Toshihiko Fukui: The outlook for Japan's economy and the conduct of
monetary policy
Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai
meeting, Tokyo, 7 November 2006.
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Introduction
At the Monetary Policy Meetings at the end of April and October, the Policy Board of the Bank of
Japan approves the text of the Outlook for Economic Activity and Prices, or the Outlook Report as we
call it for short, and makes it public. Today, I would like to discuss the Bank's view on the current state
of and outlook for the domestic economy and overseas economies as well as the Bank's thinking
behind its conduct of monetary policy, with reference to the October 2006 Outlook Report, which was
released last week.
I. Developments in overseas economies
Let me first touch upon recent developments in the global economy.
In the United States, deceleration in the pace of economic expansion is becoming clearer, as seen, for
example, in the decrease in housing investment. However, business fixed investment and production
continue to increase, and the pace of deceleration in private consumption has been moderate so far.
Meanwhile, in the euro area, the momentum of economic recovery is becoming more evident. The
increases in production and the recovery in corporate profits observed so far have contributed to an
improvement in the employment situation and increases in business fixed investment. In China, strong
expansion in both domestic and external demand is continuing. The rate of growth in fixed asset
investment remains high, although the pace of growth has been slowing slightly as a result of
measures taken by the Chinese government and the People's Bank of China to contain the
overheating of the economy. Oil-producing countries, such as those of the Middle East, continue to
experience an economic boom supported partly by the significant improvement in the external balance
resulting from the rises in crude oil prices. Other emerging economies also continue to expand. Thus,
the global economy as a whole continues to expand strongly, with the slowing growth in the U.S.
economy being offset by high growth in other economies. The global economy is expected to continue
expanding steadily across a broader range of regions.
According to the International Monetary Fund (IMF), the global economy has registered high growth
rates of around 5 percent for two consecutive years: 5.3 percent in 2004 and 4.9 percent in 2005. The
global economy is expected to continue expanding at around the same pace, at 5.1 percent in 2006
and 4.9 percent in 2007. This is the first time since the early 1970s that the global economy has
registered and is expected to continue to register high growth of around 5 percent over a period of
some years. Looking at the growth rates of individual countries, the developed economies have not
necessarily been growing faster than in the past; rather, the countries contributing to the current high
growth are the emerging economies that have taken off, one after another, as economic globalization
progressed. These countries have increased their overall presence in the global economy and have
contributed greatly to the high global growth rate. Asian emerging economies in particular have
enjoyed high growth rates for many years, and their share in the global economy has increased so
much that they have become an engine of global economic growth. This is evident from the IMF's
latest projection of world economic growth, which was revised in September. Based on a substantial
upward revision of the growth projection for Asian emerging economies, the projected growth rate of
the world economy has been pushed up despite the downward revision of the growth projection for the
U.S. economy.
II. The current state of the Japanese economy
I would now like to turn to the current state of the Japanese economy.
The current phase of economic recovery began in January 2002. In November, it will have lasted for
Izanagi
four years and ten months, exceeding the boom, the longest postwar economic expansion (57
months during 1965-70).
Looking at recent economic developments, exports have continued to increase against the
background of the expansion of overseas economies, which I have just outlined. By destination,
exports to the United States have maintained their steady growth as a whole, although growth in
automobile-related goods has slowed somewhat. Exports to Europe and East Asia have continued
their solid increases, and those to other regions, particularly the oil-producing countries, have
registered high growth.
Corporate profits have been high despite the surge in prices of raw materials such as crude oil. Large
manufacturing firms in particular have made successive upward revisions to their profit estimates due
to the increase in exports coupled with the depreciation of the yen. In this situation, business
sentiment remains favorable and business fixed investment continues to increase. According to the
Tankan
September (Short-term Economic Survey of Enterprises in Japan) conducted by the Bank's
Research and Statistics Department, if firms' business plans for fiscal 2006 are realized, current profits
will register growth for the fifth consecutive year (since 2002), and business fixed investment will
record an increase for the fourth consecutive year (since 2003).
The current strong business fixed investment continues to be led by the manufacturing sector,
although nonmanufacturers as well as small firms have started to step up their fixed investment. The
acceleration in business fixed investment reflects the fact that firms are seeking to reinforce their
capacity to supply goods and services by increasing capital equipment as they look to capture profit
opportunities in overseas markets. In the 1990s, when Japan was undergoing severe adjustments
after the bursting of the bubble economy, there was a view that the increasing supply capacity of
emerging economies was a threat that would deprive Japanese workers of job opportunities. This
view, however, is one-sided, and the rapid development of emerging economies has in fact been
playing a significant role in establishing the foundation of Japan's economic development toward a
new era. It is very beneficial to the development of Japan's economy that Japan and emerging
economies - especially strongly growing Asian emerging economies - have established a new system
of international division of the production process and interdependent relations in a constructive
manner.
