Haruhiko Kuroda: Crude oil prices and price stability
Speech by Mr Haruhiko Kuroda, Governor of the Bank of Japan, at the Japan National Press
Club, Tokyo, 27 February 2015.
* * *
Accompanying charts can be found at the end of the speech or on the Bank of Japan's website.
Introduction
Today, I am very pleased to appear before the venerable Japan National Press Club.
The Bank of Japan has been carrying out quantitative and qualitative monetary easing
(QQE) to achieve a price stability target of 2 percent at the earliest possible time, with a time
horizon of about two years. Amid this, Japan's economy has continued its moderate recovery
trend, with prices rising accompanying the increase in corporate profits and employee
income. However, the year-on-year rate of increase in the consumer price index (CPI) has
slowed recently, reflecting the substantial decline in crude oil prices since last summer. In
that situation, some opine that the Bank should take some time to achieve the price stability
target of 2 percent while others think that 2% inflation is hard for the Bank to achieve in the
first place.
Today, I will first briefly discuss the current situation of and outlook for Japan's economy.
Then I will explain the recent conduct of monetary policy, mainly the thinking behind the price
stability target and policy responses to the decline in crude oil prices.
I. The current situation of and outlook for Japan's economy
To start with, let me talk about the current situation of and outlook for Japan's economy.
Japan's economy has continued its moderate recovery trend. Regarding the outlook, it is
likely to continue growing at a pace above its potential given that exports are expected to
increase moderately and that domestic demand is likely to remain firm. Positive effects from
the decline in crude oil prices and the government's stimulus package that was formulated at
the end of last year are likely to boost such favorable developments. According to the Bank's
interim assessment in January of the October 2014 Outlook for Economic Activity and Prices
(hereafter the Outlook Report), the Policy Board members' forecasts of the real GDP growth
rate was minus 0.5 percent for fiscal 2014, but 2.1 percent for fiscal 2015, and 1.6 percent for
fiscal 2016 (Chart 1).
I will discuss the following two key points in some detail. The first one is developments in
exports and production in the corporate sector, and the second is developments in wages
and private consumption in the household sector.
Corporate sector: developments in exports and production
Exports, which had been more or less flat for a long period despite the correction in the
excessive appreciation of the yen, have finally been picking up recently (Chart 2). Looking at
the developments by region, exports to the United States registered a sizeable increase,
since capital goods and parts have increased in reflection of the recovery there in business
fixed investment. Exports to Asia have also increased, mainly in IT-related goods and in
capital goods and parts.
With regard to the outlook, overseas economies, mainly advanced economies, are expected
to continue recovering moderately, boosted partly by the decline in crude oil prices.
According to the World Economic Outlook (WEO) Update published last month by the IMF,
global growth, after registering 3.3 percent for 2014, is projected at 3.5 and 3.7 percent for
2015 and 2016, respectively. As a whole, it is expected to increase gradually, albeit with a
downward revision relative to the October 2014 WEO (Chart 3).
Looking somewhat closely at the developments in overseas economies by region, the U.S.
economy is likely to be a driving force for global growth for the time being. Against the
backdrop of a faster pace of increase in employment and a substantial decline in gasoline
prices, private consumption has seen a firm increase. Since the firmness in the household
sector has been feeding through to the corporate sector, the economy is expected to
continue to recover solidly, led mainly by private demand. As for the European economy,
momentum for the recovery has remained weak. Nevertheless, private consumption has
been recovering steadily, albeit moderately, due in part to positive effects of the decline in
crude oil prices, and exports have shown signs of picking up thanks to such effects as those
of the depreciation of the euro. Against the background of those factors, a further slowdown
in the economy has been staved off. Going forward, the European economy is expected to
continue its recovery, albeit at a gradual pace, since effects of the successive monetary
easing measures by the European Central Bank (ECB), such as the start to a purchasing of
bonds issued by euro area central governments, are expected to underpin the recovery. The
Chinese economy has been growing at a somewhat slower pace, but is likely to continue
with generally stable growth underpinned by moderate improvement in external demand and
the authorities' measures to support economic activity. Emerging economies apart from
China and commodity-exporting economies as a whole have continued to lose pace, but their
pace of growth is likely to pick up gradually as the recovery in advanced economies exerts
positive effects.
