Toshihiko Fukui: Towards a new path of growth for the Japanese economy
Summary of a speech given by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai
meeting, Tokyo, 11 November 2005.
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Introduction
Semiannually in April and October, the Policy Board of the Bank of Japan decides the text of the
Outlook for Economic Activity and Prices, or the Outlook Report as we call it, and releases it. This
report describes the Bank's outlook for economic activity and prices which provides the basis for
conducting monetary policy, and also explains the Bank's thinking behind its conduct of monetary
policy. Today I would like to focus on the October 2005 Outlook Report, which was published two
weeks ago.
I. Recent economic developments and the outlook for economic activity
Japan's economy continues to recover, having emerged from the temporary pause that began in the
summer of 2004. The adjustments in production and inventory in IT-related sectors, which triggered
the temporary pause, appear to have run their course, and domestic private demand, such as
business fixed investment and private consumption, has been stronger than expected. According to
the Cabinet Office's reference dates of business cycles, the economy has been expanding since the
beginning of 2002, that is to say, for almost four years now.
Although a V-shaped recovery is unlikely to ensue after the economy's recent emergence from its
temporary pause, it is expected to achieve solid growth at a moderate and sustainable pace. The
Bank's projection for a period of one and a half years ahead, that is, through the end of fiscal 2006, is
that the economy is likely to experience a sustained period of expansion at a pace slightly above its
potential. The Bank's main purpose in releasing the Outlook Report is to explain its thinking on the
underlying mechanisms of economic activity and prices, and the Policy Board members' forecasts are
also provided as reference figures. In the October Outlook Report, the Policy Board members forecast
a real GDP growth rate for fiscal 2005 of slightly above 2.0 percent and for fiscal 2006 of around
1.52.0 percent. If the economy performs as projected in the October Outlook Report, it will have been
expanding at a pace above its potential for a very long period of time, since the actual growth rates for
fiscal 2003 and 2004 have been around 2.0 percent, exceeding the Bank's estimate of a potential
growth rate of around 1.0 percent.
This outlook for economic growth rests on the following underlying mechanisms. Exports are likely to
remain on the increase reflecting the continuing expansion of overseas economies, and against this
background, the corporate sector is likely to continue to show strength, and the positive effects of
strong corporate performance will steadily exert an influence on the household sector-in other words,
economic growth will be led by domestic and external demand that are well in balance. Furthermore,
the extremely accommodative financial conditions are likely to support private demand.
What is notable is that domestic private demand, especially business fixed investment and private
consumption, is likely to remain strong. The context behind this is that the adjustment pressures in the
corporate sector and the financial system that have been hindering the Japanese economy from
achieving a sustainable growth path since the bursting of the economic bubble have mostly dissipated.
Specifically, in the corporate sector, firms have almost resolved the excess in debt, employment, and
production capacity-the "three excesses." As for the financial system, the nonperforming-loan (NPL)
problem, which has placed downward pressure on the economy together with these three excesses,
has nearly been resolved.
Diffusion indexes for production capacity and employment conditions in the September 2005 Tankan
(Short Term Economic Survey of Enterprises in Japan) are at the level of 1992, immediately after the
bursting of the economic bubble, showing that adjustments in the excesses have made much
progress. In particular, the number of firms perceiving their holdings of labor as insufficient exceeded
the number perceiving them as excessive, implying that firms are starting to see themselves as short
of labor. Firms have also substantially reduced their interest-bearing liabilities, as evidenced by the
marked decline in the ratios of outstanding debt to total assets and to sales not only at large firms but
also small and medium-sized firms in the last few years.
While making adjustments in the three excesses, firms have been reviewing their business lines based
on the principle of "selection and concentration" and improving their ability to generate
high-valueadded products and services as they face intensified global competition. As a result, their profitability
has improved greatly. According to the Financial Statements Statistics of Corporations by Industry,
current profits of Japanese firms have increased for three consecutive years from fiscal 2002, with
both profits and the ratio of current profits to sales for fiscal 2004 exceeding those during the height of
the bubble era. Despite the headwind of a surge in crude oil prices, corporate profits are likely to
continue on an uptrend in fiscal 2005.
