporate sector, various positive efforts have progressed at home and abroad and
firms' profitability has increased further (Chart 7). Manufacturing firms are further
accelerating their efforts toward optimizing their global-based activities, such as through
increasing their production, procurement, and fixed investment as well as hiring local
management and staff in overseas countries where there is demand. Efforts to stimulate
potential demand have been spreading to a wider range of nonmanufacturing sectors. In
Japan, these efforts range from the building of new advanced distribution centers, expansion
of home-delivery service and online shopping, to active openings of new convenience stores
and shopping malls. There also have been active moves to strengthen the economy's growth
potential by capturing local demand overseas, such as development of overseas business in
the retail, wholesale, and service industries as well as acquisition of firms.
Labor and employment conditions have also continued to improve as a trend. On the back of
proceeding with their positive efforts, firms are increasing their demand for labor and their
stance on employment is becoming active (Chart 8). Looking back on the past year, a sense
of labor shortage among nonmanufacturing firms has heightened further, and labor supply
and demand conditions at manufacturing firms have also tightened, recently turning to a
state of labor shortage. In terms of the quality of employment, firms have gradually been
making a shift to hiring part-time workers as full-time, regular workers, mainly based on the
need to secure competent human resources (Chart 9). As for wage developments, the
year-on-year rate of change in scheduled cash earnings has turned positive due to a rise in
base pay at many firms, and special cash earnings have also steadily increased, due mainly
to a rise in summer bonus payments. As a result, employee income - that is, wages per
employee multiplied by the number of employees - has been increasing by about 2 percent
year on year (Chart 10).
With regard to labor supply conditions, the labor force participation rate that had been on a
declining trend, mainly due to the demographic situation, bottomed out in 2012 and is moving
toward a pick-up (Chart 11). Breaking down the labor force participation rate by gender and
age, the rising trend in the participation rate of women is particularly prominent, and an
increasing trend is also becoming evident in recent years for men, especially in the age
category of 65-74 years (Chart 12). This seems to reflect initiatives taken by firms amid a
general sense of labor shortage to encourage the participation of female workers by
introducing flexible working systems such as shorter working hours, and also to promote the
employment of the elderly in order to pass on their skills and knowledge to younger workers.
However, it will be necessary to wait for data to accumulate for some time before making a
judgment on whether such improvements in the labor force participation rate are mainly
temporary and cyclical ones, brought about by the economic recovery, or due to sustainable
and structural changes. If the latter is the case to some degree, then the amount of potential
labor input is expected to bottom out and the potential growth rate to turn upward,
accordingly.
Many researchers would agree that estimation of the potential growth rate entails technical
difficulties.2 In many economic analyses, trend components, which are extracted from the
actual economic data using methods such as the Hodrick-Prescott (HP) filter, are often used
as proxies for the potential series of economic variables. However, it is difficult to estimate
the recent figures for these potential series, particularly those toward the end of the sample
period, on a real-time basis. Let us now take a look at Chart 11. It shows that the trend
estimates of the labor force participation rate have declined over the past year or two.
However, it should be noted that, if the recent increase in labor force participation that I
explained earlier is sustainable and structural, we should be able in the future to look back
and confirm that the actual trend in the labor force participation rate has already stopped
declining; as a result, it is quite conceivable that the potential growth rate will be revised
upward. Thus, careful monitoring of such a possibility is required.3
I have so far examined improvements on the supply side of the economy from the standpoint
of aspects such as corporate profits, demand for labor, employment and wages, and labor
supply. In all of these aspects, it is commonly observed that improvements became distinct
from around 2012. That is to say, against the background of positive efforts by firms and
households, it has become evident that the economy's capacity to generate income - as
represented by corporate profits, employee income, and labor force participation - has
increased on the whole. This supports the view that, as a result, expectations for permanent
income in the economy as a whole have improved and, in addition, anxiety and uncertainty
regarding future employment conditions have decreased considerably, which has led to
economic recovery driven by consumption. In other words, it can be explained that, from
around 2012, the improvement in the potential strength of the supply side of the economy
has been the driving force of the sustainable recovery in domestic demand, particularly
consumer demand.
Given these factors, let us now take a look at the estimates of the potential growth rate of
Japan's economy (Chart 13). The potential growth rate per capita seems to have stopped
declining in around 2010, and has been more or less flat thereafter. Although estimates of
the potential growth rate should be judged with some latitude, at least the observations so far
suggest that the potential growth rate over the past year or two may be revised upward in a
few years' time. I consider that, in order to assess the supply conditions of the economy,
particularly the recent ones, it is important not to solely rely on the estimates of the potential
growth rate, but to make a comprehensive assessment taking into consideration the actual
situation of firms and households.