For example, goods requiring a relatively high degree of processing, such as IT-related machinery,
have been gradually increasing their share in Japan's imports from other Asian economies, replacing
labor-intensive goods, such as clothing and other light manufactured goods. This is mainly because
Japan's direct investment in other Asian economies has been increasing as Japanese firms optimize
their production processes. As a result of the creation of production bases and employment
opportunities with the increased direct investment, Asian economies have been increasing their
presence in the global economy, not only as global suppliers but also as markets with high growth
potential. Asian economies are becoming one of the driving forces of the ongoing expansion of the
global economy, and this in turn is spurring Japan's exports.
One of the notable characteristics of the current recovery phase of Japan's economy is that many
Japanese firms continue to scrutinize investment profitability. They are not only increasing investment
to boost production capacity but also accelerating the replacement of obsolete capital equipment to
improve efficiency. Such corporate behavior can be interpreted as reflecting the fact that the
management of firms, amid intensifying global competition and greater exposure to the discipline of
the capital market, is becoming more attentive to increasing corporate value.
The positive influence of the strength in the corporate sector has fed steadily through to the household
sector, albeit at a moderate pace. Labor market conditions have been tightening as the ratio of job
offers to applicants has increased and the unemployment rate has been on a downtrend. The number
of employees has been increasing steadily, partly due to the recovery in the hiring of new graduates.
Yet, even in this situation, wage increases have remained moderate so far. We believe that this is
because, while employers continue to restrain labor costs, employees, having experienced a severe
employment situation, continue to prefer stable employment to a wage increase.
However, further tightening of labor market conditions seems inevitable if the number of employees
continues to increase when growth in the labor force levels off. For example, wages of part-time and
temporary workers have already started to increase and large firms are planning to increase
significantly the number of employees, including regular employees. In this environment, the pattern of
behavior of employers and employees is likely to change gradually, and upward pressure on wages,
including regular payments, is expected to strengthen accordingly. Sales at department stores and
supermarkets were relatively sluggish from spring to around July, partly due to the unfavorable
weather conditions, but picked up in August and September. Sales of electrical appliances and outlays
for services have continued to be favorable. Given that changes in regular payments are usually
considered to constitute changes in permanent income, an increase in regular payments is likely to
ensure a sustainable rise in private consumption, especially spending on durable goods and services.
In sum, Japan's economy has been expanding moderately with a virtuous circle of production, income,
and spending in operation. The current recovery has certainly been driven strongly by expansion in
external demand, but it is not accurate to say that the recovery has been brought about by external
demand alone.
Against this background of the ongoing economic expansion, the environment surrounding prices has
been gradually changing. First, the utilization of resources such as production capacity and labor has
been rising. According to the Tankan, the perception among firms of having excess production
capacity has dissipated for the first time in more than a decade. In terms of employment, firms are
increasingly feeling a shortage of labor due to improving labor market conditions. An estimate of the
output gap, which represents the difference between aggregate demand and potential aggregate
output in the economy, suggests that the conditions of persistent excess supply have been dispersed
and the output gap seems to have become positive. Second, wages are rising, albeit moderately, as
labor market conditions are improving and firms are feeling a shortage of labor in a relatively wide
range of industries. In contrast, unit labor costs, that is, the labor costs incurred to produce one unit of
product, are still decreasing due to the increase in productivity, but the pace of decrease has clearly
slowed, reflecting the moderate uptrend in wages. And third, as suggested by various survey results,
inflation expectations of firms and households are shifting up. The September Tankan showed that an
increasing number of firms in a wide range of industries answered that their output prices had risen
compared with three months ago. Retailers are considered to have a strong influence on consumer
prices, and the number of retailers expecting a rise in output prices exceeded the number expecting a
fall. According to the most recent issue of the Opinion Survey on the General Public's Views and
Behavior, which is conducted by the Bank's Public Relations Department and covers a nationwide
sample of 4,000 individuals, about 60 percent of respondents felt that prices had risen from a year
earlier, and about 80 percent of respondents expected prices to rise in the one-year period ahead.