Given the high corporate profits, business fixed investment has been increasing steadily in a wide
range of industries and is also expected to continue increasing. In the Tankan survey, business fixed
investment plans of large manufacturers for fiscal 2005 showed a double-digit increase for the second
consecutive year, and small and medium-sized firms are also revising their plans upward. As a result,
business fixed investment is expected to increase for the third consecutive year for firms of all sizes in
all industries.
The strength of the corporate sector is steadily spreading to the household sector. In particular,
improvements in the employment and income situation are becoming noticeable. Firms have been
placing priority on restraining labor costs, but their stance on employment is becoming positive with
the problem of excessive holdings of labor in the corporate sector nearly resolved. One notable
example suggesting a change in firms' stance on employment is that the ratio of part-time workers to
regular employees, which had been generally on an uptrend since the bursting of the economic
bubble, has started to decline. With respect to wages, summer bonus payments have recorded
relatively high increases, and regular compensation has started to increase very slightly due partly to
the peaking out of the ratio of part-time workers. Supported by the improvement in the employment
and income situation, employee income is likely to continue to increase moderately, and against this
background, private consumption is expected to continue to rise steadily. Although private
consumption has been somewhat weak since the summer, it should be regarded as a reaction to the
strong developments in the first half of 2005 and it is likely that this weakness will be temporary, given
that positive influences from the corporate sector to households are spreading steadily via increases in
employee income.
There have also been remarkable improvements in the financial system. The NPL problem, which has
long been a burden on the Japanese economy, has generally been resolved. The amount outstanding
of NPLs at major and regional banks has been decreasing since reaching its peak at the end of fiscal
2001, and due mainly to the resulting decline in credit costs, their earnings for fiscal 2004 were the
highest in recent years. Net income turned positive in fiscal 2004, for the first time since fiscal 2000 at
major banks and since fiscal 1994 at regional banks. Against the background of improvements in
profitability and capital adequacy ratios, financial institutions' lending attitude has become more
accommodative. Bank lending, excluding the effects of marketing of loan assets and disposal of NPLs,
has turned positive on a year-on-year basis since this August, after a prolonged decrease. Financing
in capital markets through, for example, issuance of CP and corporate bonds has also been favorable
for firms. In this situation, firms' perception of their financial positions has improved to the level of the
early 1990s. Such accommodative financial conditions seem to be contributing to the recent increases
in housing investment as well as business fixed investment by small and medium-sized firms. These
accommodative financial conditions are likely to support private demand.
II. Pace of recovery
Japan's economy is likely to continue to expand against the background I have just explained. As I
mentioned at the beginning of this speech, the pace, however, is expected to be moderate with less
likelihood of acceleration. The main reason for this is the cautiousness of corporate behavior, which is
expected to persist.
It seems that firms have still not become confident about the future, having come through a protracted
period of low economic growth following the bursting of the economic bubble. Relative to the
recordhigh level of profits that firms have been posting, the improvement in business sentiment, according to,
for example, the Tankan survey, is only moderate. Although business fixed investment has been
increasing, it still remains substantially below the level of cash flow, and firms are reluctant to
aggressively increase fixed investment by raising the funds through bank loans or capital markets.
While an increasing number of firms are making more efficient use of cash flow since they have nearly
completed paying back their excess debt, they still appear cautious about accelerating inventory and
capital investments in response to increases in sales and production.
As a result of such corporate behavior, economic recovery is likely to remain moderate but at the
same time excessive build-up of stocks is unlikely. The current economic recovery, which is already
the third longest in the post-World War II period, is likely to be sustained for this reason.
III. Positive and negative deviations
Japan's economy is expected to continue to recover supported by strength in both the corporate and
household sectors with adjustment pressures that have lingered since the bursting of the economic
bubble dissipating. Under these conditions, it is unlikely that the economy will fall into recession due to
domestic factors, although with globalization, Japan's economy could be adversely affected in the
event of a major external shock, for example, a slowdown of the global economy. It is therefore
necessary to pay attention to the path of the global economy, as this could pose a downside risk to
Japan's economy. In particular, developments in crude oil prices, which continue to be high, and a
possible shift from the current accommodative financial conditions observed globally require close
monitoring.
