Haruhiko Kuroda: Moving forward - Japan's economy under Quantitative
and Qualitative Monetary Easing
Speech by Mr Haruhiko Kuroda, Governor of the Bank of Japan, at the Japan Society, New
York City, 26 August 2015.
* * *
Accompanying charts can be found at the end of the speech or on the Bank of Japan's website.
Introduction
It is a great honor to be invited to speak at the Japan Society today.
More than two years have passed since the Bank of Japan introduced Quantitative and
Qualitative Monetary Easing (QQE) to achieve the price stability target of 2 percent. Let me
briefly look back at these two years. In the first year, Japan's economy improved
impressively, registering both rising growth and inflation. Real GDP growth in fiscal 2013
exceeded 2 percent and annual CPI inflation (consumer price index, all items less fresh food)
increased from minus 0.5 percent just before the introduction of QQE to 1.5 percent in April
2014 (Chart 1).
In contrast, in fiscal 2014, the second year after the introduction of QQE, Japan's economic
performance was a little disappointing. One reason is that the negative impact of the
consumption tax hike in April 2014 was larger than expected. The tax hike brought about
swings in demand and a decrease in real income, both of which resulted in sluggish private
consumption, in particular of durable goods such as automobiles. On the inflation front, crude
oil prices declined substantially from the beginning of autumn. Although the oil price decline
should have a favorable impact on economic activity in the longer term, in the short term it
has a downward impact on inflation through the decline in energy prices such as gasoline
and electricity prices. As a result, annual CPI inflation rapidly declined toward the end of last
year and has been about 0 percent this year so far.
Against this background, it is not surprising that some wonder whether the Bank's price
stability target of 2 percent can really be achieved. Has the trend toward overcoming
deflation come to an end? This is far from the case.
What I would most like to stress here is that the two factors - the consumption tax hike and
the substantial decline in oil prices - only temporally have a downward impact on inflation.
The growth and inflation figures were strongly affected by these factors and were indeed
disappointing, but if we take a closer look at the underlying trends, we find that significant
changes that were not observed during the deflationary period are taking place.
Let me highlight two of these changes. The first is that Japanese firms are seeing record
profits and their investment stance has become increasingly positive. The other change is
that wages have clearly risen for the first time in two decades, reflecting that the tight labor
market has brought about "full employment" - that is, a situation in which, from a statistical
perspective, there is no unemployment other than that due to the frictional mismatch
between job openings and job applicants.
What I would like to focus on today are the remarkable changes that have been taking place
in Japan's economy during the past two years under QQE. I would also like to review the
transmission mechanism of QQE and how QQE has brought about those changes. I believe
that at the end of my speech you will share our outlook for Japan's economy.
I. Changes in Japan's economy
Record profits and firms' positive investment stance
I would like to start by touching on the improvement in the corporate sector. As I mentioned,
Japanese firms have been making record profits. In fact, their profits have considerably
exceeded those around 1990 at the peak of the bubble economy (Chart 2).
Let me briefly review what has happened in Japan's economy over the past several years.
Japan's economy was hit much harder than the U.S. economy by the global financial crisis
triggered by the failure of Lehman Brothers in 2008, even though the United States had been
the epicenter of the crisis caused by subprime mortgages. In fiscal 2008, industrial
production in Japan fell by more than 10 percent and real GDP contracted by about
4 percent. There were a number of reasons why Japan's economy was hit particularly hard.
One notable factor is that, since Japanese products and technologies play an essential part
in global supply chains, the decline in global final demand affected Japanese firms especially
severely. Subsequently, in 2011, Japan was hit by the Great East Japan Earthquake, which
caused widespread damage to people and facilities. The situation was further exacerbated
by the sharp appreciation of the yen. In sum, Japan's economy was confronted with a series
of adverse shock during these years. In the face of this adversity, firms made progress in
improving their efficiency and profitability through a wide range of efforts such as
reorganizing production and shifting operations overseas. Having survived the hardship of
the recent past, Japanese firms improved their profitability considerably.
Under Abenomics, the excessive appreciation of the yen has been corrected. This correction
has not only improved Japanese firms' export profitability, but also raised the yen value of
the profits generated through foreign subsidiaries and other overseas-related business. The
latter effect is larger than in the past because of the expansion of firms' overseas operations
in recent years. In addition, the decline in oil prices since last autumn has been pushing up
profits in a wide range of sectors in Japan's economy, which is almost completely dependent
on imports for crude oil supply. Meanwhile, despite of the correction of the yen's excessive
appreciation, the recovery in exports - compared to past recovery phases - remained
sluggish due to the expansion of Japanese firms' overseas production. However, since the
July-September 2014 quarter, exports have clearly been picking up, rising for three quarters
in a row before registering a small decline in the latest quarter.
