Miyako Suda: The current situation of and outlook for Japan's economy
and the conduct of monetary policy
Summary of a speech by Ms Miyako Suda, Member of the Policy Board of the Bank of Japan,
at a meeting with Business Leaders, Wakayama, 3 June 2010.
* * *
I. Japan's economy and prices and the conduct of monetary policy
A. Developments in financial markets
1. Developments in global financial markets and the situation in Greece
The topic I would like to discuss today is the current situation of, and outlook for, Japan's
economy and the Bank of Japan's conduct of monetary policy. Let me begin by looking at
developments in global financial markets.
Following the unprecedented turmoil triggered by the failure of Lehman Brothers in
September 2008, global financial markets regained stability from around the spring of 2009
due to various measures taken by governments and central banks around the world. The
LIBOR-OIS spread, an indicator of counterparty credit risk, has narrowed to levels
significantly below those seen before the Lehman shock. Recently, however, signs of
instability have reemerged due to concerns over fiscal problems in some European
countries, particularly Greece, and uncertainty regarding financial regulation in the United
States and Europe. The crisis in Greece has caused large fluctuations in stock prices and
foreign exchange rates around the world, increasing investors' risk aversion and deepening
the fiscal woes of other European countries. In what follows, I would like to review recent
developments in global financial markets, focusing in particular on the situation surrounding
Greece.
The Greek debt crisis was triggered by a loss of confidence in Greece's official statistics and
its ability to repay its debt. In October 2009, the new administration in Greece announced
that the country's budget deficit in 2009 would be far greater than previously estimated. The
significant revision gave rise to concerns about the reliability of Greece's official statistics and
fiscal discipline, prompting a large rise in Greece's sovereign risk premium. In January this
year, the Greek government submitted to the European Commission a three-year plan to cut
its budget deficit, and in April, the 16 euro area member states agreed on a 30-billion euro
financial support package. At that stage, Greece was still able to procure funds relatively
smoothly through the issuance of government securities. However, Greece's sovereign risk
premium increased rapidly from the end of April to early May, following a further revision to
its budget deficit estimate, a sharp downgrading of Greek government bonds by a major
credit rating agency, and successive news reports about the escalation of street protests in
Greece. In response, worldwide stock prices tumbled and foreign exchange rates fluctuated
sharply. For example, the Dow Jones Industrial Average experienced its largest recorded
intraday points fall on May 6, 2010.
To address this situation, the European Union agreed on a 500 billion euro emergency loan
package, the European Stabilization Mechanism, with the International Monetary Fund (IMF)
pledging additional funds. The European Central Bank (ECB), for its part, decided to
intervene in euro area public and private debt securities markets through the Securities
Markets Programme, while adopting a fixed-rate tender procedure with full allotment in the
regular three-month longer-term refinancing operations (LTROs), a six-month LTRO with full
allotment, and U.S. dollar liquidity-providing operations. Furthermore, the Greek government
announced additional fiscal consolidation measures, which gradually are helping to ease the
severe strains in financial markets. However, fiscal deficits are not a problem for Greece
alone. Rather, this problem is shared by all countries that responded to the rapid economic
deterioration with large-scale expansionary fiscal measures in the aftermath of the Lehman
shock. However, the problem has become particularly acute in the euro area, with its strict
fiscal rules enshrined in the Stability and Growth Pact and its single common currency, which
means that countries cannot use exchange rate adjustments to modify trade between
member states. This basic constraint is identical for countries other than Greece, such as
Portugal, Italy, Ireland, and Spain, on which attention has recently focused. These countries
face structural problems in terms of managing fiscal policy and maintaining competitiveness
under a single currency. Consequently, fiscal reconstruction is likely to be a painful and time
consuming process and financial markets are likely to remain wary of the sovereign risks of
these five countries and the credit risks of financial institutions with large exposure to them.
Against this background, stock prices have remained weak in the United States and Europe,
while the LIBOR-OIS spreads for the U.S. dollar and euro are expected to continue to widen.
In the foreign exchange market, the euro is tending to be weak. In sum, global financial
markets remain unpredictable, requiring continued close monitoring.