Taking the above into consideration, Japan's exports are expected to increase moderately,
as overseas economies continue to see moderate recovery, mainly advanced economies.
That said, due attention needs to be paid to various uncertainties such as the outcome of the
debt problem in Europe, including the developments in Greece, developments in the
emerging and commodity-exporting economies facing structural issues or political instability,
and geopolitical risks.
Against the backdrop of the pick-up in exports and resilience in private consumption as a
whole, about which I will discuss in more detail next, production has been picking up due to
the progress in inventory adjustments. Corporate profits have continued to improve, with the
ratio of current profits to sales for major firms exceeding the level prior to the global financial
crisis (Chart 4). In that situation, firms have maintained their positive stance in their business
plans, and fixed investment is planned to be increased steadily following last fiscal year.
Some firms have increased their share of domestic investment for this fiscal year, and it has
been noticeable in media reports recently that firms that relocated production sites overseas
amid the phase of the appreciation of the yen have started to attach importance to domestic
production. Going forward, against the backdrop of a moderate recovery trend in the
economy, an increase in exports, and the decline in crude oil prices, corporate profits are
likely to continue improving and business fixed investment is projected to continue on a
moderate increasing trend.
Household sector: Developments in wages and private consumption
Turning to the household sector, firms' positive stance has led to a tightening in labor market
conditions and, accordingly, an improvement in the employment and income situation. With
regard to firms' views on employment, even amid the sluggish economic recovery until last
summer, the degree of labor shortage has risen further (Chart 5). In this situation, total cash
earnings have risen moderately, albeit with fluctuations since last spring. Last year, the
yearon-year rate of increase in scheduled cash earnings was positive, reflecting the revival of an
increase in base pay at many firms, which had been lost for many years. This winter's
bonuses also increased solidly. On the back of the rises in total cash earnings and the
number of employees, employee income has been rising moderately. Private consumption
as a whole has remained resilient against the background of steady improvement in the
employment and income situation. Sales of durable consumer goods such as household
electrical appliances, which had been affected by the decline in demand after the
consumption tax hike for a protracted period, have been on an improving trend since early
autumn. Going forward, private consumption is expected to remain resilient with the
employment and income situation continuing to improve steadily.
As I have explained so far, with a virtuous cycle from income to spending likely to be
maintained steadily in both the household and corporate sectors, Japan's economy is
expected to continue growing at a pace above its potential.
II. The price stability target and quantitative and qualitative monetary easing
Next, I would like to talk about monetary policy. To start with, I will explain the thinking behind
targets for price stability in some depth, referring to examples of such targets in other major
economies.
A. Thinking behind targets for price stability
Many central banks including the Bank of Japan have been implementing monetary policy,
aiming to achieve an inflation rate of around 2 percent (Chart 6). For example, central banks
in such countries as Japan, the United Kingdom, Canada, and New Zealand have set
2 percent inflation as a target, and in the United States, the Federal Reserve has set a
longer-run goal for inflation at the same rate. In the euro area, the ECB has presented a
quantitative definition of price stability and expressed it in a numerical way, which is below,
but close to, 2 percent. While there are various ways of how this is expressed, conducting
monetary policy that aims at around 2 percent inflation has become a global standard.
Looking at developments in the CPI in these economies, even in the United States and the
United Kingdom, where CPI inflation has been considered stable at the rate of around
2 percent, the rate has been moving in a rather wide range depending on the situation
(Chart 7). In reality, the inflation rates in those economies have been centered at around
2 percent on average in the medium term. In other words, the inflation rate may move up and
down according to cyclical factors such as the business cycle, fluctuations in commodity
prices, and other factors. In such an environment, central banks have been conducting
monetary policy to achieve the target level of inflation on average in the medium term, which
often is equated with being over the business cycle. For example, during a press conference
in January 2012 when the Federal Reserve announced its decision to adopt a longer-run
goal for inflation at the rate of 2 percent, then-Chairman Bernanke said the following as part
of his answer to a question: "'medium term' - which is, these targets are all medium term - is
a flexible concept." The Reserve Bank of Australia specifies that "the appropriate target for
monetary policy in Australia is to achieve an inflation rate of 2-3 percent, on average, over
the cycle." In the case of New Zealand around the middle of the 1990s, when the central
bank was strictly pursuing a target for price stability, its Policy Targets Agreement with the
Minister of Finance included escape clauses, so to speak, or a range of events that would
allow the central bank governor to be exempted from being held responsible for deviations
from the target; for example, "shifts in the aggregate price level as a result of exceptional
movements in the prices of commodities traded in world markets" and "a natural disaster
affecting a major part of the economy."
