Kikuo Iwata: Japan's economy and monetary policy
Speech by Mr Kikuo Iwata, Deputy Governor of the Bank of Japan, at a meeting with
business leaders, Okayama, 2 December 2015.
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Accompanying charts can be found at the end of the speech and on the Bank of Japan's website.
Introduction
It is my pleasure to have the opportunity today to exchange views with administrative,
financial, and business leaders in Okayama Prefecture. I would like to take this chance to
express my sincerest gratitude for your cooperation with the activities of the Bank of Japan's
Okayama Branch.
Today, I would like to have your views on the actual situation of the local economy as well as
your candid opinions about the Bank's policies and activities.
Before exchanging views with you, I will briefly explain the recent economic developments at
home and abroad, and then touch on some points regarding monetary policy.
I. The current situation of Japan's economy and its outlook
Looking at Japan's economy, exports and production are affected by the slowdown in
emerging economies, particularly China. However, with firms having seen record profits, a
virtuous cycle from income to spending in both the corporate and household sectors is in
place, and Japan's economy has continued to recover moderately. In the following, I would
like to elaborate on this issue.
A. Developments in exports and overseas economies
Japan's exports have been more or less flat recently (Chart 1). Breaking these down by
region, exports to advanced economies such as the United States and Europe have
maintained their moderate increasing trend, but those to emerging economies have shown
weaker developments, particularly to East Asia. The background to this is that the
decelerated situation for the Chinese economy is continuing with downward pressure from
excess capacity and inventory adjustments in the manufacturing sector, and that the effects
of the Chinese economy have been spreading to other emerging and commodity-exporting
economies through trade. In this situation, Japan's production also has been more or less
flat.
As for the outlook for overseas economies, it is likely that the effects of the slowdown in
emerging economies will remain for the time being, but that moderate growth, mainly in
advanced economies, will continue, and this will positively affect emerging economies. The
Chinese economy is expected to generally follow a stable growth path with a variety of
economic stimulus measures being implemented. As shown in the October 2015 World
Economic Outlook (WEO) published by the International Monetary Fund (IMF), global growth
for this year is projected to decline somewhat to 3.1 percent, but for 2016, it is projected to
moderately accelerate on the whole and register 3.6 percent (Chart 2).
In this situation, Japan's exports and production are expected to remain more or less flat for
the time being, but after that they are likely to increase moderately. Nevertheless, taking
account of the decline in growth expectations for and excess capacity in emerging and
commodity-exporting economies, risks for the time being seem to continue to skew to the
downside, and this warrants close attention.
B. Developments in domestic private demand
Despite the lackluster developments in exports and production I have outlined, corporate
profits are at record high levels (Chart 3). The improvement in corporate profits is partly due
to a fall in commodity prices - particularly crude oil prices - and to the rise in repatriated
income from overseas business through dividends and interest, which has accelerated partly
as a result of the correction of excessive appreciation of the yen.
In addition, what can be pointed out as a characteristic of the recent economic recovery is
the fact that the recovery of the nonmanufacturing sector has been marked on the back of
the resilience in domestic demand. In the past economic recoveries, the general course of
events was an increase in exports leading to a rise in production and rises in corporate
profits and business fixed investment in the manufacturing sector; this time, however,
different developments are being seen. According to the September Tankan (Short-Term
Economic Survey of Enterprises in Japan), the diffusion index for business conditions in the
nonmanufacturing sector improved to a level exceeding that seen during the economic
recovery period in the mid-2000s, while some cautiousness has been observed in the
manufacturing sector.
An improvement in corporate profits is producing a virtuous cycle that is spreading to
domestic private demand through the corporate and household sectors. First, the corporate
sector is maintaining its positive fixed investment stance. This can be confirmed by the high
year-on-year rate of growth in fixed investment plans for all enterprises and industries for
fiscal 2015; namely, 6.4 percent, as shown in the September Tankan.