2. Developments in Japanese financial markets
Turning to Japanese financial markets, interest rates, particularly those on term instruments,
have been declining since the beginning of 2009 in tandem with the improvement in the
functioning of various markets as a result of the stabilization in global financial markets. In
December 2009, the Bank introduced a new market operation, which provides funds at a
fixed rate against pooled collateral, to counter instability in global financial markets following
the financial crisis triggered by the surfacing of payment rescheduling problem of
government-affiliated firms in Dubai, and to quell any concerns that market confidence might
deteriorate in the face of increased news reports about deflation. In addition, in order to
further lower interest rates on term instruments, the Bank, in March 2010, sharply increased
the volume of funds provided through the new funds-supplying operation, and interest rates
on term instruments have been declining since. On the other hand, while stock prices were
on an upward trend from the spring of 2009 due to improved economic sentiment, they have
been falling sharply since the beginning of May in tandem with the decline in U.S. and
European stock prices reflecting the emergence of the problems surrounding Greece. Along
with the fall in stock prices, risk avoidance among investors has grown, leading to increased
purchases of government bonds and a moderate downward trend in long-term interest rates.
In the foreign exchange market, the dollar has been trading at around 90 yen, while the euro
has weakened significantly against the yen.
As for the environment for corporate financing, firms' cash inflow has improved, reducing
demand for external funds and narrowing the issuing spreads even on debt securities issued
by firms with low credit ratings. In view of the improvement in the corporate financing
environment, the Bank terminated the special measures introduced after the Lehman shock:
outright purchases of CP and corporate bonds were wound up at the end of December 2009,
while special funds-supplying operations to facilitate corporate financing were terminated at
the end of March 2010. The termination of these measures has had no major impact on
markets, but given the current marked instability in stock prices and foreign exchange rates,
the Bank is paying close attention to the effects of developments in risk aversion.
B. The current situation of the economy and prices
As I explained earlier, uncertainty remains regarding developments in global financial
markets, but an increasing number of recently released economic indicators show that signs
of an economic recovery in Japan are becoming more broad-based. Following the
assessment at the Monetary Policy Meeting on April 6 and 7, 2010, that Japan's economy
"has been picking up," the Bank raised its assessment at the meeting on May 20 and 21,
stating that the economy shows further signs of a moderate recovery. However, as I have
repeatedly mentioned, developments in global financial markets have recently been
unstable, and attention should be paid to how they affect economic activity in Japan. I would
now like to discuss in detail the current situation for each demand component and then
consider the outlook as well as risk factors for the economy.
First, real exports, the main engine of Japan's economic growth, have been increasing,
especially to emerging and commodity-exporting economies, and here particularly those in
Asia. Let us look at the global economic and price situation forming the background to the
increase in Japan's exports. The U.S. economy, for example, is recovering at a moderate
pace. Private nonfarm payroll employment has started to clearly increase, and retail sales
data provide signs of a recovery in a broad range of business areas. However, with the
unemployment rate still high and the average duration of unemployment at a new peak,
credit card lending remains tight and the pressure on households to adjust their balance
sheets continues to weigh on the recovery of private consumption. Similarly, in the housing
market, home price indices have been slow to recover, and mortgage delinquency rates and
the number of foreclosures have been rising. Against this background, the pace at which the
recovery in the corporate sector has been spreading to the household sector has remained
moderate.
Economic activity in the euro area has been picking up as a whole, with some differences in
growth by country. The pace of recovery, however, remains moderate compared to that in
the United States. In the euro area, exports and production continue to increase, but private
consumption has been weak, reflecting persisting adjustment pressure on households'
balance sheets against the background of the severe employment situation and the fact that
consumer sentiment has deteriorated somewhat due, for example, to the growing severity of
the situation in Greece.
On the other hand, emerging and commodity-exporting economies continue to show robust
growth underpinned by strong domestic demand. In China, due mainly to the effects of the
expansionary macroeconomic policies, bank lending has expanded by more than 20 percent
from a year earlier and retail sales and fixed asset investment are at much higher levels than
in 2009. The strong domestic demand in China has stimulated economic activity in other
countries in the region such as the NIEs and the ASEAN countries through increased exports
to China. As a result, these economies continue to show high growth supported by a virtuous
circle of growth in production, income, and spending.