III. The Bank's outlook for economic activity and prices
In the April Outlook Report, the Bank presented the projection that, from fiscal 2006 through fiscal
2007, Japan's economy was likely to experience a sustained period of expansion, with the positive
influence of the strength in the corporate sector feeding through into the household sector and the
corporate and household sectors well in balance. Comparing the recent developments in economic
activity and prices to the April projection, developments in the corporate sector have been somewhat
stronger, as evidenced in corporate profits and business fixed investment, while those in the
household sector have been somewhat weaker, as evidenced in wages and private consumption. On
the whole, however, economic developments have generally been in line with the April projection.
Given these developments, the Bank, in the October Outlook Report, projected that economic
developments in the near future are likely to follow in general the path projected in the April Outlook
Report. That is, from the second half of fiscal 2006 through fiscal 2007, the economy is likely to
experience a sustained period of expansion, with domestic and external demand increasing and the
positive influence of the strength in the corporate sector feeding through into the household sector. As
the economic expansion lengthens and matures, growth in business fixed investment is likely to
moderate. As a result, the economic growth rate is likely to slow gradually from around 2.5 percent for
fiscal 2006 to around 2 percent for fiscal 2007, approaching the potential growth rate.
On the price front, the domestic corporate goods price index has been exceeding the April projection,
mainly reflecting the rises in crude oil and other international commodity prices. The index is likely to
continue to be on an uptrend, although the projection is subject to developments in crude oil and other
commodity prices and foreign exchange rates. The year-on-year increase in the consumer price index
(CPI; excluding fresh food, on a nationwide basis) is likely to gradually rise from the 0.0-0.5 percent
range in fiscal 2006 to around 0.5 percent in fiscal 2007.
The CPI was rebased in August 2006, with the base year being changed to 2005 from 2000, and
yearon-year figures as far back as January 2006 were revised retroactively. Accordingly, the Bank used
the 2005-base CPI in the October Outlook Report while it used the 2000-base CPI in the April Outlook
Report. At the time of the April Outlook Report, the Bank estimated that the extent of the negative
divergence caused by the rebasing was likely to be slightly less than 0.3 percentage point,
approximately the same as that at the previous rebasing of the CPI from the 1995 base to the 2000
base. In fact, the negative divergence turned out to be greater, around 0.5 percentage point on
average during January and July 2006, but this was due to the effects of changes in the calculation of
indices for existing items in the CPI basket, such as mobile telephone charges. Since such effects
disappear after the first year, the divergence is likely to be reduced. Thus, the basic view on the CPI in
the current projection remains the same as that in the April projection, which used the 2000-base CPI,
and the Bank's projection that the year-on-year increase in the CPI is likely to gradually rise continues
to be valid as the Bank's main scenario.
IV. Factors causing positive and negative deviations in economic activity
Economic activity has so far been generally in line with the April projection. However, any kind of
projection is subject to upside and downside risks. It should be noted that the following factors could
cause positive and negative deviations from the baseline projection of economic activity.
The first risk concerns the growth path of the global economy.
The latest outlook is based on the following environment surrounding exports: although the pace of
expansion in the U.S. economy has been decelerating recently, the economy is likely to realize a soft
landing and to move toward sustainable growth; and overseas economies as a whole are likely to
keep expanding across a broader range of regions. These views are generally comparable with the
IMF's World Economic Outlook and forecasts by other international organizations and private research
institutes. Global economic growth is likely to remain robust even with a modest slowdown in the U.S.
economy, as the growth of emerging economies has increasingly become self-sustained. Recent
developments in Japan's exports show that goods, particularly capital goods and automobiles, in
which Japanese firms have a competitive edge, are being exported to an increasing number of
countries. According to the September Tankan, firms perceived overseas demand for Japanese
products as exceeding supply in the current period and continuing to do so in the future. This implies
that at this point firms do not feel that the slowdown in U.S. economic growth will substantially affect
overseas demand for Japanese products.
However, if a greater-than-expected downward adjustment in housing prices occurs in the United
States, it may lead to lower growth rates in the U.S. economy via, for example, a deceleration of
growth in private consumption. If the pace of U.S. economic growth decelerates unexpectedly,
adjustment pressure may build up in the IT-related sector. Global demand for IT-related goods has so
far been on a steady uptrend due partly to the rapid growth in emerging economies, such as the BRIC
economies (Brazil, Russia, India, and China). However, the pace of global increase in the supply of
ITrelated goods has also been rapid, and thus if downside risks to the outlook of the U.S. economy
materialize, the balance between supply and demand of IT-related goods may be disturbed. In
addition, inflation expectations may rise, if the U.S. economy does not slow considerably in a situation
where resource utilization, namely in production capacity and labor, is high. One of the factors
supporting the sustained expansion of the global economy is the continuing stable financial conditions
and generally subdued inflationary pressures due at least in part to the appropriate conduct of
monetary policy in countries around the world. Any changes to the picture may adversely affect the
global economy, and be accompanied by shifts in international capital flows and repricing in financial
markets. With the fall in crude oil prices, it is becoming increasingly likely that inflation pressures in the
United States will gradually ease as economic growth decelerates moderately. However, risks in the
United States of a slowdown in economic growth or an acceleration in the inflation rate still require
attention because if either occurs, the impact on the global economy will be large.
