Kazumasa Iwata: The current state of the Japanese economy and its outlook
Excerpt of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at a meeting with
Business Leaders, Niigata, 7 March 2007.
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Introduction
Today, as a representative of the Bank of Japan, I am pleased to have this opportunity to present the
Bank's view on the current state of the Japanese economy and its outlook. I would also like to explain
the Bank's decision to raise the policy interest rate at its Monetary Policy Meeting (MPM) in February
as well as the thinking behind its conduct of monetary policy.
I. Overseas economic and financial developments
Let me start with overseas economies. In the United States, the economy expanded at an annual rate
of 2.0-2.5 percent over the last three quarters with housing investment continuing to cool significantly.
However, spillover effects from the housing adjustments have been limited, and private consumption
has continued to show solid growth. As for price developments, the rates of increase in the core
consumer price index (CPI) and in the core personal consumption expenditure (PCE) deflator have
been at relatively high levels.
Both upside and downside risks currently coexist in the U.S. economy, surrounding the inflation
situation and the economic growth rate, respectively. Nevertheless, given the robustness and the
flexibility of the economy it is likely to avoid a significant slowdown in the growth rate and to realize a
soft landing, returning to its potential growth path from the current 2.0-2.5 percent by late 2007, with a
gradual decline in the rate of inflation. In the euro area, economic recovery continues to be solid, while
in China and India strong expansion is continuing on the back of growth in demand both at home and
abroad. Overseas economies taken as a whole continue to exhibit strong growth. At the G-7 meeting
held about a month ago, there was a consensus view that the world economy is likely to keep
expanding with more balanced growth.
Turning to global financial markets, a plunge in the Chinese stock market at the end of February
resulted in large fluctuations in stock prices worldwide and higher volatility in asset prices. Up until
then, volatility in asset prices had been very low internationally, resulting in tighter credit spreads and
smaller term premiums. With investors appearing "overly complacent" about asset price changes and
various other risks, a situation developed in which investors focusing on the interest rate differential
between Japan and abroad favored the yen carry trade. Recently, however, there has been some
unwinding of this trade. Although these adjustments seem so far to have been limited basically to
technical corrections in position-taking by those who felt overexposed, careful attention should be paid
to whether the higher volatility in asset prices may have some implications for investors' risk-taking
behavior in the future.
II. Developments in Japan's economy
Against the background of the strong growth in overseas economies, Japan's economy has been
experiencing a sustained period of moderate expansion. The economy maintained a rate of growth of
about 2 percent from fiscal 2003 to fiscal 2006, a pace which it seems likely to sustain during fiscal
2007.
A. Slow permeation of strength in the corporate sector through to the household sector
The current economic expansion is now six years old, but partly because of the gradual pace of
growth, it is not making itself felt by households to the same extent as in past economic expansions.
In the corporate sector, however, corporate profits have been favorable and business fixed investment
is growing at a rapid pace, especially among manufacturers. Corporate profits and business fixed
investment are expected to keep increasing steadily, and this suggests that the engine of the
economic expansion remains intact.
Despite the strength in the corporate sector, the pace at which this positive influence has filtered
through into the household sector has been slow. Faced with intensifying global competition and
greater exposure to the discipline of the capital market, corporate management has been increasing
the emphasis it places on raising profitability.
Reflecting these factors, growth of wages has been modest. Especially since summer 2006, the
effects of the baby-boomers' retirement and of cuts in personnel expenses for local civil workers are
exerting additional downward pressure on the growth of wages per person.1 The modest increase in
wages seems also due to management's greater efforts to reduce fixed costs to cope with sharp rises
in prices of crude oil and other materials from 2004 through fall 2006, and employees' preference for
employment stability over a wage increase after their past experiences of a severe employment
situation.
With regard to the employment situation, the number of employees has continued to increase steadily
at an annualized rate of slightly over 1 percent, and labor market conditions are gradually becoming
tighter. The unemployment rate for women was 3.8 percent in January 2007, lower than that for men
(4.1 percent), and women's wages have been increasing steadily since 2005. Hourly wages for
parttime workers have posted year-on-year increases since 2003, and the rate of increase rose gradually
through 2006. Looking forward, wages, including those for men, are expected to rise steadily as labor
market conditions become increasingly tight.