As for the price situation in overseas economies, a disinflationary trend in the United States
and Europe continues. Specifically, in the United States, the year-on-year rate of increase in
the consumer price index (CPI) for all items less energy and food, or the core CPI, has
continued to slow, registering 0.9 percent in April, the smallest increase since January 1966.
In the euro area, the year-on-year rate of increase in the core CPI declined to 0.8 percent in
April, the lowest since the introduction of the index. These developments in the United States
and Europe imply that the deterioration in the aggregate demand and supply balance in
these economies has been exerting downward pressure on prices. On the other hand,
inflationary concerns are intensifying in emerging economies. In China, in particular, real
estate prices in 70 major cities in April marked the largest year-on-year increase on record
and the year-on-year increase in the CPI in April was the highest in a year and a half.
Turning to domestic demand in Japan, public investment has been decreasing since the
second half of fiscal 2009. On the other hand, corporate profits have been following a
recovery trend due mainly to increased production and labor cost restraint. Reflecting these
developments, business fixed investment has leveled out and started to show signs of
picking up, as evidenced by the continued increase in shipments of capital goods, a
coincident indicator of business fixed investment. The employment and income situation
remains severe, but gradually signs of a recovery are emerging: the unemployment rate has
peaked out, and nominal wages per employee increased by 1.5 percent in April year on year,
registering a positive figure for the second consecutive month. Against this background,
private consumption, notably of durable goods, has picked up due to the effects of policy
measures such as tax reductions on purchases of environmentally friendly cars and the
introduction of the eco-point system, which favors energy-efficient products. It should be
noted, however, that the substantial increase in sales of electrical appliances through March
was due to a rush of demand prior to tighter application of the eco-point system for flat panel
televisions, and that sales at department stores, which marked a quarter-on-quarter increase
in the first quarter of 2010 for the first time since the fourth quarter of 2007, have been
sluggish since the beginning of April, largely due to weak sales of apparel reflecting
unfavorable weather conditions. Although some market participants regard the improved
sales of luxury goods as a sign of a self-sustaining recovery, I believe that the situation in
private consumption still requires careful monitoring. Meanwhile, the decline in housing
investment has almost leveled out, as evidenced by, for example, improved sales of newly
built condominiums in the Tokyo metropolitan area.
Reflecting the situation in domestic and overseas demand I just described, production has
been rising. The decline in inventories has almost leveled out, and the shipment-inventory
balance, on the whole, has improved to a level where there are no inventory adjustment
pressures.
Looking at developments in prices in Japan, the pace of the year-on-year decline in the CPI
(excluding fresh food) - which posted the largest fall on record, minus 2.4 percent, in
August 2009 - has started to decelerate with the effects of the drop in the prices of
petroleum products following their surge in 2008 waning. The moderating trend in the pace of
decline in the CPI has continued against the background of the gradual improvement in the
aggregate demand and supply balance. Recently, the rate of change in the CPI has been
hovering around minus 1 percent once the effects of subsidies for high school tuition fees are
taken out.
C. Outlook for the economy and prices
Japan's economy is starting to recover moderately, induced by the improvement in overseas
economic conditions. The Bank's projections for economic activity in Japan are as follows:
while the effects of various policy measures are likely to wane, emerging and
commodityexporting economies are likely to maintain high growth, and the momentum for a
selfsustaining recovery in Japan's domestic private demand is expected to gradually gather
pace; Japan's economy therefore is likely to be on a recovery trend.1 For these projections to
materialize, it is important that improvements in the corporate sector feed through to the
household sector supported by a virtuous cycle of increased production, income, and
spending. However, considering Japan's experience during the economic recovery phase
since 2002, the pace with which improvements in the corporate sector feed through is likely
to remain moderate. Moreover, uncertainties regarding the economic outlook have been
heightening due to instability in global financial markets reflecting concerns over fiscal
problems in some European countries. I will discuss these risk factors later on, and would
now like to address the outlook for each demand component.