In the euro area, the European Central Bank has been raising its policy interest rate amid appreciation
of the euro, and the sustainability of economic recovery should be watched carefully. In Germany,
fullscale fiscal consolidation has started; for example, the value-added tax rate will be raised from
January 1, 2007, and such measures may place downward pressure on the economy in the short
term. In China, the economy continues to expand strongly, and there is a possibility that this growth
will accelerate during the projection period, influenced by developments in fixed asset investments and
exports. Even though administrative measures will probably help to contain the rise in the growth rate
of investment for some time, the risk of a further acceleration of the economy and subsequent
repercussions cannot be ruled out, since the financial environment continues to be accommodative.
Global economic developments may also be influenced by international commodity prices, such as
crude oil prices, depending on their future movements.
The second risk is a further acceleration of business fixed investment.
Although firms, especially manufacturers, have been stepping up their business fixed investment, an
excessive build-up of capital stock has not so far been observed in the economy overall. Since firms
are very careful in choosing their investment projects, business fixed investment as a whole has,
despite recent acceleration, generally been kept within cash flow and the pace of increase in capital
stock is moderate. In evaluating whether the growth in capital stock is excessive or not, developments
not only in the moderately growing domestic market but also in strongly growing overseas markets
need to be taken into account.
With the economy continuing to expand moderately, financial conditions remain extremely
accommodative. Short-term interest rates have been very low relative to the state of economic activity
and prices. The yen has been depreciating against other major currencies. The real effective
exchange rate is currently as low as that recorded in the period immediately after the conclusion of the
Plaza Accord in 1985. Given such extremely accommodative financial conditions, firms may further
accelerate investment based on optimistic assumptions of future profitability, such as favorable
expectations regarding the growth rate, financing costs, and foreign exchange rates. Such
acceleration may push up overall growth in the short run, but may lead in turn to an excessive build-up
of capital stock that could precipitate an economic slowdown.
The upturn in land prices, particularly in major cities, is becoming more broad-based. Such a recovery
in land prices basically indicates that people's view on future economic activity has improved and they
are increasingly expecting higher returns from investment in real estate projects. There seems no
need at present to be concerned about possible excessive rises in land prices, but a rise in asset
prices is likely to push up private demand.
V. Factors causing positive and negative deviations in prices
Regarding the outlook for prices, attention needs to be paid to factors that may cause prices to deviate
either upward or downward from the projection. Developments in the prices of crude oil and other
commodities are an example of such factors. Another important factor is to what extent consumer
prices will change in response to economic developments, especially changes in the output gap.
Turning to the outlook for the CPI, the year-on-year rate of increase is expected to rise gradually,
reflecting increasing upward pressure on wages and the moderate widening expected in the positive
output gap. This outlook, however, assumes that the rate of increase in the CPI will not noticeably
accelerate, since it takes into account the possibility that prices may be less sensitive to changes in
the output gap than in the past.
This decline in sensitivity is attributable to deregulation, advances in information and communication
technology, the robust global economic growth, and economic globalization reflecting such growth. For
example, if competition between domestic goods and imported goods from emerging economies
intensifies, upward pressure on prices may be contained even when the domestic output gap turns
positive. Likewise, if intensifying global competition is pushing firms to raise corporate value, upward
pressure on prices may be contained as firms try to increase wage restraint despite tight labor market
conditions and to raise productivity.
The sensitivity of prices to changes in the output gap, however, may be subject to substantial variation
as it differs depending on how it is influenced by deregulation, advances in information and
communication technology, and economic globalization. If sensitivity to the output gap is not as weak
as assumed, prices may rise more than expected. Similarly, even if prices are less sensitive to
changes in the output gap in the short term, the rate of wage and price increases might accelerate at
some point accompanied by an increase in inflation expectations. On the other hand, if the sensitivity
of prices to the output gap is weaker than assumed, prices will not respond even if economic activity is
stronger than expected. Our projection assumes that as the economic expansion lengthens,
productivity increases will slow and wages will rise. However, if the pattern of employers' and
employees' behavior that I mentioned - firms maintain their restraint on labor costs, while employees
continue to prefer stable employment to a wage increase - persists for longer than expected and rises
in wages lag behind, upward pressure on prices may continue to be contained.