Turning to the household sector, the employment and income situation has been improving
steadily. Labor market conditions have continued to tighten and the active job
openings-toapplicants ratio is at a high level last seen in 1992. The unemployment rate for October has
declined to 3.1 percent, a low level last seen in 1995.
Under this circumstance, upward pressure is being exerted on wages. Scheduled cash
earnings in the Monthly Labour Survey have been positive on a year-on-year basis for three
consecutive quarters since the turn of the year, with base pay being raised for two years in a
row (Chart 4). Private consumption has been resilient, as evidenced by a clear increase on a
quarter-on-quarter basis for the July-September quarter against the background of steady
improvement in the employment and income situation.
That said, a virtuous cycle in both the corporate and household sectors has been maintained
in Japan's economy. The real GDP growth rate for the July-September quarter was slightly
negative for a second consecutive quarter, but this is mainly due to the progress in inventory
adjustments, and final demand as a whole has been increasing. Turing to the outlook,
Japan's economy through fiscal 2016 is likely to continue growing at a pace above its
potential, which is estimated to be around 0.5 percent or lower recently. As shown in the
Outlook for Economic Activity and Prices (hereafter the Outlook Report) released at the end
of October, the outlook in terms of the median of the Policy Board members' forecasts of the
real GDP growth rate was 1.2 percent for fiscal 2015 and 1.4 percent for fiscal 2016.
II. Monetary policy and price developments in Japan
As I have explained, Japan's economy is likely to continue growing at a pace above its
potential. In this situation, how are prices expected to develop? Next, I would like to talk
about price developments in Japan after touching on the Bank's monetary policy.
A. Change in policy regime
The Bank is implementing quantitative and qualitative monetary easing (QQE) that aims at
converting people's deflationary mindset, which has been formed firmly amid the prolonged
period of deflation, to one that moderate inflation is to be expected. That is, it is preparing a
foundation on which people can act on the assumption that prices will continue to rise
moderately.
QQE consists of two pillars. The first is a clear commitment under which the Bank will
achieve the price stability target of 2 percent in terms of the year-on-year rate of change in
the consumer price index (CPI) at the earliest possible time, with a time horizon of about two
years.
The second pillar is the Bank's thorough communication of its measures and implementation
of them to achieve the price stability target. These measures are to massively increase the
"quantity" of the monetary base through the Bank's large-scale asset purchases - mainly the
purchase of Japanese government bonds (JGBs) - and to change the "quality" of its asset
purchases, mainly through the purchase of long-term government bonds that entail relatively
large risks (Chart 5).
By pursuing QQE, the Bank aims at decreasing expected real interest rates through exerting
downward pressure on nominal interest rates across a wide range of maturities and raising
peoples' inflation expectations toward 2 percent (Chart 6). The decline in expected real
interest rates will lead to a rise in prices of risky assets such as equities and hence to an
increase in private consumption through the wealth effect. In addition, with the excessive
appreciation of the yen being corrected, real exports have increased, albeit moderately, and
exporting companies' earnings have improved, due partly to an improvement in profitability.
In this situation, the number of foreign visitors to Japan has also increased noticeably.
Moreover, households and firms, which have devoted their efforts to increase their savings,
are expected to expand housing investment or business fixed investment in view of the
decline in expected real interest rates and the improvement in their income and financial
conditions.
As illustrated above, QQE aims at raising the observed inflation rate toward 2 percent by
increasing aggregate demand through several transmission channels in which its effects start
with the decline in expected real interest rates brought about by the drastic change in the
policy regime.