With the number of employees increasing steadily, household income has continued rising moderately
and private consumption has been firm. A more distinct upward momentum in private consumption is
likely to emerge as the adverse effects from temporary factors -- such as last year's weather
conditions (a long spell of rainy weather in early summer as well as the unseasonably warm winter
weather) and consumers' reluctance to buy before the introduction of new products -- fade and wages
resume their upward trend reflecting improved labor market conditions.
B. Production and inventory adjustments
Production exhibited high quarter-on-quarter growth of 2.6 percent in the October-December quarter of
2006, but a downward reaction to this high growth coupled with adjustments in the IT-related sector
will likely suppress growth in the January-March quarter of 2007. Unlike inventory adjustments in
ITrelated goods during 2002-03 and 2004-05, adjustments this time seem largely due to
weaker-thanexpected demand for cellular phones and new game consoles, although the impact of the introduction
of a new personal computer operating system has still to be fully ascertained.
C. Developments in consumer prices
The year-on-year rate of change in the CPI (excluding fresh food) was flat in January, and depending
on developments in crude oil prices and foreign exchange rates, it may turn slightly negative in the
short term. From a longer-term perspective, however, consumer prices are expected, over time, to
display trend increases given that the economy has expanded at an annual rate of around 2 percent
over the last four years and that the expansion is expected to be long-lasting. With the continuing
economic expansion, the utilization rates of production capacity and of labor have been rising steadily,
and they are expected to increase further. As the recent Tankan (Short-Term Economic Survey of
Enterprises in Japan) indicates, corporate managers are increasingly feeling shortages of production
capacity and labor, while a positive output gap suggests that demand currently exceeds supply in the
economy as a whole.
Since autumn last year, upward movement in the CPI has been subdued partly because of sluggish
growth in private consumption and wages. However, the CPI is expected to resume a moderate
upward trend as the effects of the drop in crude oil prices fade out. When considering the effects of the
fall in crude oil prices, we should note the consequential improvement in Japan's terms of trade and
concomitant decrease in the amount of wealth transferred to oil-producing countries, which will boost
private consumption in Japan by improving households' real income through higher corporate profits
and lower prices.2
III. Decision at the MPM in February
Based on the "New Framework for the Conduct of Monetary Policy" announced in March 2006, the
Bank examines future risks from two perspectives.
The first perspective examines the prospects as well as risks for the economy and prices basically
within a projection period of one and a half to two years. At the MPM held in February, it was judged
that Japan's economy "is likely to continue its moderate expansion with a virtuous circle of production,
income, and spending in place." It was also judged that although the year-on-year rate of change in
the CPI (excluding fresh food) may register around zero in the short run, depending, for example, on
developments in the prices of crude oil, it is likely to "increase as a trend" given the expected
continuation of the economic expansion.
The second perspective extends the horizon beyond that of the above forecasting period and takes
into account various risks that would significantly impact the economy should they materialize, even
though the probability of such materialization may be low. At the February MPM, it was noted that "[i]f
expectation takes hold . . . that interest rates will remain low for a long time regardless of economic
activity and prices, there is a possibility that sustained economic growth will be hampered by
misallocation of funds and resources through excess financial and economic activities."
Based on its assessments from these two perspectives, the Bank has decided to change the guideline
for its money market operations so as to encourage the uncollateralized overnight call rate to remain
at around 0.5 percent. At the same time, the basic loan rate applicable under the complementary
lending facility (the standby lending facility through which the Bank will extend a loan at the request of
a counterparty up to an amount not exceeding the value of that counterparty's collateral) was set at
0.75 percent. With respect to the outright purchases of long-term interest-bearing Japanese
government bonds, the Bank has decided that purchases will continue at the current amount and
frequency for some time.
With regard to the future course of monetary policy, the Bank stated that it will adjust the level of
interest rates gradually in the light of developments in economic activity and prices, while maintaining
the accommodative financial conditions ensuing from very low interest rates for some time.
IV. Thinking behind the conduct of monetary policy
It takes quite a while for the effects of a monetary policy change to filter through to the economy and
prices. Because of the long and variable lag length, the conduct of monetary policy needs to be
forward looking, based on the outlook for the economy and prices over a sufficiently long term.