Changes in prices of international commodities, such as crude oil, also affect price developments.
Crude oil prices had declined after posting a record high in the summer, but they are still at a high
level. They may either surge or plunge in the future depending on, for example, developments in
geopolitical risks.
VI. Conduct of monetary policy
I would now like to turn to the Bank's conduct of monetary policy, based on the outlook for economic
activity and prices.
In March 2006, when the quantitative monetary policy implemented in 2001 was terminated, the Bank
introduced the "New Framework for the Conduct of Monetary Policy," with the aim of ensuring the
transparency of monetary policy from a relatively long-term viewpoint. In line with the new framework,
the Bank assesses economic activity and prices from two perspectives, taking account of the
"understanding of medium- to long-term price stability," which is expressed as approximately 0 to 2
percent in terms of the year-on-year rate of change in the CPI, and outlines and makes public its view
on the future course of monetary policy.
The Bank's assessment from the first perspective, which is the outlook that it deems most likely for
economic activity and prices through fiscal 2007, is that Japan's economy is likely to continue
expanding with domestic and external demand increasing and that the year-on-year rate of increase in
the CPI (excluding fresh food, on a nationwide basis) is expected to rise gradually through fiscal 2007,
as the level of excess demand in the economy (the positive output gap) is increasing at a moderate
pace and downward pressure from declining unit labor costs is weakening. In sum, Japan's economy
is likely to achieve sustainable growth under price stability. This outlook is based on the assumption
that market participants and firms have, to some extent, factored future changes in monetary policy
into their decisions. Therefore, for economic activity and prices to develop in line with the above
outlook, adjustment in the level of the policy interest rate seems necessary.
The assessment from the second perspective - in which the Bank assesses the risks considered most
relevant to conducting monetary policy, looking over a longer time horizon and taking account of the
cost incurred should risks materialize, however improbable they might be - is that although at present
there seem to be no signs of overinvestment, the stimulative effect of monetary policy on economic
activity and prices may be amplified with corporate profitability high and prices on a positive trend. For
instance, if the expectation takes hold that interest rates will remain low for a long time regardless of
economic activity and prices, there is a risk in the medium to long term of larger economic swings,
resulting in large fluctuations in the rate of inflation, channeled, for example, via financial behavior and
investment activity.
Meanwhile, depending on future developments, the economic expansion and rising prices may stall.
However, Japan's economy seems more resilient to such shocks, since the financial system has
regained stability and the economy has now cast off excesses in production capacity, employment,
and debt. In fact, the economy recovered its momentum shortly after entering a soft patch due to
adjustments in IT-related industries in the summer of 2004. Unlike in the past, the risk of the economy
falling into a vicious circle of declining prices and deteriorating economic activity seems small, even if
the economic expansion and rising prices stall.
With regard to the future course of monetary policy, as a result of the assessment of economic activity
and prices from the two perspectives, it seems appropriate to 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.
Such an adjustment in the policy interest rate, in our view, will contribute to ensuring price stability and
achieving sustainable economic growth in the medium to long term. Should a large disturbance in the
price and economic situation occur, a drastic policy change may become necessary, which would
potentially carry the danger of causing large economic swings. In order to avoid this happening, it is
important for the Bank to take a forward-looking approach in its conduct of monetary policy. Such
forward-looking policy is not intended to stifle growth potential, but rather to steer the economy toward
a sustained period of expansion. As I have emphasized repeatedly, the Bank does not have a
predetermined view regarding a future increase in the policy interest rate. The Bank will adjust the
level of interest rates gradually, carefully assessing economic activity and prices.
Conclusion
Under the new framework for the conduct of monetary policy, it is very important for the Bank to
carefully explain its assessment of the state of the economy and financial developments and its
thinking regarding the conduct of monetary policy. The Bank has been communicating with the public
through, for example, the Outlook Report, the minutes of Monetary Policy Meetings, the Monthly
Report of Recent Economic and Financial
Developments, press conferences and speeches, and by
enriching the content of its web site. In July this year when the Bank brought the zero interest rate
environment to an end after five years, financial markets remained calm, a fact that has been lauded
by overseas central banks and international organizations. The calm response of financial markets can
be regarded as evidence that the Bank's message to market participants was well understood and the
new framework for the conduct of monetary policy functioned effectively in communicating with market
participants. Ensuring transparency with the new framework is important not only in terms of better
communication with market participants, but also in terms of increasing the effectiveness of monetary
policy. The Bank will continue to conduct monetary policy appropriately and to contribute to achieving
sustainable economic growth under price stability.