Overseas economies, in particular the U.S. and Chinese economies, are likely to continue to expand.
The International Monetary Fund (IMF) also expects a high rate of world economic growth, forecasting
4.3 percent real growth both in 2005 and 2006, even though the figure falls short of 5.1 percent, a
historic high marked in 2004. Although the growth of the U.S. economy is expected to slow temporarily
due to the effects of hurricanes, it is expected to basically continue to expand at a pace around its
potential growth rate, partly since there is likely to be reconstruction-related demand. As for the
Chinese economy, inventory adjustment has been in progress mainly in sectors related to domestic
demand since the second half of 2004 in response to the government's measures to rein in the
overheated economy. However, inventory adjustment pressures are likely to taper off in the face of
robust economic growth.
Despite the ongoing global economic expansion, there is recently increased awareness of downside
risks stemming from the surge in crude oil prices. So far, the global economy has continued to expand
despite the record-high level of crude oil prices. A number of factors have contributed to this
development. First, one of the primary factors of the surge in crude oil prices is increased global
demand, reflecting developments such as high growth in emerging economies, and there is little
influence from supply-side constraints. Second, a mechanism of income reflow from oil-producing to
non-oil-producing countries is operating. The third and the most important factor from central bankers'
viewpoint is that the rise in crude oil prices has not led to a sharp rise in inflationary expectations, and
thus monetary policy has not been tightened aggressively. This is because inflationary expectations
have been contained as a result of the intensified global competition accompanying emerging
economies' transition to a market economy, and central banks have been taking appropriate monetary
policy measures.
Long-term interest rates in the United States and other major industrial countries have not yet shown
any clear upward movement compared with two years ago when crude oil prices started to rise and a
year and a half ago when the Federal Reserve started to raise the federal funds rate target. The
coincidence of surging oil prices and relatively low long-term interest rates in a climate of stable
economic expansion is hard to explain on the basis of past experience. A growing sense of a surfeit of
funds in the economy stemming from the slack in the global balance between savings and investment
and the increase in investment in long-term bonds by institutional investors, such as pension funds,
have been cited as factors. However, since long-term interest rates basically reflect the market's
outlook for economic activity and prices, the fact that inflationary expectations have been contained
has greatly contributed to the stability in the rates.
The maintenance of accommodative financial conditions has played a crucial role in the global
economic expansion. This is evident in the United States in particular, where stability in long-term
interest rates, by causing a continued rise in housing prices, has led to buoyant spending by
households through the wealth effect, and this in turn has been supporting economic expansion.
Should there be unexpected changes in monetary accommodation in light of rising inflationary
expectations caused by, for example, a further rise in crude oil prices, not only would growth in
advanced economies slow but the global economy including emerging economies could also be
adversely affected, perhaps via a shift in the international flow of funds.
So much for downside risks: let us now look at upside potentials. The domestic view of the outlook for
the Japanese economy tends to be pessimistic, due probably to the experience of low growth that
lasted for more than a decade. The view held overseas, however, has become increasingly optimistic,
with the October 8 issue of The Economist carrying a feature titled "The sun also rises." In fact,
firmness in Japanese stock prices since this summer owes significantly to the active investment by
foreign investors. As for the Bank's outlook, it assumes that corporate behavior will generally remain
cautious. However, with the three excesses having run their course, and the marked progress in
restructuring corporate balance sheets, it is probable that firms will become more confident about the
economic outlook as the economic recovery continues. In that case, firms, supported by
accommodative financial conditions, are likely to increase business fixed investment and hiring. Under
such circumstances, if there are stronger positive influences from the corporate sector to households
via increases in employee income, household spending may increase further. These developments
would entail an acceleration of economic recovery.
Developments in asset prices such as stock prices and land prices reflect people's perceptions about
the economic outlook. Asset prices are determined based on future cash flow expected to be
generated, and they therefore contain important information about people's view of the future.