Looking ahead, corporate profits are expected to remain high. According to the Bank of
Japan's June Tankan (Short-Term Economic Survey of Enterprises in Japan), firms have
revised their fiscal 2014 profits upward and the outlook for fiscal 2015 remains strong. Given
this favorable profit situation, firms are more confident about their business outlook and the
recovery in business fixed investment is becoming more pronounced. A particularly
significant change is that, after prioritizing overseas investment in the past few years, firms
are turning to domestic investment in response to the correction of the yen's excessive
appreciation.
There has been some concern over the weakness in exports and production in recent
months, but we see this as temporary, mainly reflecting the sluggishness of the U.S.
economy in the January-March quarter and the recent slowdown in Asian economies.
Indeed, in the recent Tankan, business sentiment has remained favorable, and firms expect
corporate profits to remain high and plan to increase business fixed investment further in
fiscal 2015. Moreover, leading indicators such as machinery orders and construction starts
also point at an increase in business fixed investment. At the same time, due attention needs
to be paid to risks such as the situation in emerging and commodity-exporting economies
and recent developments in global financial markets.
Full employment and the positive feedback between wage increases and inflation
Another significant change is that, with the economy virtually at full employment, wages have
increased for the first time in two decades. There now is a positive feedback mechanism
operating between wage increases and moderate inflation. I would like to elaborate on this
point since it is the key to overcoming deflation.
Japan's economy was mired in deflation - a persistent decline in prices - for more than
15 years, starting in the mid-1990s. A key feature of deflation is that it tends to become
entrenched in a self-fulfilling manner once the economy falls into it. Under deflation, people
engage in economic activities based on the expectation that prices will continue to decline in
the future or that, at least, prices will not increase. The decline in prices of goods and
services in turn results in a decline in firms' sales and profits, leading to stagnant wages.
Households become cautious in their consumption, since they do not expect their wages to
increase. As a result, the economy falls into a vicious cycle of sluggish demand and a decline
in prices of goods and services. John Maynard Keynes argued that during a recession
downward rigidity in nominal wages would cause unemployment to increase. However, in
Japan, downward rigidity in nominal wages, which was widely considered rock-solid, started
to disappear in the mid-1990s and the economy fell into an equilibrium with declining wages
and prices (Chart 3).
Under deflation, there were various changes in economic and social practices that had been
built on the assumption that prices would rise. For instance, in Japan, workers and
management engage in wage negotiations every year called shunto or the spring offensive,
which take place collectively across industries in early spring. Until the mid-1990s, base pay
increases, that is, across-the-board wage increases reflecting inflation, were common as part
of the shunto. In the late 1990s, such base pay increases disappeared. Another
longstanding tradition in Japan was that prices of a wide range of goods and services were raised
at the beginning of each fiscal year in April. This practice also disappeared.
In order to escape from this deflationary equilibrium, it was necessary to dispel the
deflationary mindset - that is, the entrenched view that prices will not rise - and achieve a
state in which firms and households act based on the assumption that prices will continue to
rise moderately in the future. In the economics jargon, inflation expectations needed to be
raised. In plain English, this means that we have to change firms' and households' views on
prices, which form the basis for their economic activities.
In this context, there have been very encouraging changes since the introduction of QQE.
The practices that disappeared in the deflationary period have come back.
First, in the shunto last year, base pay was increased for the first time in two decades. And in
the shunto this year, base pay was raised for the second year in a row and at many firms the
increases were larger than last year. In addition, base pay increases have become
widespread across industries and firms of different size.
The practice of hiking prices at the beginning of the fiscal year also seems to have returned
this year. Let me provide you with some evidence. First, looking at the items that make up
the CPI (all items less fresh food), the share of items whose prices rose minus the share of
items whose prices fell has risen markedly since the beginning of this fiscal year and has
reached the highest level since the early 2000s (Chart 4). Second, daily and weekly indices
of the prices of food and daily necessities - namely, the University of Tokyo Daily Price Index
and the SRI-Hitotsubashi Consumer Purchase Price Index - since April this year also point
at clear price increases on a year-on-year basis. Moreover, the rate of increase shown by
these indicators has continued to go up. Many firms attempted to raise their prices at the
beginning of the last fiscal year as well, but this coincided with the consumption tax hike,
which was followed by a decline in demand. Firms were therefore forced to quickly take price
rises back. The price changes this year present a clear contrast with those last year. For
example, in April this year, the price of ketchup was raised for the first time in 25 years - I
should note that this price hike was not due to purchases by the Bank of Japan.
The simultaneous comeback of these practices - base pay increases in the shunto and price
hikes at the start of the fiscal year - is by no means a coincidence. Workers have demanded
increases in base pay, since they expect the rising trend in prices to continue and want to
avoid a decline in real wages. On the other hand, firms' management has agreed to such
demands, since they expect that the wage increases can be absorbed by raising sales
prices. The government's initiative at the joint meeting of representatives from the
government, labor unions, and firms' management may have facilitated these developments,
but it is clear that a positive feedback loop between wage increases and moderate inflation is
now firmly in place.