To begin with, Japan's real exports are likely to continue increasing, especially those to
emerging and commodity-exporting economies. Examining developments in the world
economy, on which developments in Japan's exports depend, emerging and
commodityexporting economies are likely to continue achieving strong growth led by domestic demand,
which in turn should contribute to a continued moderate recovery in the U.S. and European
economies. Specifically, the momentum for a self-sustaining recovery is expected to
gradually become more pronounced in the U.S. economy with a continued improvement in
the employment and income situation. Nevertheless, the pace of economic recovery will
likely remain moderate, given that it will take considerable time for the housing market to
recover, and that adjustment pressure on households' balance sheets will continue to be a
constraint on a recovery in consumption. The economy of the euro area is also expected to
continue recovering moderately, with exports, partly due to the weak euro, expected to grow,
which in turn will boost production. However, the pace of economic recovery in the euro area
is expected to be more moderate than that in the United States, not only because adjustment
pressure on households' balance sheets and sluggish consumer confidence stemming from
unstable financial market conditions are likely to persist for some while at a time when the
employment and income situation remains severe, but also because stringent fiscal
consolidation measures required of countries facing serious fiscal problems will exert
downward pressure on economic activity in the euro area.
Turning to domestic demand in Japan, the momentum of recovery in private consumption
might temporarily weaken in the latter half of fiscal 2010 as the effects of policy measures
gradually wane. Nevertheless, the underlying trend of a recovery is not likely to be
interrupted given the continued improvement in the employment and income situation.
Business fixed investment, which has stopped declining, is expected to gradually start
picking up, given that machinery orders (private demand, excluding orders of shipbuilding
and orders from electric power companies), which are a leading indicator of machinery
investment, are expected to have risen in the April-June quarter for the third consecutive
quarterly increase. Housing investment will likely continue recovering moderately: the
number of housing starts - a leading indicator of housing investment - is starting to recover
as a result of support measures and adjustments in condominium prices. Reflecting such
developments in demand both at home and abroad, production is likely to continue rising as
a trend. The industrial production index may temporarily become weak in the October-
December quarter, that is, the quarter immediately after the purchase support for eco-friendly
cars expires, but the uptrend in production is expected to remain intact with the continued
increase in demand both at home and abroad.2
As for prices, under the assumption that medium- to long-term inflation expectations remain
stable, there are prospects that the year-on-year rate of change in the CPI (excluding fresh
food) could turn positive in fiscal 2011 as the aggregate demand and supply balance
moderately improves.
D. Risk factors
Next, I will discuss the risk factors relevant to the outlook I have just talked about. The three
risk factors that I am particularly concerned about at present are: (1) developments in global
financial markets; (2) the sustainability of growth in emerging and commodity-exporting
economies; and (3) a decline in the expected growth rate of the economy. The outlook is
becoming increasingly uncertain due to these risk factors which at present I see as tilted to
the downside.
Regarding the first factor, global financial markets have become volatile due to a number of
reasons including: (1) the fiscal deficit problem in some European countries; (2)
balancesheet problems at European financial institutions; (3) the effect on the United States and
Europe of the adoption of more stringent financial regulations, including the restrictions on
short selling in Germany; and (4) expectations that monetary policy will be tightened in
China. While all of these factors require close attention, I am particularly concerned about
developments with regard to the fiscal deficit problem in some European countries, such as
Portugal, Ireland, Italy, Greece, and Spain. As I pointed out at the beginning of this speech,
the fiscal deficit problem in some European countries arises from the difficulties of an
economic system based on a common currency, the euro. Therefore, the road to recovery
may be long and painful due to the need for severe fiscal consolidation. Such worries are at
the root of the significant volatility in stock prices and foreign exchange rates around the
world, which in turn may have a negative impact on private consumption and business fixed
investment not only in Europe but also in Japan through a deterioration in household and
corporate sentiment. Furthermore, a possible downturn of the economy of the euro area as a
result of rigorous fiscal consolidation measures may affect Japan's exports to some extent.
There is also a risk that weakness in European financial markets could spread to other
countries through losses incurred by European financial institutions. Other risks that require
attention include that expansionary macroeconomic policies in countries such as China are
adjusted too quickly or too slowly.
