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, to the Naigai Josei
Chousa Kai (Research Institute of Japan), Tokyo, 15 May 2006.
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Introduction
Japan's economy has been recovering for more than four years since the trough in January 2002. The
Bank of Japan projected in its Outlook for Economic Activity and Prices (hereafter the Outlook Report)
released on April 28, 2006 that from fiscal 2006 through fiscal 2007 the economy was likely to
experience a sustained period of expansion, with domestic and external demand and also the
corporate and household sectors well in balance.
Today, I will focus on the Bank's view concerning future developments in economic activity and prices
given the projection in the Outlook Report, and I will explain its future monetary policy conduct.
I. Developments in the world economy
I will first touch on developments in the world economy, which underlie developments in Japan's
economy. The world economy has been expanding steadily since 2003, recording a growth rate of
around 5 percent in 2005, and is projected to maintain high growth into the future. At the G-7 meeting
held in Washington, D.C., in April 2006, finance ministers and central bank governors agreed that the
outlook for the world economy remained favorable, although risks remained from factors such as oil
market developments and global imbalances. They also agreed that inflation remained contained
despite high oil prices and that global trade growth was buoyant.
Economic developments among Japan's main trading partners indicate that the U.S. economy
continues to expand steadily, at a pace around its potential growth rate, led mainly by business fixed
investment and household spending, although there are signs of a slowdown in some parts of the
economy, specifically in the housing market. The Chinese economy continues to expand strongly as a
whole despite some imbalance in the pace of growth between industries and regions. The NIEs and
ASEAN economies continue to expand at a moderate pace on the whole, although the negative
effects of high energy prices can be seen in some areas of economic activity.
II. Current situation and outlook for Japan's economy
Turning to Japan, the economy continues to recover steadily. One of the characteristics of the current
economic situation is that domestic and external demand and also the corporate and household
sectors are well in balance. Exports continue to increase against the backdrop of global economic
expansion and trade expansion resulting from further progress in international division of the
production process. As for domestic private demand, corporate performance continues to be strong.
The Bank's Tankan (Short-Term Economic Survey of Enterprises in Japan) indicates that corporate
profits increased for the fourth consecutive fiscal year, and firms expect their sales and profits to rise in
fiscal 2006. Business fixed investment plans for fiscal 2006 are relatively strong. As for the household
sector, the employment and wage situation has been improving and private consumption has been on
an increasing trend. Japan's economy is likely to continue to show balanced growth.
Another characteristic is that the sustained economic recovery has resulted in a higher level of
utilization of resources such as capital and labor. The current recovery has already lasted for over four
years, and if it continues much longer, in October 2006 it will equal the Izanagi boom (1965-70), which
is the longest postwar economic expansion to date. As a result of the sustained recovery, according to
the Tankan, for the first time in more than a decade firms are no longer perceiving excess capacity but
have started to feel more strongly that their labor holdings are insufficient. The ratio of job offers to
applicants, below 1.00 from 1992 until recently, has now exceeded 1.00 since the end of 2005.
Furthermore, the conditions of persistent oversupply have been dispersed and the output gap, the
difference between actual and potential output, which had long been negative, seems now to have
closed. This indicates that demand and supply capacity in the economy are well balanced.
Given these characteristics of the current economic situation, the following are considered to be the
three core elements of the most likely projection for economic activity and prices two years into the
future.
The first element is that the household sector is expected to be the main driving force behind firm
domestic private demand.
Strong corporate performance has been benefiting the household sector, and this positive influence is
likely to become more evident from now on. Employment and wages have been improving against the
background of favorable corporate profits and rises in labor shortages. The number of part-time
employees and bonus payments are rising, and the number of full-time employees and regular
payments are also on an uptrend. These developments suggest that households can expect the
increase in their income to be more permanent, and this has contributed to the improvement in
consumer sentiment. Households' average propensity to consume is likely to remain at its current
elevated level, and private consumption is expected to follow an increasing trend. Housing investment
is likely to continue to trend moderately upward, supported by the improvement in household income
and the view that interest rates will only rise from current levels, as land prices are starting to rise
particularly in major metropolitan areas. Increases in household spending will feed back to the
corporate sector via increases in sales and profits, and thus, a virtuous circle between the household
and corporate sectors is likely to keep operating.