B. Developments in the underlying trend in inflation
In the Bank's current outlook for prices, the timing in which the year-on-year rate of change in
the CPI (all items less fresh food) reaches around 2 percent is projected to be around the
second half of fiscal 2016. Comparing the current projection to the previous one, the timing is
likely to be delayed. That said, the delay is mainly due to the effects of the decline in crude
oil prices, and the underlying trend in inflation itself can be judged to be improving steadily as
the transmission mechanism of policy effects has worked as expected. Here, I would like to
discuss developments in the underlying trend in inflation from the following three
perspectives: (1) those in consumer prices; (2) those in the output gap, which is a gap
between aggregate demand and supply capacity of the economy as a whole; and (3) those in
medium- to long-term inflation expectations.
1. Developments in consumer prices
To begin with, let me talk about developments in consumer prices. The year-on-year rate of
change in the CPI for all items less fresh food has been about 0 percent recently. However,
in the case where crude oil prices decline by about 50 percent in a short period, as they did
for some months starting from last summer, the CPI excluding fresh food and energy
(hereafter, the CPI excluding energy) becomes a more important indicator in assessing the
underlying trend in inflation.
To verify this point, I would like to break down the year-on-year rate of change in the CPI for
all items less fresh food (hereafter, the CPI including energy) into two components: the
contribution of energy items and the contribution of the CPI excluding energy (Chart 7).
Until the introduction of QQE, the year-on-year rate of change in the CPI including energy
had mostly been hovering within slightly negative territory, with a positive contribution of
energy items being offset by a negative contribution of the CPI excluding energy. This means
that, if price developments had been assessed on the basis of the CPI excluding energy
instead of the CPI including energy, they should have been judged as being deeper in
deflation.
By contrast, after the introduction of QQE, the negative contribution of the CPI excluding
energy started to lessen. Its contribution turned positive in early autumn 2013 and moved
further into positive territory until around April 2014 when the consumption tax rate was
raised. During the same period, with the positive contribution of energy items, the
year-onyear rate of change in the CPI including energy - excluding the direct effects of the
consumption tax hike - also continued to rise and reached 1.5 percent in April 2014. In other
words, annual CPI inflation had continued to rise steadily toward 2 percent from the
introduction of QQE until around April 2014 when the consumption tax rate was raised.
Thereafter, until early 2015, partly due to the effects of the consumption tax hike, the positive
contribution of the CPI excluding energy - and also excluding the direct effects of the
consumption tax hike - shrank. Moreover, since around the summer of 2014, a substantial
decline in crude oil prices has become a factor that decreases the year-on-year rate of
increase in the CPI. In light of these developments, the Bank decided at the end of October
2014 to expand QQE in order to preempt manifestation of a risk that conversion of the
deflationary mindset might be delayed and to maintain the improving momentum of
expectation formation.
Looking at the developments after the expansion of QQE, the positive contribution in the CPI
excluding energy stopped decreasing in early 2015 and then resumed an uptrend. The
positive contribution has been about 1 percentage point recently, thus marking the largest
size since the introduction of QQE. During the same period, the year-on-year rate of change
in the CPI including energy has declined, which can be attributed mainly to an increase in the
negative contribution of energy items.
Given these developments, it can be judged that the underlying trend in inflation, which was
on the verge of returning to deflation due to the consumption tax hike, has come back since
the turn of 2015 on a rising path toward 2 percent thanks to the effects of the expansion of
QQE.
2. Output gap
Next, I would like to talk about developments in the output gap, which can be defined as a
gap between the aggregate demand and supply capacity of Japan's economy. In short, the
output gap is likely to improve steadily against the backdrop of an expansion of demand such
as business fixed investment and private consumption.
With regard to business fixed investment, as I have explained, surveys including the Tankan
suggest that firms' fixed investment plans for fiscal 2015 have been at high levels. Although
firms' actual fixed investment has been somewhat weaker than planned so far, possibly in
view of high uncertainty over prospects regarding the slowdown in emerging economies, for
example, it is expected to take place firmly sometime soon.
With regard to private consumption, the employment and income situation is the key. On this
point, labor market conditions have continued to tighten, as I have mentioned, and a rise in
wages has started to spread across industries and by size of firms. Looking ahead, reflecting
historical high corporate profits and the tight labor market, wages are expected to gradually
rise further, which will underpin resilience in private consumption.