The second risk factor concerns the sustainability of growth in emerging and
commodityexporting economies. At present, these countries are enjoying high economic growth and are
expected to maintain high levels of growth. However, a further increase in the inflow of funds
to these countries as a result of global monetary easing could lead to excessive investment
activity and position-taking, possibly triggering an overheating of these economies or a surge
in primary commodity prices. A price surge in primary commodities could affect the Japanese
economy by leading to a downturn in corporate profits through a deterioration in the terms of
trade or by pushing down private consumption. Furthermore, if economies overheat, the
subsequent unwinding of excesses could cause a sharp downturn of the global economy and
destabilize financial markets. In fact, in China, expectations of a tightening of monetary policy
have recently induced volatility in stock prices, while international commodity prices, such as
those of crude oil, have started to fall as investors are becoming more cautious about taking
on risks. If these trends gain further momentum, prices in industrialized countries, including
Japan, may be affected somewhat through funds flowing out of emerging and
commodityexporting economies and international commodity markets, causing a further decline in
international commodity prices.
The third risk factor is a decline in the expected growth rate resulting from domestic structural
trends such as: (1) corporate efforts to restrain wages to survive global competition; (2) the
growing economic divergence between large and small firms as well as between large cities
and regional areas; and (3) the aging and shrinking of the population. A decline in the
expected growth rate could hamper the virtuous circle of production, income, and spending.
Furthermore, it could lead more firms to increase business fixed investment overseas rather
than in Japan. In fact, the results of the Annual Survey of Corporate Behavior (Fiscal 2009)
conducted by the Cabinet Office show that 55.7 percent of responding manufacturers were
planning to increase and strengthen overseas production. Also, if expansionary
macroeconomic policies are maintained for longer than is necessary, this could lower the
expected medium- to long-term growth rate of domestic demand by slowing down the
response to structural changes, keeping resources in inefficient areas, and delaying
improvements in productivity in the economy as a whole.
E. Monetary policy for the immediate future
So far, I have talked about developments in financial markets at home and abroad, the
economy, and prices, as well as the risk factors relevant to the outlook with regard to these. I
will now move on to the issue of the Bank's monetary policy.
The Bank recognizes that Japan's economy faces the critical challenge of overcoming
deflation and returning to a sustainable growth path with price stability. To this end, the Bank
will continue to consistently make contributions as the central bank. In the conduct of
monetary policy, the Bank will aim to maintain the extremely accommodative financial
environment. Furthermore, in view of the current state of the Japanese economy, and
recognizing the need to strengthening the foundations for economic growth, the Bank has
decided to introduce a new initiative to contribute to the strengthening of the foundations for
economic growth. Specifically, the Bank decided, through the provision of funds, to support
efforts by private financial institutions that would help to strengthen the foundations for
economic growth, and on May 21, 2010 announced a preliminary framework for this initiative.
At present, the Bank is exchanging views with a wide range of financial institutions and firms
in order to formulate concrete plans for the initiative.
The provision of funds by a central bank specifically to strengthen the foundations for
economic growth is an unprecedented measure. Such a move could increase the risk of:
(1) distorting resource allocation in the private sector; (2) reducing the flexibility of monetary
adjustments by lengthening the duration of assets held by the Bank; and (3) negatively
affecting the soundness of the Bank's balance sheet. The decision to resort to such a
measure reflects the acute concern of the Bank over the prolonged weakness of the
Outlook for Economic Activity and Prices
Japanese economy. In the (hereafter the Outlook
Report) released on April 30, the Bank stated at the opening that: (1) the presence of
emerging and commodity exporting economies in the global economy is growing; (2) in
advanced economies, the outstanding amount of public debt has risen to unprecedented
levels; (3) discussions have proceeded regarding a review of financial regulation and
supervision; and (4) Japan - where domestic demand is expected to decline against the
backdrop of an aging and shrinking population - faces the critical challenge of raising real
economic growth and productivity. The report also states that the Bank takes into account
"these medium-to long-term changes in, and challenges facing, the global economy and
Japan's economy" when examining the outlook for economic activity and prices. This
statement is based on the belief that firms' expectations for economic growth, and hence the
outlook for growth, will change if each and every one of us moves forward and takes action
to tackle these structural changes.3
These problems ailing the Japanese economy are already well known. Various prescriptions
have been provided on how to deal with these structural changes and problems. However,
the absence of any effective measures and concrete results has given rise to a growing
sense of despair among the public. Estimates of future population trends in Japan underline
the pressing need for per capita productivity to rise if growth expectations are to be
maintained.
