Toshihiko Fukui: Developments in economic activity and prices and the
Bank of Japan's conduct of monetary policy
Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting
with business leaders, Nagoya, 3 December 2007.
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Introduction
Today, I would like to explain the Bank of Japan's view regarding developments in economic
activity and prices and the basic thinking behind its conduct of monetary policy. In addition, I
would like to touch upon the issues currently facing Japan's financial system.
I. The current situation and the outlook for economic activity and prices
I would first like to talk about the current situation and the outlook for economic activity and
prices.
Japan's economy as a whole has continued to expand moderately, although the pace of
improvement in the household sector has remained slow relative to the strength in the
corporate sector. At the end of October, we released the Outlook for Economic Activity and
Prices (hereafter the Outlook Report), and presented the projection through fiscal 2008. The
gist of the Outlook Report is that although there are uncertainties regarding overseas
economies and global financial markets, Japan's economy is likely to continue its sustained
expansion under price stability. In terms of the rate of real GDP growth, we projected that this
is likely to register around 2 percent on average, somewhat higher than the potential growth
rate. I would now like to elaborate on the mechanisms that form the basis for the outlook as
well as some associated risk factors.
Within the corporate sector, exports have remained on the increase, reflecting the widening
base of continuing world economic growth. Business fixed investment is likely to keep rising
steadily, supported by high corporate profits. The rate of growth is, however, likely to be
lower than it was up until fiscal 2006, since capital investment has continued to increase at a
rapid pace for the last several years.
The positive influence of the strength in the corporate sector has been feeding through into
the household sector slowly but steadily. With the number of employees rising, employee
income has been increasing moderately, and growth in household income has continued to
be further supported via various other channels, for example, increased dividends.
Meanwhile, wages have been somewhat weak recently, reflecting labor cost restraint by
firms in the face of greater exposure to global competition and capital market discipline, and
increased materials prices. The change in the composition of the workforce due to the
retirement of the high-salaried baby-boomer generation and increases in part-time workers
has also contributed to the weakness in wages. However, given the further tightening of labor
market conditions and firms' growing sense of labor shortage, upward pressure on wages is
expected to increase gradually. Against this background, private consumption is likely to
follow a moderate upward trend.
In assessing wages and other flows of income from the corporate to the household sector,
business conditions at small firms are especially relevant because small firms account for a
large share of Japan's total employment. Since its inception, the current economic expansion
has coincided with continued progress in globalization, and thus there has been disparity in
business conditions depending on the extent of involvement with economies abroad.
Recently released surveys indicate that business sentiment at small firms is weakening.
Factors behind this include the deterioration in small firms' terms of trade, resulting from the
surge in materials prices, and the fact that production remained virtually flat in the first half of
2007. Although production has been increasing since the summer, future developments in
business conditions at small firms continue to warrant attention.
Regarding prices, while the domestic corporate goods price index (CGPI) has been rising
mainly due to higher international commodity prices, the year-on-year rate of change in the
consumer price index (CPI, excluding fresh food) has remained at around 0 percent. This
seems to reflect the fact that fierce competition due partly to progress in deregulation has not
allowed firms at the retail level to pass increased materials prices on to consumers to the
extent that has been possible at the wholesale level. Looking ahead, however, as economic
growth is expected to continue at a rate somewhat higher than the potential growth rate, the
level of utilization of resources, namely in labor and production capacity, should rise further,
and unit labor costs (labor costs per unit of output) are likely to stop falling. Given this, the
year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent
in the short run, but is expected gradually to rise in the longer run.
II. Positive and negative deviations
As I have outlined, the scenario we consider the most likely is that Japan's economy will
continue its sustained expansion with a virtuous circle of growth in production, income, and
spending in place. However, it should be noted that such projections are always subject to
upside and downside risks, which warrant close attention.
The first risk concerns developments in overseas economies. In the United States, housing
investment has been decreasing, and, with inventory levels high, the correction in the
housing market is expected to continue for a while. Banks are becoming increasingly
cautious in extending loans in view of disruptions in financial markets due to subprime
mortgage problems. Nevertheless, to date, other parts of the economy seem not to have
been harmed significantly, and private consumption and business fixed investment are
continuing their moderate upward trend, although the pace of increase is decelerating.
Employment has also continued increasing. Given these developments, it seems likely that
the U.S. economy will register relatively low growth rates in the short run but will eventually
realize a soft landing and move toward sustainable growth. However, if the correction in the
housing market intensifies or the negative effects of disruptions in financial markets become
unexpectedly widespread, private consumption and business fixed investment may fall below
expectations through negative wealth effects, credit tightening, and deterioration in business
and consumer sentiment, thereby leading to further deceleration in U.S. economic growth.
Meanwhile, the European economy has continued to expand, but the possible adverse
effects on financial conditions of global financial market disruptions may pose a downside
risk. If downside risks related to the U.S. and European economies were to materialize and
have significant adverse effects, growth in other parts of the world may be hampered and this
could cause global economic growth to be weaker than expected.
At the same time, attention should also be paid to the risk of inflation, since the world
economy, taken as a whole, has been expanding at a rapid pace. In the United States,
underlying inflationary pressures do not seem to have subsided, reflecting continued high
levels of resource utilization as well as developments in crude oil prices. In China, with signs
of overheating, especially in fixed asset investment, economic growth and inflation may
exceed expectations. Meanwhile, given the currently elevated prices of crude oil and grains
such as wheat and soybeans, possible shifts in international commodity prices may also
influence the outlook for the global economy and the price situation.