Outlook for Economic Activity and Prices
The Bank releases the (the Outlook Report) semiannually, in
which it describes its forecast for the economy and prices over a horizon of one and a half to two
years. The Bank's conduct of monetary policy is based on this forecast. It has become a common
practice among central banks to conduct monetary policy based on published forecasts for economic
activity and prices.
The key point of a "forward-looking policy framework" is to conduct policy on the basis of a forecast of
the most likely outlook for the economy and prices, as well as identification of the accompanying
upside and downside risks, by conducting a careful analysis of incoming indicators and other relevant
data. Especially in cases where the implications of the available data are mixed, the accuracy of the
forecast should be carefully examined in making policy decisions. Coming to a decision through
painstaking examination of the available economic data and other relevant information, therefore, is
the basis of forward-looking monetary policy. Arguments that treat the assessment of available data
and the conduct of forward-looking monetary policy independently of each other are incompatible with
the basic reasoning behind the Bank's new policy framework.
Reviewing the forecasts presented in the October Outlook Report in January, it was judged that
Japan's economy and prices had so far deviated slightly below the outlook forecasts, but that
economic expansion was likely to continue under price stability. Although at the January MPM many
members said that they were not confident enough about the outlook to prescribe a policy change, at
the February MPM, after examining all available data, most Policy Board members were able to
reaffirm that the virtuous circle of production, income, and spending remained intact. This increased
their confidence in the outlook for economic activity and prices, and therefore the decision to raise the
target rate was taken.
In the "New Framework for the Conduct of Monetary Policy," it is stated that Policy Board members
will conduct monetary policy in the light of their understanding of what constitutes medium- to
longterm price stability. Taking account of the actual measurement bias in the CPI and Japan's history of
low inflation, an approximate range between 0 and 2 percent in terms of the year-on-year rate of
change in the CPI is generally consistent with the individual distributions given by Policy Board
members to describe their own understandings of medium- to long-term price stability.3 The range
includes 0 percent, but this does not mean that the Bank is conducting monetary policy to achieve
zero percent inflation. On the contrary, it should be noted that most Policy Board members' median
figures fell on one side or the other of 1 percent.
As I have stated earlier, the rate of change in the CPI may temporarily be around zero or even slightly
negative in the short run depending on developments in the prices of crude oil. Also, it is possible that
the sensitivity of prices to higher rates of domestic resource utilization may have been reduced due to
the progress of economic globalization. Meanwhile, a fall in crude oil prices may contribute to the
continuing economic expansion, since it would improve Japan's terms of trade, thus boosting real
wages and private consumption.
What is important in terms of the forward-looking monetary policy is the basic trend of inflation. Under
the assumption that overseas economies are to continue their expansion and that the growth
mechanism underpinning the domestic economy is firmly maintained, trend increases in the CPI are
likely to take hold in the long run, as the influence of declining crude oil prices fades. In any event, it is
important to make an effort to achieve price stability in the medium to long term based not on
shortterm fluctuations in prices but on forecasts for the economy and prices from a sufficiently long-term
perspective.
There has been criticism that dialogue between the Bank and financial markets has not been smooth.
Central banks need to carefully explain to market participants and the public the basic thinking behind
their monetary policy conduct and their assessment of the economic and financial situation. Through
careful explanation of these two points, not only will the transparency of monetary policy conduct be
ensured but the effectiveness of the policy will be enhanced.4
Market participants form expectations regarding future interest rates by adjusting their views on the
economy and prices on the basis of information provided by the central bank. Meanwhile, central
banks deduce market participants' views on the economy and prices from movements in market
interest rates or shifts in the yield curve. Dialogue with markets thus constitutes a two-way exchange
of information. The key point here is that central banks provide information concerning the basic
direction of monetary policy but do not specify the timing of an actual policy change.
At an MPM, the Policy Board members discuss the current and future state of the economy and prices
based on the latest data and information to have become available by the time of the meeting. It is
therefore impossible to inform markets of the timing of the policy change in advance. Even if it were
possible to do so, the result would be to deprive the Bank of the benefit of information that it could
have gleaned from markets. It is desirable that dialogue between the Bank and markets be left to take
place as free as possible from noise and distortion.