C. Increasing upward pressure on prices
When improvements on the supply side of the economy lead to a sustainable increase in
domestic demand, particularly consumer demand, upward pressure on prices is likely to
increase. Let me explain this from a theoretical viewpoint.
First, given the standard analysis based on aggregate supply and demand curves,
improvement on the supply side shifts the aggregate supply curve (or the Phillips curve) to
the right. In this case, economic activity improves while upward pressure on prices weakens.
However, if, at the same time, aggregate demand increases in a sustainable manner, the
aggregate demand curve shifts to the right, thereby increasing upward pressure on prices. It
is purely an empirical question as to which of the two factors - the shift of the supply curve or
of the demand curve - outweighs the other. An empirical analysis using Japan's data that
examined the effects of an increase in total factor productivity (productivity shock) showed
that the effects of an increase in upward pressure on prices caused by the increase in
demand outweigh those of an increase in supply; thus, an improvement on the supply side
leads to an improvement in the output gap and causes a modest increase in prices.4
Second, when sales of goods and services increase sustainably in line with firms' strategy of
creating differentiated products and higher value-added, their price-setting behavior might
become more active. In other words, in a situation where demand is expected to increase
sustainably, firms will be able to charge higher markups (profit margins) or pass production
costs more directly on to sales prices. If these developments are structural, this will steepen
the Phillips curve, which will also increase upward pressure on prices.
Third, it is likely that a mechanism will operate through which improvements on the supply
side increase people's medium- to long-term inflation expectations. If people expect that
economic activity and sales will continue to improve, their inflation expectations will increase
- considering, for example, the Phillips curve relation in the future. This mechanism is called
forward-looking expectation formation of the New Keynesian Phillips curve. Improvements on
the supply side thus increase people's somewhat long-term inflation expectations, and in turn
shift up the intercept of the Phillips curve.
In fact, medium- to long-term inflation expectations have been increasing gradually (Chart 4).
Developments in medium- to long-term inflation expectations seem to largely correlate with
those in the potential growth rate per capita that I explained earlier, with the exception of the
most recent period (Chart 13).
In a situation where these mechanisms work in combination, it is possible to say, as
suggested from Chart 3, that upward pressure on the consumer price inflation rate has been
increasing. In other words, mechanisms such as (1) sustainable improvement in the output
gap and increasing expectations for future improvement, (2) firms' increased ability to pass
costs on to sales prices, and (3) a rise in medium- to long-term inflation expectations have all
contributed to heightening upward pressure on overall prices.
I should note that, as a different kind of logic to explain the recent rise in prices in Japan,
some argue that prices have risen due to the constraint of sluggish supply. How should we
explain this argument? I consider the key to be whether the supply capacity of the economy
is actually increasing. Price rises that are not accompanied by improvements on the supply
side will restrain growth in demand and thus prevent economic activity from expanding.
Looking at the recent situation in Japan, however, improvements on the supply side have
become clear over the past year or two; in fact, demand has been increasing sustainably.
Specifically, (1) demand for goods and services and for labor has been increasing
sustainably at a pace exceeding growth in supply capacity; (2) production of goods and
services has been increasing, and the employment situation has been improving; and
(3) prices as well as wages have been rising moderately. Given these observations, I think
that it is difficult to attribute the recent price rises to sluggish supply or supply constraints.
II. Conduct of monetary policy
The recent macroeconomic performance that I have described so far will also create a
desirable situation with regard to conducting unconventional monetary policy. As I will
explain, if the potential strength of the economy heightens, the 2 percent price stability target
will be achieved more smoothly in a well-balanced manner, with a sustainable economic
recovery, and price stability will be maintained. Moreover, with the heightened strength of the
economy, greater policy effects will be produced while potential negative side effects - such
as financial imbalances - will likely be suppressed.
A. The 2 percent price stability target
In January 2013, the Bank released a joint statement with the government and introduced a
price stability target of 2 percent in terms of the year-on-year inflation rate of the CPI, making
a clear commitment to achieving this target at the earliest possible time.
Looking back at the situation around that time, some notable progress was made in terms of
external factors: downside risks to the global economy caused by the extremely strong
headwinds - such as the sovereign debt crisis in Europe and the fiscal cliff in the United
States - had subsided in the latter half of 2012, and thus uncertainties had diminished to a
considerable degree. Given these developments, the Bank showed its determination to attain
sustainable economic growth in Japan in coordination with the government, aiming to
overcome deflation and dispel deflationary sentiment at the earliest possible time.