In this way, each country views that the 2 percent inflation rate will be achieved on average
over the business cycle. In line with this, what each central bank attaches importance to in
conducting monetary policy are developments in medium- to long-term inflation expectations.
This is because, if the medium- to long-term inflation expectations are anchored at around
2 percent - in other words, if firms and households act on the assumption that prices will
increase by about 2 percent - it is likely that the target for price stability will be achieved on
average in the medium term even if the inflation rate deviates from the target level as a result
of being affected by the business cycle or temporary factors.
This view on the conduct of monetary policy was reflected well in the different responses
taken by the Federal Reserve and the ECB to the substantial decline in crude oil prices since
last summer. In general, a decline in crude oil prices exerts downward pressure on prices in
the short term, but year-on-year effects will dissipate going forward. Moreover, from a
longerterm perspective, the decline induces a positive effect of increasing the real purchasing
power in an oil-importing country, and will eventually push up prices. Therefore, if firms' and
households' medium- to long-term inflation expectations are anchored at the target level,
which central banks aim to achieve, and the general public perceives that prices will revert to
2 percent sooner or later even if they fall temporarily, monetary policy responses are judged
unnecessary since trend inflation is unchanged. In fact, the Federal Reserve maintains its
policy stance of starting a liftoff of the federal funds rate even in a situation where the
headline CPI inflation clearly is declining in reflection of the effects of falling crude oil prices.
As the background to this, the January Federal Open Market Committee (FOMC) statement
illustrated a view that "survey-based measures of longer-term inflation expectations have
remained stable" and that, as for the outlook for prices, "[i]nflation is anticipated to decline
further in the near term, but the Committee expects inflation to rise gradually toward
2 percent over the medium term as the labor market improves further and the transitory
effects of lower energy prices and other factors dissipate." As for Europe, the ECB recently
decided an additional easing measure that includes a start to the purchasing of bonds issued
by euro area central governments. As the background to this, President Draghi pointed out
that the weak headline inflation dominantly driven by the fall in oil prices could adversely
affect medium-term price developments through the second-round effects on wage and
price-setting. As a matter of fact, in Europe, in a situation where the momentum of economic
recovery is weak, the inflation rates have declined to a negative figure for the first time in
about 5 years due to the effects of the fall in crude oil prices, and some indicators have
started to suggest a decline in the medium- to long-term inflation expectations. Therefore,
Europe is faced with a situation in which the public's perception that prices will increase by
about 2 percent might be impaired, or in other words, a situation in which there is a risk that
2 percent inflation expectations might become de-anchored. The easing by the ECB was
made in response to such risk.
B. The reason for aiming at achieving the price stability target of 2 percent at the
earliest possible time
What I have outlined so far is the standard view on the target for price stability. The Bank's
price stability target is basically in line with that view.
Nevertheless, the situation in Japan, on the basis of which monetary policy should be
discussed, greatly differs from that in the United States and Europe. The challenge for the
United States and Europe, on the one hand, is how to maintain inflation expectations, which
already have been anchored at around 2 percent. On the other hand, the issue for Japan is
to deliberately raise inflation expectations - which had been considerably below 2 percent
during the years of deflation - through monetary policy.
Looking at the situation in Japan, the year-on-year rate of change in the CPI had been in
negative territory or slightly above zero since the second half of the 1990s up until before the
introduction of QQE. In other words, over the business cycle, it has been at around 0 percent
on average. Amid protracted deflation over this long period, medium- to long-term inflation
expectations declined, and consequently, a sense that prices would not increase became
entrenched. Under these circumstances, firms' incentives to launch new initiatives through
investing in business facilities and in research and development became reduced, because
the holding of cash or deposits became a relatively better investment strategy. Thus, Japan's
economy was deprived of vitality and this generated a vicious cycle in which the low vitality
made it more difficult to overcome deflation. In order to escape from such a situation, it has
become necessary to pursue a policy that quickly and drastically changes firms' and
households' mindset that prices will not increase. To that end, what was introduced as a
prescription was QQE. This policy aims at creating an economic situation where prices
increase at around 2 percent on average, as is the case with the United States and Europe,
by raising people's medium- to long-term inflation expectations to around 2 percent and
re-anchoring these expectations at that level.