Finally, I would like to mention the tight labor market conditions behind these wage
increases. Japan's unemployment rate, which was above 4 percent before the introduction of
QQE, has declined to a range of 3.0-3.5 percent (Chart 5). The decline in the unemployment
rate has been accompanied by increases in both the labor force participation rate and the
number of employees. Based on the relationship between job openings and job applicants in
the past, the current unemployment rate of 3.0-3.5 percent can be regarded as
corresponding to "full employment," that is, the remaining unemployment is solely due to the
mismatch between job openings and job applicants and there is no excess labor. In the
United States, against the background of higher-than-normal long-term unemployment, there
has been intense debate on the degree of slack in the labor market. In contrast, in Japan, all
relevant indicators strongly suggest that labor market conditions are very tight. For example,
the broadly-defined unemployment rate, which counts so-called marginally attached workers
as unemployed and corresponds to U-6 in the United States, has declined to about 6
percent, which is low compared to past levels.
II. Transmission mechanism of QQE
As I just explained, remarkable changes have been taking place in Japan's economy in the
last two years. Of course, these changes cannot entirely be attributed to the effects of QQE
implemented by the Bank of Japan. However, it can be judged that QQE has been producing
its intended effects through the transmission mechanism envisioned at the time of its
introduction. Let me review the transmission mechanism of QQE.
Japan's monetary policy has been constrained for a long time by the zero lower bound on
short-term nominal interest rates. In this situation, QQE aims to achieve further easing
effects by reducing long-term real interest rates. Specifically, the mechanism is as follows.
The Bank raises inflation expectations through a strong and clear commitment to achieving
the price stability target of 2 percent and large-scale monetary easing to underpin the
commitment (Chart 6). At the same time, the Bank exerts downward pressure on nominal
interest rates across the entire yield curve through massive purchases of Japanese
government bonds (JGBs). As a result, long-term real interest rates decline. With private
demand being stimulated, the output gap improves, and actual inflation rates rise
accordingly. Once people actually experience increases in inflation, their inflation
expectations rise, further reinforcing this process.
The changes we have witnessed since the introduction of QQE are broadly consistent with
this transmission mechanism. Nominal long-term interest rates have declined, with yields of
10-year JGBs down by about 0.3 percentage point. Medium- to long-term inflation
expectations seem to have increased by about 0.5 percentage point. The combined effects
of these two factors - the decline in nominal long-term yields and the increase in inflation
expectations - have brought about a decline in real interest rates by slightly less than
1 percentage point. Studies for the United States and Europe suggest that the effects of a
downward shift of the entire yield curve - i.e., including long-term interest rates - on
economic activity and prices are several times larger than those of a decline in short-term
rates under conventional monetary policy. Along similar lines, empirical research by our staff
suggests that the effects of QQE are roughly equivalent to those arising from lowering the
short-term policy rate by 2 percentage points. Given how powerful monetary easing under
QQE has been, it is no wonder that Japan's economy has been experiencing the drastic
changes I mentioned.
The former Fed Chairman, Ben Bernanke, is quoted to have said, "The problem with QE is it
works in practice but it doesn't work in theory." The effectiveness of QE likely differs across
economies, depending on economic conditions and financial structures, and academics have
not reached a consensus on how effective QE is. However, in the case of Japan, we believe
that it is possible to explain how QQE works in theory, and QQE has been working as
envisaged.
Based on this belief, the Bank will continue to steadily pursue QQE to achieve the price
stability target of 2 percent at the earliest possible time. It will examine both upside and
downside risks to economic activity and prices, and make adjustments without hesitation if
necessary.
Conclusion
With the prospect of overcoming deflation in sight, efforts to raise the growth potential of
Japan's economy should gather steam. The government is currently implementing various
regulatory and institutional reforms as part of its growth strategy. I am aware that many have
found previous proposals to raise Japan's growth potential disappointing. In hindsight, it is
clear that there has been a lack of sufficient incentive and impetus to make change happen.
Firms had few incentives to grow and simply removing obstacles to growth had little effect.
Partly because of this, the political will to remove such obstacles was also weak. But this
time is different. Since Japanese firms now believe that deflation is over, there will be strong
incentive for change. Under deflation, sticking to the status quo was a reasonable business
strategy. This is no longer the case and, aware of the drastic changes that have occurred in
the domestic business environment, a growing number of Japanese firms are now taking
action. This should be a major driving force for removing regulatory and institutional
obstacles. For instance, low labor participation by women has long been an issue for Japan's
economy; however, faced with a tight labor market, firms have recently made efforts to
promote labor participation by women. At the same time, the government has also tried to do
so by incorporating institutional reforms in the growth strategy. As a result, labor participation
by women has finally increased. The key to raising the growth potential is "action" and there
is no better time than now to move forward. The Bank of Japan will contribute to raising the
growth potential of Japan's economy by achieving the price stability target of 2 percent at the
earliest possible time through QQE and dispelling the deflationary mindset that has taken
hold of Japan.
Thank you very much for your attention.
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