The second element is that there is likely to be a cyclical slowdown in the economic growth rate as the
recovery has already lasted for over four years and is likely to mature.
Given the high level of corporate profits and the expansion in domestic and external demand, the
momentum driving increases in business fixed investment is likely to be maintained. However,
considering that there is a stable relationship in the long term between the capital stock and aggregate
demand, the pace of increase in business fixed investment will probably slow eventually. Business
fixed investment has steadily increased for the third consecutive year since fiscal 2003, and this has
resulted in high growth in the capital stock relative to the projected increase in aggregate demand.
Therefore, unless firms can make stronger forecasts for the economic growth rate and the rate of
return on investment, it is becoming unlikely that they will keep up the current pace of increase in
business fixed investment. In this situation, the growth rate of Japan's economy is likely to slow toward
the potential growth rate, which the Bank estimates to be in the 1.5-2 percent range. The forecast is
around 2.5 percent for fiscal 2006 and around 2 percent for fiscal 2007.
The third element is that, as the economic recovery matures, a slowdown in the growth in productivity
and upward pressure on wages are expected to exert upward pressure on prices.
At an early stage of economic recovery, firms usually retain surplus labor and capacity and are
therefore able to increase productivity by raising their rate of resource utilization. With the maturing of
the economic recovery, however, firms have less scope to increase productivity in this way. As I have
already explained, the output gap has closed, and as the economy is likely to continue expanding at a
pace above its potential through fiscal 2007, the output gap is likely to become positive and then to
widen moderately.
Moreover, in a situation of improving labor market conditions and with labor shortages being observed
in a relatively wide range of industries, wages are likely to continue rising moderately. The rise in
wages and the slowdown in the growth in productivity will together put upward pressure on unit labor
costs (labor costs per unit of output). Through fiscal 2007, unit labor costs are likely to show smaller
declines, and to start increasing slightly at some point.
One of the factors holding back upward pressures on prices during the economic recovery phase has
been declining unit labor costs. As the effect of this factor diminishes, prices will be more inclined to
rise than before. As for the year-on-year rate of change in the consumer price index (CPI; excluding
fresh food), which has been positive since November 2005, we estimate that this will gradually rise to
around the middle of the range between zero and 1 percent in fiscal 2006 and to slightly below 1
percent in fiscal 2007.
III. Upside and downside risks to the outlook for economic activity
In the above sections, I have outlined the core elements of the most likely projection for economic
activity and prices. However, the economy constantly faces various risks and it should be noted that,
should particular risks materialize, economic activity and prices may deviate from this projection.
As downside risks to the outlook for economic activity, the April 2006 Outlook Report raises the
following factors: slowdown in the growth of the world economy; and inventory adjustments, for
example, in IT-related sectors. As for the first risk factor, developments in crude oil prices, which have
been rising, and their impact on the world economy warrant attention. In relation to this, there is also a
risk of a change in the situation where stable financial conditions are durable and inflationary
pressures generally subdued which has been supporting the ongoing global economic expansion.
With regard to the second factor, it should be borne in mind that inventory adjustments may be
triggered as the economic recovery matures. Even if inventory adjustment occurs, it is unlikely that
inventory adjustment carried out in some industries would seriously affect overall economic activity,
since Japanese firms as a whole have completed adjustments in various excesses and their
profitability has been recovering.
As an upside risk to the outlook for economic activity, there is a possibility of further acceleration of
business fixed investment. If firms accelerate investment, there may be a positive impact on overall
growth. On the other hand, such acceleration may lead to an excessive build-up of the capital stock
relative to the level of expected growth in demand, which may precipitate an economic slowdown via
adjustments. Given that the output gap has already closed, if economic activity accelerates further and
as a result the positive output gap widens rapidly, this will increase the risk of a subsequent
compensatory correction. However, large economic swings can be avoided, thereby realizing
sustainable economic expansion, if firms' investment stance does not become too aggressive.