The mechanism of QQE is expected to be as follows: first, inflation expectations will be
raised through a clear commitment and through a large-scale monetary easing to underpin
the commitment; second, concurrently, downward pressure will be put on nominal interest
rates through massive purchases of government bonds, thereby decreasing real interest
rates and stimulating private demand such as business fixed investment. Namely, to start
this mechanism, the Bank aimed at first igniting inflation expectations. Raising inflation
expectations by changing people's deflationary mindset is itself an aim of overcoming
deflation, and at the same time the key to implementing the mechanism of QQE.
Considering the unique situation facing Japan and the prescription for it, importance is
attached to a "time frame" during which the target should be achieved, compared with the
target for price stability in other countries. If the Bank had simply stated that it would achieve
2 percent inflation at some point in the future and that it therefore expects firms and
households to change their actions, would those entities, which had experienced deflation for
a long time, change their actions in belief of such a vague promise? I doubt it. It is because
the Bank presented a time frame of achieving the price stability target at the earliest possible
time with a time horizon of about two years, and made a clear commitment that it will do
whatever is necessary to achieve that target that the perception of inflation by firms and
households started to change and the mechanism of QQE started to operate.
This is why the Bank adheres to achieving 2 percent inflation "at the earliest possible time."
After the inflation expectations are anchored at 2 percent, as in the case of the United States,
pushing back the inflation rate to 2 percent can be achieved in a more relaxed manner.
However, to raise inflation expectations to 2 percent, it is necessary to have strong enough
levels of speed and momentum to change people's expectations. Deflationary equilibrium is
a steady state, so there is gravity that pulls prices to the equilibrium. This is why deflation has
been protracted for 15 years in Japan despite the cyclical economic fluctuations and
monetary and fiscal stimulus measures. In order to escape from deflationary equilibrium,
tremendous velocity is needed, just like when a spacecraft moves away from Earth's strong
gravitation. It requires greater power than that of a satellite that moves in a stable orbit.
Reaching orbit at an altitude of 1 percent, for example, which is lower than that for satellites
of other countries, is not enough. This is because satellites at a low altitude can be pulled
back by gravity. An altitude of 2 percent is a global standard employed by each country, and
this level is set in view of experiences of monetary policy around the globe; namely, an
upward bias of the CPI, which indicates inflation higher than the true inflation rate, and a
buffer at a level that prevents falling into deflation.
In sum, the Bank's price stability target as a framework is no different from the targets for
price stability employed in other economies. What is distinctive in Japan's case is that a
stronger-than-usual measure is necessary in the phase of escaping from the deflationary
equilibrium. The crux of QQE is to realize a rise in inflation expectations (or conversion of
deflationary mindset) with sufficient speed and momentum through the Bank's commitment
to achieve the price stability target of 2 percent at the earliest possible time and through a
monetary easing measure of an unprecedented scale.
C. Assessing trend inflation
For these reasons, the Bank aims at achieving the 2 percent inflation rate at the earliest
possible time. In this regard, we occasionally are asked which price index we use as a
guideline for arriving at that figure. The Bank, as many other central banks do, defines the
price stability target as the headline CPI. However, it should be noted that achieving
2 percent temporarily will not suffice. The Bank aims at maintaining the inflation rate at
2 percent in a stable manner. Therefore, it is necessary to judge trend inflation by identifying
factors that are prone to fluctuate in the short term - such as commodity prices, including
crude oil prices, and prices of fresh food - from developments in the CPI for all items. In
doing so, it should be noted that each price index has both advantages and disadvantages,
and there is no single index that appropriately reflects trend inflation for any given economic
situation. The Bank has been assessing the CPI from various aspects, including that for all
items less fresh food, that for all items less food and energy, the trimmed mean CPI, and the
ratio of increasing and decreasing items. On this basis, the Bank's outlook for inflation
presented in the Outlook Report and its interim assessment refers to the CPI for all items
less fresh food, which has reflected trend inflation relatively well. Even so, as in the recent
case of crude oil prices changing substantially, a problem arises that the outlook for inflation
depends considerably on the assumption for the future path of crude oil prices. Against this
background, in the January interim assessment, the Bank disclosed an assumption for the
future path of crude oil prices, which was shared by all the Policy Board members in making
their forecasts, as well as the contribution of energy items to the CPI based on this
assumption, in an attempt to communicate the Bank's assessment of trend inflation more
clearly.