Recently, stock prices have been strong, and land prices in some parts of Tokyo and other major
metropolitan areas have started to rise, suggesting an upturn in people's expectations regarding the
economy. However, land prices on the whole continue to be on the decline. Thus, not all asset prices
are increasing, reflecting continuing caution in people's perception of the outlook. Since developments
in asset prices reflect changes in people's perceptions as well as influence investment activity of firms
and households, they require close attention.
IV. Outlook for prices
Given this economic outlook, the environment influencing prices is likely to change gradually.
The output gap is expected to continue narrowing moderately as the economy continues to recover.
Firms' and households' expectations regarding prices play an important role in the formation of prices
via, for example, firms' price setting stance. Various survey results show that the number of
respondents perceiving that prices will rise in the future has been increasing gradually since hitting
bottom in 2001-02.
The consumer price index (CPI; excluding fresh food) has been decreasing on a year-on-year basis
since the middle of 1998 for more than seven years now. Recently, however, the pace of decline has
slowed considerably, with a 0.1 percent decline in September year-on-year. As the effects of special
factors such as the decline in rice prices and the reduction in electricity and telephone charges fall off,
the year-on-year changes in the CPI are likely to turn positive toward the end of 2005. Thereafter, in
this environment, the year-on-year changes are expected to remain positive. Forecasts of the majority
of Policy Board members for the CPI in fiscal 2006 are between 0.4 and 0.6 percent on a year-on-year
basis.
Despite the fact that the economy has been growing at a pace above its potential since fiscal 2003,
over two years now, and the output gap continues to improve, the impact on prices has remained
small. This is mainly because the decline in unit labor costs-labor costs per unit of production of goods
and services-which was brought about by a decline in wages and a rise in productivity worked to
contain upward pressure on prices. Unit labor costs are unlikely to record a clear increase in the near
future because the rise in productivity will still tend to hold them down despite the increases in wages.
In this situation, it is unlikely that the pace of increase in prices will accelerate.
The impact of economic activity on prices has been weakening, and this has been a global
phenomenon. However, it is uncertain whether this will continue in the future. A sustained narrowing of
the output gap may cause a greater-than-anticipated increase in inflationary expectations. This can
prompt firms to pass increases in costs, for example, a rise in input prices, on to sales prices. Although
it is most likely that the rise in prices will be contained, the risk of an upward deviation in prices should
nevertheless be kept in mind.
V. Conduct of monetary policy
It has been four and a half years since the Bank first introduced the framework of the quantitative
easing policy. This policy is unprecedented not only in the history of Japan but anywhere in the world.
In the spring of 2001, Japan faced an economic deterioration and a decline in prices, and concerns
about financial system stability intensified. With regard to monetary policy, short-term interest rates
were already practically zero percent and the Bank could not reduce them further. In response to this
situation, the Bank introduced the current quantitative easing policy framework, which has two pillars:
provision by the Bank of ample liquidity to the money market so that the outstanding balance of current
accounts at the Bank exceeds the amount of required reserves; and a commitment by the Bank to
continue with this ample provision of liquidity until the year-on-year rate of change in the CPI
(excluding fresh food) registers zero percent or higher on a sustainable basis.
When there were strong concerns over the stability of the financial system, the Bank's ample provision
of liquidity, which met financial institutions' liquidity demand, stabilized financial markets and
maintained accommodative financial conditions, and thus contributed to averting a contraction in
economic activity. This was the case in 2001-02 when the disposal of NPLs at major banks reached its
peak and the partial removal of blanket deposit insurance drew near, and in 2003 when public funds
were injected into Resona Bank. The commitment by the Bank, together with market participants'
expectations for consumer prices, has led them to expect that short-term interest rates will remain at
zero percent for some time, and as a result longer-term interest rates have remained stable at low
levels. The quantitative easing policy has thus been contributing greatly to the recovery in Japan's
economy through the Bank's provision of ample liquidity and its policy commitment.