On this point, firms so far continue to increase business fixed investment based on favorable
projections for sales and profits. However, overall, the value of fixed investment is being kept within
the amount of firms' cash flow, and this suggests that they remain relatively cautious about
accelerating fixed investment. The outlook for economic activity described earlier assumes that firms
will maintain this cautious stance regarding investment.
However, the current conditions point to further acceleration in investment by firms. Looking at
corporate finances, firms' risk-taking capacity has increased as a result of the reduction of their debt
excesses and the strengthening of their capital bases. Levels of return on assets are comparable to
those recorded during the bubble era of the late 1980s. Since interest rates are extremely low, this
favorable financial environment is likely to stimulate firms' investment. A turnaround in land prices in
major metropolitan areas and a rise in stock prices may also accelerate firms' investment partly
through increases in household spending boosted by the wealth effect.
If firms were to further accelerate investment in this situation, overall economic growth would increase
for a while, although this would generate the risk of a subsequent correction.
IV. Upside and downside risks to the outlook for prices
The following are considered to be key upside and downside risks to the outlook for prices: the path of
international commodity prices including crude oil prices; and the degree of sensitivity of the rate of
increase in the CPI to economic developments, that is, changes in the output gap.
The April outlook does not assume that the rate of increase in the CPI will accelerate noticeably even
when the output gap becomes positive, i.e., actual output exceeds potential output. This takes account
of the weaker sensitivity of the rate of increase in the CPI to changes in the output gap, which is a
tendency that has been observed in recent years not only in Japan but also worldwide. This is
because prices of goods and services as well as wages have been under downward pressure due to
industrialization of emerging economies as well as to firms in industrial countries shifting production
facilities to overseas locations. Upward pressure on overall prices seems to have been restrained by
increased productivity and intense competition both as a result of deregulation and advances in
information and telecommunication technology. Additionally, in Japan unit labor costs have been able
to fall considerably due to the relatively low rate of resource utilization. However, unit labor costs are
expected to start increasing. Furthermore, as the output gap becomes positive, the sensitivity of prices
to changes in economic activity may increase at some point, reflecting changes in firms' price-setting
stance and higher inflationary expectations among the public, and thus prices may increase faster
than anticipated.
V. The impact of an increase in the potential growth rate
I have thus far outlined the Bank's outlook for economic activity and prices for the next two years. I will
next explain in more detail a point touched on in the projection described earlier, namely, the impact of
the change in the potential growth rate on the Bank's conduct of monetary policy.
The potential growth rate seems to have been increasing recently, as a result of firms' efforts in
reducing excesses in production capacity and employment and their reallocation of capital and labor to
areas likely to generate higher profitability and growth in demand. The Bank estimates that the
potential growth rate has recovered to the 1.5-2 percent range recently, from its previous estimate of
approximately 1 percent.
When considering the impact of a rise in the potential growth rate on the conduct of monetary policy,
the important point is to assess how such a rise affects aggregate supply and demand and hence
prices. On the supply side, an increase in the potential growth rate gives rise to downward pressure on
prices. More concretely, a rise in the potential growth rate acts to increase the supply capacity of the
economy and thus exerts downward pressure on prices. Furthermore, since a rise in the potential
growth rate tends to be accompanied by an increase in productivity, downward pressure may also be
exerted on prices by the decrease in unit labor costs that can occur if wage rises lag behind the
increase in productivity.
On the demand side, however, a rise in the potential growth rate acts to boost aggregate demand.
Therefore, a rise in the potential growth rate does not necessarily exert downward pressure on prices.
The recent rise in the potential growth rate stems from firms' efforts to reallocate their resources to
areas likely to generate higher profitability and growth in demand, and this implies an improvement in
the overall economy's ability not only to produce goods but also to increase profits and income by
selling those goods. Such real economic improvements brighten firms' and households' expectations
regarding future income, and this brighter outlook, together with the wealth effect stemming from the
rise in stock prices, is likely to stimulate aggregate demand by bolstering their spending. Moreover,
since the expected rate of return on investment increases when the potential growth rate is rising,
monetary easing effects become stronger at any given level of the real interest rate. The result is to
further increase investment demand, triggering upward pressure on prices.