In global financial markets, disruptions due to subprime mortgage problems have continued
to be observed. In the United States and Europe, the functioning of markets for securitized
products has deteriorated significantly, while money markets are still in the process of
recuperating. Stock prices and foreign exchange rates have been unstable across the world.
The recent volatility in global financial markets seems to reflect a reversal of the previous
laxity in risk evaluation that had developed during the long period of benign economic and
financial conditions. This adjustment is therefore expected to require some time to work itself
out, and during the process financial institutions will have to bear a certain amount of losses.
Still, there is a degree of uncertainty as to how the global economy will be influenced by
future developments in global financial markets and conditions at financial institutions.
If such disturbances to overseas economies and global financial markets should indeed
materialize, Japan's economy may be adversely influenced through, for example, changes in
exports and imports, corporate profits, and financial market conditions. Attention should
continue to be paid to this potential risk.
The second risk concerns possible larger swings in financial and economic activity under
continuing accommodative financial conditions. In terms of their impact on Japanese
financial conditions, the adverse effects of subprime mortgage problems and the consequent
volatility in global financial markets have so far been limited: the lending attitude of financial
institutions has been positive; and the issuing environment for CP and corporate bonds has
continued to be favorable. Meanwhile, with extremely accommodative financial conditions
continuing, there is a risk of a misallocation of resources in the long run as agents become
over-extended in financial markets or pour funds and other resources into inefficient
economic activities. Such behavior may push up economic growth and asset prices in the
short run, but lead to later downward adjustments and hamper the sustainability of economic
growth.
III. Conduct of monetary policy
I would now like to explain the Bank's thinking regarding the conduct of monetary policy
based on the above-mentioned assessment of economic activity and prices.
As I have just said, Japanese financial conditions have been extremely accommodative, and
if Japan's economy is to follow a path of sustainable growth under price stability, the level of
interest rates is to be raised. We have no predetermined view regarding the timing or the
pace of increase in interest rates, and will determine these in light of our assessment of the
future path of the economy and prices and its likelihood, as well as a careful consideration of
both upside and downside risks. Our outlook suggests that Japan's economy will realize
sustainable growth under price stability. But still, we need to examine the likelihood of this
scenario. We are also aware of the importance of examining risk factors that may influence
the outlook, and in this respect we should not focus merely on immediate downside risks, but
should be attentive to both upside and downside risks. It is vital for monetary policy to adopt
a wide-ranging perspective that takes due account of the various factors influencing
economic activity and prices. This is something we bear in mind in our efforts to ensure the
appropriate conduct of monetary policy.
IV. Issues facing Japan's financial system
As the last topic of my speech today, I would like to touch upon the recent volatility in global
financial markets and its implications for Japan's financial system.
As subprime mortgage problems have intensified and become more widespread in financial
markets abroad, the impact on Japanese financial institutions has been gradually increasing
and is greater than originally expected. For instance, the decline in the market value of
investment products has resulted in losses at some Japanese financial institutions, and some
financial institutions have posted losses from revaluation on unsold products arranged as
part of their overseas securitization business. However, since Japanese financial institutions'
exposure to credit markets is relatively small, it seems that so far each financial institution or
financial group is able to absorb losses incurred sufficiently within its earnings for the period
or its buffer capital. We will keep our eyes on developments in U.S. and European financial
markets, but it currently seems unlikely that this particular problem will pose any significant
threat to the stability of Japan's financial system.
Based on the assessment I have just made, let me now turn to current issues relating to risk
management by market participants.
First, market participants, including financial institutions, need to assess the risks pertaining
to financial products more precisely.
It cannot be denied that the current disruptions in financial markets are due partly to lax risk
assessment by market participants caught out by the rapid expansion of markets for
securitized products as well as the increased market penetration of complex financial
products whose riskiness is difficult to assess. Innovative new financial products, in
particular, have only a limited amount of accumulated historical data, for example on price
fluctuations, and they also have complex risk profiles and relatively low market liquidity. For
this reason, market participants should seek to quantify risks as accurately as possible,
subject to very strict stress testing, and should then conduct appropriate risk management
accordingly.
Second, market participants should further involve themselves in enhancing market
transparency.
As seen in recent events, once a significant shock has occurred, the market as a whole
tends to suffer anxiety and it can take some time for the proper functioning of financial
markets to be restored. Furthermore, market reaction seems to become larger where
financial products traded incorporate more advanced financial technologies. From the
viewpoint of minimizing market over-reactions and facilitating the prompt recovery of market
functioning, initiatives by market participants to further enhance information disclosure are
highly desirable. Greater market transparency could be achieved, for instance, through the
disclosure by financial institutions of the outstanding amounts of their investments and
information concerning their profits and losses, as well as the provision by rating agencies of
detailed information relevant to credit ratings.
I would like to emphasize that we do not view the recent development of financial markets,
especially for securitized products, in a negative light. Risk diversification using new financial
products has broadened the range of participants in financial markets, and has contributed
significantly to the growth of the world economy. The problem has been that the techniques
to assess and manage the associated risks have not kept up with the pace of product
innovation. What we need is to improve those techniques. At the Bank of Japan, we will
continue to closely monitor developments in global financial markets and to assess their
implications for the Japanese financial system. At the same time, we will study and analyze
in greater depth the various risk management issues I have discussed today, and so
contribute to the enhancement of risk management by Japanese financial institutions.
Closing remarks
Amid intensifying global competition, Chubu, which has an industrial sector that is highly
competitive at the international level, has been pulling the Japanese economy forward. I feel
confident that the Chubu region will make use of the advanced technological expertise it has
built up to take advantage of new business opportunities, and to enjoy further breakthroughs.
I believe this will in turn lead to the sustained and dynamic growth of Japan's economy.