The effects of the quantitative easing policy have been changing with developments in economic
activity and prices as well as the state of the financial system since its introduction. With regard to the
effects of ample liquidity provision by the Bank, an effect of reducing very short-term interest rates to
practically zero percent remains unchanged. However, as described earlier, with the progress in the
disposal of NPLs, precautionary demand for liquidity has declined substantially, reflecting diminishing
concerns over financial system stability. The effects of the policy commitment by the Bank have also
been changing. In principle, the expected duration of the quantitative easing policy based on the
Bank's commitment can either lengthen or shorten depending on market participants' expectations for
prices. With more market participants recently expecting that the year-on-year rate of change in the
CPI will be a positive figure in the near future, the duration of the policy as expected by market
participants is shortening. As a result, the policy commitment is gradually losing its influence on the
formation of longer-term interest rates. This is a natural consequence considering the characteristics
of the commitment.
As a result of the above changes, the stimulative effects of the quantitative easing policy on economic
activity and prices are at present increasingly coinciding with the effects of short-term interest rates
being at practically zero percent.
As for a change of policy framework, the Bank will judge whether the policy commitment has
effectively been fulfilled, in other words, whether the year-on-year rate of change in the CPI is
registering zero percent or higher on a sustainable basis, by monitoring economic activity and price
developments. Assuming that economic activity and price developments follow the projection
described in the October Outlook Report, the possibility of a departure from the present monetary
policy framework is likely to increase over the course of fiscal 2006. We cannot tell exactly when the
Bank will actually change the framework, since it depends on future economic and financial
developments. In any case, the Bank will appropriately determine the timing in view of these
developments.
Such a change of framework would mean a reduction in the outstanding balance of current accounts
at the Bank toward a level in line with required reserves, and a shift in the main operating target for
money market operations from the outstanding balance of current accounts to short-term interest
rates. At present, the effects of the quantitative easing policy are increasingly coinciding with the
effects of short-term interest rates being at practically zero percent. Thus, a change of policy
framework itself does not imply an abrupt change in terms of effects of policy. There will then be a
period of very low short-term interest rates followed by a gradual adjustment to a level consistent with
economic activity.
Conceptually, the course of monetary policy after the change of framework will be a reduction in the
outstanding balance of current accounts, a period of very low short-term interest rates, and a gradual
adjustment to a level consistent with economic activity.
How exactly the Bank will proceed, in other words, how the Bank will reduce the outstanding balance
of current accounts and set the level and time path of short-term interest rates thereafter, will depend
on future developments in economic activity and prices as well as financial conditions. In this regard, if
it is judged that upward pressure on prices continues to be contained and the economy follows a
sustainable and balanced growth path, this is likely to give the Bank latitude in conducting monetary
policy through the entire process. Based on this, I would like to point out two things.
First, when reducing the outstanding balance of current accounts, the Bank will need to monitor
financial market conditions carefully. With the Bank's quantitative easing policy, financial institutions
have for a long period of time been conducting their financing based on the existence of the large
current account balance at the Bank. Although the functioning of the money market will recover
eventually, investment and raising of funds in financial markets may be hindered for a while after the
change of framework.
And second, it is essential to ensure that financial markets are able to perform the pricing function
smoothly, reflecting underlying economic and price conditions. The markets in principle perform the
function of envisaging future monetary policy based on economic and price conditions and also
perform the function of forming interest rates. However, given that there is no precedent for a change
from the current policy framework to another, it is important for the purpose of smooth formation of
interest rates that the Bank clearly explain its assessment of economic activity and prices as well as
the thinking behind the conduct of monetary policy, and endeavor to stabilize market expectations. In
order to realize sustainable economic growth and stable prices, the Bank will take measures in an
appropriate and timely manner in response to economic and financial developments.
Conclusion
I have talked mainly about the content of the October Outlook Report as well as expected
developments in Japan's economy and the thinking behind the conduct of monetary policy. The
economy is on the threshold of a new path of growth, after an adjustment process lasting over ten
years since the bursting of the economic bubble. The Bank will continue to conduct monetary policy
appropriately and support this growth from the financial side.