In terms of the time frame, a rise in the potential growth rate often causes an increase in production
capacity in the relatively short term, while in the longer term it seems to bring about an increase in
demand and to strengthen monetary easing effects. Such a picture, however, is inevitably attended by
uncertainty, since individual economic agents may increase demand in advance, taking account of
increases in their expected future income and in response to the wealth effect. Whatever the case, a
rise in the potential growth rate warrants close attention as it may give an expansionary push to the
economy not only from the supply side but also from the demand side, and because its effect on
prices can be both upward and downward.
VI. Conduct of monetary policy
I would now like to talk about the Bank's conduct of monetary policy, based on the outlook for
economic activity and prices.
At the Monetary Policy Meeting held on March 8 and 9, 2006, the Bank decided to terminate the
quantitative easing policy, which had been maintained during the five years since March 2001. It
decided to change the operating target of money market operations from the outstanding balance of
current accounts at the Bank to the uncollateralized overnight call rate. The new target for the
uncollateralized overnight call rate was set at effectively zero percent.
Under the new guideline for money market operations, the volume of short-term funds-supplying
operations by the Bank has been decreasing. Accordingly, the outstanding balance of current
accounts at the Bank has now declined to around 16 trillion yen. So far, the short-term money market
remains stable and there is gradually more activity being seen in the interbank market. The Bank will
continue to closely monitor conditions in the short-term money market in reducing the outstanding
balance of current accounts at the Bank. As long as the short-term money market remains stable, the
reduction in the outstanding balance will be completed in line with the projection the Bank made when
it terminated the quantitative easing policy in March. However, completing the reduction of the
outstanding balance of current accounts at the Bank and raising the target interest rate, which is
effectively zero percent, are two different issues. While the reduction in the outstanding balance of
current accounts at the Bank is carried out taking full account of conditions in the short-term money
market, the level of the target interest rate is to be set based on the Bank's assessment of economic
activity and price developments.
With regard to the future conduct of monetary policy based on the new operating target of money
market operations, namely, the uncollateralized overnight call rate, the Bank introduced a new
framework. The Bank announced that, under this framework, it would assess economic activity and
prices from two perspectives, taking account of the "understanding of medium- to long-term price
stability," which is expressed as an approximate range between zero and 2 percent in terms of the rate
of year-on-year change in the CPI. In light of this assessment, it would outline and release its current
view on monetary policy. The April Outlook Report was compiled under the new framework.
In the Outlook Report, the Bank examined, from the first perspective, whether the outlook deemed
most likely by the Bank for economic activity and prices two years into the future is that the economy
will follow a path of sustainable growth under price stability. The Bank judged that Japan's economy is
likely to achieve sustainable growth under price stability as long as the economy develops in line with
the outlook described earlier.
From the second perspective, the Bank examined the risks that are most relevant to conducting
monetary policy, looking over a longer time horizon.
As a result, the Bank came to the conclusion that, as an upside risk, it should pay attention in the
medium to long term to larger economic swings, resulting in large fluctuations in the rate of inflation,
mainly due to acceleration of business fixed investment reflecting the accommodative financial
conditions.
As for downside risks, the Bank examined the possibility of economic activity and the rate of inflation
deviating downward from its projection due to various factors. The Bank's judgment was that even if
economic activity is less robust and the inflation rate lower than expected, the risk of the economy
falling into a vicious circle of declining prices and deteriorating economic activity has become smaller,
since the Japanese financial system has regained stability and the economy has now cast off
excesses in production capacity, employment, and debt.
With regard to the future course of monetary policy, based on the assessment of economic activity and
prices from the two perspectives, it seems probable that the accommodative financial conditions
ensuing from very low interest rates will be maintained for some time following a period in which the
uncollateralized overnight call rate is at effectively zero percent. Through and beyond this stage, the
Bank will adjust the level of the target interest rate gradually in the light of developments in economic
activity and prices.
The Bank will continue to support the economy so as to achieve sustainable growth under price
stability through the appropriate conduct of monetary policy.