Therefore, increases in business fixed investment and private consumption are likely to lead
to an improvement in the output gap and thereby push up prices moderately. Such a virtuous
cycle is likely to become more evident going forward.
On this point, looking at the recent developments in fixed investment and wages in relation to
corporate profits, it is true that these give the impression that the paces of increase in fixed
investment and wages were still relatively slow when considering that firms have been
making record profits (Chart 8). However, this situation has started to change as the output
gap has continued to improve moderately and is expected to turn to excess demand.
3. Medium- to long-term inflation expectations
Lastly, I would like to talk about inflation expectations. Looking from a somewhat longer-term
perspective at results of various surveys such as those conducted of firms and households,
these expectations started to increase around the introduction of QQE (Chart 9). Although
there are some indicators that show relatively weak developments recently, firms'
pricesetting behavior clearly has changed, particularly since the start of this fiscal year. Firms'
price-hiking behavior has become widespread and sustained. Looking ahead, as the
observed inflation rate rises toward 2 percent, which itself will push up inflation expectations,
medium- to long-term inflation expectations are also likely to rise toward 2 percent.
As I have explained, an examination of all three developments - namely, those in the CPI,
the output gap, and inflation expectations - confirms that the underlying trend in inflation has
been improving steadily toward achieving the price stability target of 2 percent. On this basis,
the year-on-year rate of increase in the CPI including energy is projected to reach around
2 percent around the second half of fiscal 2016, taking into account such developments as
those in crude oil futures prices.
Of course, in reality, there are various uncertainties in the global economy. The most
significant risk at this moment is that a further slowdown in the emerging economies,
particularly China, and commodity-exporting economies will exert negative effects on Japan's
economy, which will exert downward pressure to the underlying trend in inflation. As for the
future monetary policy management, if the manifestation of such risk leads to a deterioration
of the underlying trend in inflation, the Bank will make adjustments without hesitation.
Concluding remarks
In conclusion, let me touch on the economy of Okayama Prefecture.
The prefecture is privileged not only for being a transport node that connects the Chugoku
and Shikoku regions, but also for experiencing natural disasters less frequently than others;
industries taking advantage of this geography have been underpinning the economy of the
prefecture through the ages.
Specifically, many factories of iron and steel products, motor vehicles, and chemical products
are located in Okayama Prefecture, and Mizushima Coastal Industrial Area in particular, and
about 30 percent of gross product in the prefecture is by manufacturers.
Nonmanufacturers saw consecutive construction starts of large distribution centers covering
the whole of the Chugoku and Shikoku regions making use of the highway network, and the
floor area of warehouses has increased by slightly less than 20 percent in the last ten years.
Initiatives to start up new businesses have been observed in sectors with growth potential;
for example, in Maniwa City, which is located in the north of the prefecture, a biomass power
station - using timber from forest thinning for fuel - co-funded by local businesses has
started to operate in April this year.
Moreover, Okayama Prefecture is endowed with tourist attractions such as Korakuen, the
Kurashiki Bikan historical quarter, and the Shizutani School. I have heard that these are
attracting many visitors within Japan and from abroad. Last month, the first Okayama
marathon was held in Okayama City and many people from all over Japan have participated
in it. In May next year, the Summit Education Minister's Meeting will be held in Kurashiki City.
Through these opportunities, I hope the fascination with Okayama Prefecture will further
expand within Japan and to abroad.
I believe people in Okayama Prefecture have already been tackling new challenges while
fully exploiting the inherited merits of geographical conditions and rich tourism resources. I
would like to encourage the staff at the Okayama Branch to contribute to these
developments in this region through their analysis of the regional economy and
dissemination of information.
In closing, I wish you all the best for the further development of the regional economy.
Thank you.

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