In order to grasp trend inflation, a comprehensive assessment - based on examinations of
various price indices, as well as the output gap and medium- to long-term inflation
expectations and economic developments behind them - is necessary. Moreover, as for
inflation expectations, it is important not only to monitor market-based indicators and surveys
of firms, households, and economists, but also to analyze changes in the inflation rate
perceived by the general public by examining firms' and households' actions, such as wage
negotiations and firms' price-settings. This is because thoughts and actions by firms and
households, not by traders in financial markets, actually influence economic and price
developments.
D. Outlook for prices and monetary policy management
To conclude my speech, I would like to talk about the developments in prices and monetary
policy management on the basis of the view on prices I have mentioned thus far.
The year-on-year rate of increase in the CPI for all items less fresh food for April 2014 had
improved to 1.5 percent excluding the direct effects of the consumption tax hike, but its rate
of increase slowed against the background of a substantial decline in crude oil prices since
the summer, and the latest figure for the rate in January is 0.2 percent (Chart 8). In this
situation, the Bank decided in October last year to expand QQE (the so-called additional
easing). This decision was not made to respond to the decline in crude oil prices itself. It was
made out of concern over a risk that the decline in crude oil prices affects inflation
expectations through sluggish growth in the inflation rates, thereby delaying conversion of
the deflationary mindset. As I mentioned earlier, a rise in inflation expectations is the start of
the mechanism of QQE, and is also the key to its successful implementation. If people
consider that the Bank is not serious about achieving the price stability target of 2 percent at
the earliest possible time, QQE, which has been exerting intended effects so far, would not
function properly anymore. Actually, the large reaction by markets after the additional easing
suggests that the Bank's determination may have been questioned earlier. In any case,
however, I believe such doubt was cleared after the easing.
Crude oil prices have been declining further even after October last year, but conversion of
the deflationary mindset is proceeding steadily. Of the indices relating to inflation
expectations, although market-based indicators such as the break-even inflation rates have
declined in line with those in the United States and Europe, medium- to long-term inflation
expectations have been maintained according to the results of surveys of economists. In
terms of corporate behavior, negotiations between management and labor over a base pay
increase seem to have progressed, and base pay is likely to rise for the second consecutive
year this spring. We judge that, at the moment, manifestation of a risk that conversion of the
deflationary mindset might be delayed has been prevented due to the easing measure in
October.
The output gap, which is another determinant of trend inflation, has been improving mainly
on the labor front, as seen in the fact that the unemployment rate has declined to around
3.5 percent, and is likely to follow an improving trend with the economy expected to continue
growing at a pace above its potential. In this sense, the decline in crude oil prices is a
supporting factor. Therefore, trend inflation rates are expected to rise steadily going forward
and, as the effects of the decline in crude oil prices on a year-on-year basis dissipate, the
2 percent CPI inflation is likely to be achieved. The timing of this could be either earlier or
later to some extent, depending on future developments in crude oil prices; however, based
on the assumption that crude oil prices are expected to rise moderately from the recent level,
the CPI is likely to reach 2 percent in or around fiscal 2015 (Chart 1). Needless to say, the
Bank maintains its policy stance that it will make adjustments as necessary without
hesitation, when there are changes in trend inflation, in order to achieve the price stability
target at the earliest possible time. The Bank will not respond to developments in crude oil
prices themselves, but in conducting monetary policy, it will closely monitor how they affect
inflation expectations - or, in other words, whether conversion of the deflationary mindset will
nevertheless proceed.
Thank you very much for your attention.
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