II. The potential growth rate and deflation
I will now talk about the vital necessity to raise the potential growth rate in order to get out of
the deflationary impasse. A comparison of the growth rate of consumer prices in the United
States, Europe, and Japan shows that, after the collapse of Lehman Brothers, the CPI
(excluding food and energy prices, which tend to be volatile) declined in Japan alone, even
though Japan was outside the epicenter of the financial crisis. In terms of the downward
trend in inflation, this has been quite similar in the United States, Europe, and Japan, so that
the reason why prices in Japan have been falling is that the inflation rate was low to start
with. In any case, in order to find out why Japan alone is experiencing deflation, it is
necessary to look into why the inflation rate has been low in Japan compared with the United
States and Europe from the latter half of the 1990s. I will now look into this issue from a
medium- to long-term perspective.
A. Negative productivity shocks
A major factor behind the prolonged deflation in Japan since the 1990s is the negative output
gap, which has prevailed for a long time. One of the reasons often cited recently for this
negative output gap is the slowdown in productivity growth - that is, negative productivity
shocks.4 I will now discuss these negative productivity shocks and their relation with the
output gap, which is the cause of deflation.
The reasons for Japan's slower growth trend from the 1990s, compared with those of the
United States and Europe, can be attributed to successive negative productivity shocks. The
first shock is the rapid advance in population aging and decline. The second is the continuing
IT revolution and the intensification of global competition based on the increased supply
capacity of emerging markets. It has been argued that against the background of these major
structural changes, corporate governance in Japan, being bound by past success, has
shown insufficient adaptability and flexibility.5 The third factor is that these negative
productivity shocks coincided with the disposal of nonperforming loans following the burst of
the real estate bubble.6 To be more specific, following the burst of the real estate bubble of
the late 1980s, manufactures were busy dealing with excesses in production capacity,
employment, and debt, while financial institutions were unable to perform their credit
intermediation function properly because they were preoccupied with the disposal of
nonperforming loans. It is thought that these factors combined put downward pressure on
labor input, capital input, and total factor productivity.7 Indeed, the pace of labor productivity
growth in Japan moderated from the 1990s onward. Also, during this period, there was
limited room for reducing interest rates and it therefore was impossible to ease monetary
policy to the extent required for countering the decline in the potential growth rate.
At the same time, growth expectations for the economy have also been weighed down by
anxiety about the future stemming from the large fiscal deficit and problems regarding the
pension system. The decline in growth expectations has pushed down people's permanent
income expectations, leading to general restraint in consumption and investment. Since
supply can be adjusted only relatively slowly, the demand and supply balance deteriorated,
exerting downward pressure on prices. Thus, the significant and prolonged downward
pressure on prices in Japan has been caused by the intermittent negative production shocks
that occurred during the 1990s. Given this environment, firms placed greater emphasis on
profitability by further restraining wages against the background of the slow rise in labor
productivity, causing unit labor costs (labor costs per unit of output) to trend downward in
contrast with the situation in the United States and Europe. The downward pressure on
wages has been strong because of (1) the tendency in Japan to restrain personnel costs
through wage adjustments rather than job cuts, (2) the increased tendency of firms to shift
production overseas in the search for low-cost labor, and (3) the weakening of labor unions.
In addition, fierce competition particularly among nonmanufacturers also contributed to lower
inflation rates. It has been argued that the productivity gap of the nonmanufacturing sector
vis-à-vis manufacturing was partly responsible for pushing up services prices (according to
the structural inflation theory), but this tendency has lessened as a result of increased
competition since the 1990s.8
Furthermore, medium- to long-term inflation expectations - another large factor affecting
prices - appear to be lower in Japan than in other countries. This is probably due to the
decline in growth expectations mentioned earlier, coupled with the fact that inflation rates in
Japan have been comparatively low in the past. Survey results suggest that long-term price
expectations have been relatively stable in a range between 0 and 2 percent since the latter
half of the 1990s and that fluctuations in expectations seem to correlate with the potential
growth rate. Based on these findings, it may be said that the decline in the potential growth
rate in Japan since the 1990s exerted downward pressure on prices by triggering a decline in
demand exceeding that in the p