The Japanese people expect to have price stability that is achieved not by a mere price hike,
but by a moderate rise in prices brought about by balanced and sustainable economic growth
together with improvements in employment, wages, and corporate profits. The Bank set the
price stability target at 2 percent in terms of the year-on-year rate of change in the CPI based
on the recognition that the inflation rate consistent with price stability on a sustainable basis
would rise as efforts by a wide range of entities toward strengthening growth potential and
competitiveness of the economy made progress.
In fact, steady progress has been made in a variety of initiatives toward strengthening growth
potential and improving the supply side, with strong support from the financial side through
QQE. Japan's economy has continued to recover in a well-balanced manner as employment,
wages, and corporate profits have improved in a sustainable manner, and the year-on-year
rate of change in the CPI has been increasing gradually toward the 2 percent price stability
target.
B. The role of QQE
In April 2013, the Bank introduced QQE to achieve the 2 percent price stability target at the
earliest possible time, with a time horizon of about two years. With the aim of achieving the
target, the Bank decided to continue with QQE, as long as it was necessary for maintaining
that target in a stable manner.
QQE is mainly composed of three important components: a large expansion of the monetary
base (at an annual pace of about 60-70 trillion yen); large-scale purchases of JGBs (at an
annual pace of about 50 trillion yen) with an extension of the average remaining maturity (to
about seven years); and an increase in the purchase of risk assets. It also incorporates
elements of an open-ended framework that links the continuation of such large-scale
monetary easing with its policy target. That is, the Bank has committed to continuing with
QQE "as long as it is necessary for maintaining the 2 percent price stability target in a stable
manner" without restricting the time frame or the total amount in advance. This commitment
seems to have helped create further accommodative financial conditions by exerting a strong
influence on market expectations about future monetary policy.
The effects of QQE are more likely to materialize if the potential strength of the economy
heightens. Specifically, given an increase in firms' profitability, extremely accommodative
financial conditions will drive their positive efforts and risk-taking activities, thereby further
heightening economic stimulus effects. Large-scale purchases of JGBs can exert downward
pressure on longer-term interest rates and upward pressure on asset prices. If fundamentals
such as corporate profits improve at the same time, asset price rises will become more
sustainable and justified. As a result, potential negative side effects - such as heightened
financial imbalances - will likely be suppressed.
In addition, if some decisive measures produce further positive effects in a situation where
the potential strength of the economy heightens, positive efforts of firms and households,
business fixed investment, and a structural transformation in the economy will be stimulated
further. This may then accelerate a virtuous cycle that further bolsters the potential strength
of the economy and the effectiveness of the policy measures. The economic recovery in
Japan seems to have strengthened its sustainability, as corporate profits have been on an
improving trend and potential strength has heightened further through the implementation of
the measures in 2013. An improvement in corporate profits can be seen in Japan and in the
United States while aggressive monetary easing continues and stock prices remain on a
rising trend in both countries. It is likely that firms' positive efforts to improve profits have
been encouraged further by the extremely accommodative financial conditions (Chart 14).
Concluding remarks
Let me conclude by touching on the outlook for the economy and price developments in
Japan.
Japan's economy is expected to continue on its moderate recovery trend, and the effects of
factors such as the decline in demand following the front-loaded increase prior to the
consumption tax hike are expected to wane gradually. Supported by the accommodative
financial conditions, improvements on the supply side and the sustainable recovery trend of
the economy, as well as the moderate improving trend in inflation expectations, are likely to
continue. The economy is therefore expected to follow a path toward achieving the 2 percent
price stability target in a balanced manner, accompanied by improvements such as in
employment, wages, and corporate profits.
On the other hand, as for private consumption, the effects of factors such as the decline in
demand following the front-loaded increase have somewhat lingered in terms of the
consumption of durable goods, and therefore the pace of recovery warrants a certain degree
of attention. In order for the improvements in economic activity and prices to continue in a
wide range of areas, it is important that the positive effects of the increase in corporate profits
spread throughout the economy - including households and small and medium-sized firms -
by way of increases in wages and employment, a raise in delivery prices paid to suppliers, or
other channels.
The Bank has committed to continuing with its aggressive monetary easing, as long as it is
necessary for maintaining the 2 percent price stability target in a stable manner. It also will
continue to examine both upside and downside risks to economic activity and prices, and
make adjustments as appropriate to achieve the price stability target. In standing by its
commitment and clarifying its policy stance, the Bank will further encourage positive
initiatives taken by a wide-range of economic entities from the financial side. The Bank is
therefore determined to fulfill its responsibility toward achieving sustainable economic growth
through price stability.
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