Toshihiko Fukui: Recent 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, Osaka, 29 September 2005.
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Introduction
Today I plan to focus on recent developments in economic activity and prices and the basic
thinking behind the Bank of Japan's conduct of monetary policy.
The current situation and the outlook for economic activity and prices
The Japanese economy has recently emerged from a pause that started during the summer
of 2004 and continues to recover. The current economic expansion has lasted three years
and eight months as of this September, based on the Cabinet Office's reference dates of
business cycles, thus recording the third longest expansion phase in the post-World War II
period. The economy is expected to continue to recover, albeit at a moderate pace.
Real GDP growth has been strong so far this year with a large annualized increase from the
previous quarter of 5.8 percent in January-March 2005, followed by a 3.3 percent increase in
the April-June quarter, although it either remained unchanged or dipped slightly over the
three quarters from April-June 2004.
This favorable performance can be attributed to the stronger-than-expected domestic private
demand, such as business fixed investment and private consumption, along with moderate
export growth due to the expansion in overseas economies. In this environment, positive
effects stemming from the increased corporate profits have gradually spread to household
income, feeding back to the corporate sector via the increase in private consumption: in other
words, there is a positive interaction between the corporate and household sectors. Industrial
production is on the increase with the completion of adjustment in IT-related sectors.
Overall, the current economic recovery appears moderate in pace, but sustainable. The
economy is thus unlikely to fall into recession due to domestic factors. In the corporate
sector, profitability has substantially improved, as the adjustment in excess capacity and
employment has finally come to an end. According to 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. In fiscal 2005, profits are
forecast to grow for the fourth consecutive year, signifying buoyancy in corporate
performance.
Backed by high corporate profitability, business fixed investment is growing steadily in a wide
range of industries. Still, given the historically high levels of profits and cash flow, the current
level of business fixed investment appears too modest. This cautious corporate behavior
contributes to the mild and long-lasting recovery. However, as the economy continues to
recover and the business outlook becomes brighter, an increasing number of firms are likely
to start earmarking more cash flow for business fixed investment, the wellspring of their
future profits, with their focus on maximizing corporate value. We will examine the
robustness of business conditions, by using, for example, the results of the September
Tankan (Short-Term Economic Survey of Enterprises in Japan), which will be released in
early October.
Now turning to the household sector, the employment and income situations appear to be
improving steadily after a prolonged period of difficulty, as a result of firms' efforts to reduce
excesses in the workforce and personnel expenses. The number of employees has been
increasing since last year. More recently, the number of full-time employees has begun to
increase, while the rise in the number of part-time employees, who were more in demand
when corporate restructuring was in full swing, has slowed. Regular payments are steadily
increasing and bonus payments for this summer have also increased.
Given such improvement in the employment and income situations, private consumption has
been firm, and is on an upward trend, albeit with some fluctuations. Although sales of
automobiles and sales at department stores were slightly weak in July and August, this was
mainly in reaction to the substantial increase in sales during the April-June quarter, and the
upward trend in private consumption remains intact.
Of course, risk factors do exist and ought to be taken into account in assessing an economic
outlook. We should pay attention to the protracted surge in crude oil prices and its possible
effect on overseas economies, including that of the United States.
Crude oil prices, which have been rising for the past few years, marked a record high around
the end of August. Rises in crude oil prices entail the risk of deceleration of world economic
growth as a result of declines in the real purchasing power of non-oil producing countries. So
far, however, the world economy continues to expand at a robust pace and shows no sign of
this risk materializing. There are several reasons for this. First, the recent rises in crude oil
prices have not been caused by oil production capacity constraints. Rather, they are to a
large extent attributable to an expansion of demand mainly in emerging countries, whose
economies have enjoyed rapid growth. Second, rises in oil prices tend to cause income
transfer to oil-producing countries through deterioration in the terms of trade of non-oil
producing countries, thereby boosting the purchasing power of the former. The critical point
in this regard is how the increased income is spent. Judging from the recent rise in Japanese
exports to oil-producing countries and other evidence, it seems that a mechanism of income
reflow from oil-producing countries to non-oil producing countries is in fact operating.
In addition, it should be stressed that the recent crude oil hike has not led to a rise in a broad
range of categories in consumer prices nor a heightening of inflationary expectations in major
countries, and as a result, there has been no need for a rapid tightening of monetary policy.
This can be explained by factors such as the increased credibility of monetary policy in
countries pursuing price stability, and also the expansion of supply of low-priced products
flowing into the global market as a result of entry of emerging countries. Long-term interest
rates remain at low levels in major economies as a result of stable prices and
accommodative monetary policy. The pervasive low interest rate environment has laid the
foundation of world economic growth, as seen, for example, in the U.S. economy, where low
mortgage interest rates have boosted housing prices and this in turn has been supporting an
increase in household expenditure.
If crude oil prices remain high, we should keep close watch for any sign of a rise in inflation
expectations or rapid tightening of monetary policy, leading to deceleration in world economic
growth. In this context, we should also assess the negative effects of the hurricane which hit
the United States late last month and has caused devastating damage to the oil production
facilities and refineries in the area.
Based on the above economic outlook, I will elaborate on price developments. The corporate
goods price index continues to rise, mainly reflecting the rise in crude oil prices, and this
uptrend is expected to continue for the time being.
With regard to the consumer price index (CPI), the change in the core CPI, which excludes
fresh food, is hovering slightly below zero percent on a year-on-year basis. It is likely to
become zero or slightly higher toward the end of the year since the negative contribution of
rice prices and the reduction in electricity and telephone charges is expected to dissipate.
The year-on-year rate of change in the CPI is expected to increase thereafter, as the
Japanese economy is likely to continue growing at above its potential rate, causing the gap
between supply and demand to shrink further, and also the recent uptrend in wages is likely
to exert upward pressures on prices.
The bank's conduct of monetary policy
Based on the above assessment of economic activity and prices, I will explain the Bank's
thinking on the conduct of monetary policy.
The Bank has been implementing the quantitative easing policy to achieve sustainable
economic growth under price stability. The framework consists of two key elements. First, the
Bank provides ample liquidity to the money market far in excess of required reserves.
Second, the Bank is firmly committed to maintaining such ample provision of liquidity until the
year-on-year rate of change in the core CPI registers zero percent or higher on a sustainable
basis. This framework underpins expectations, based on inflation projections among market
participants, that the quantitative easing policy will continue for some time. As a result,
market interest rates remain steady at low levels, including those with relatively longer
maturities.
With regard to the first element, the Bank's provision of ample liquidity greatly contributed to
maintaining financial system stability and an accommodative corporate financing
environment by responding to precautionary demand for liquidity of financial institutions when
there were strong concerns about financial system stability. Since then, concerns about
financial system stability have largely subsided, as evidenced by the smooth implementation
of the full removal of blanket deposit insurance in April 2005. As a result, the quantitative
easing policy is effectively becoming closer to a maintenance of zero interest rates. In the
current situation, the quantitative easing policy contributes to maintaining an accommodative
financial environment by stabilizing market interest rates, thus allowing firms to continue to
enjoy low funding costs.
As for the conduct of monetary policy, the Bank will continue to maintain the quantitative
easing policy based on the commitment mentioned earlier since the core CPI is still
registering a slight year-on-year decline.
The Bank formulated this commitment when it introduced the quantitative easing policy in
March 2001. At the time, following the bursting of the global IT bubble, and the resultant
sharp fall in aggregate demand, the economy had fallen into recession and prices were
declining. The Bank decided to employ an unprecedented measure, linking its commitment in
terms of policy duration to the observed CPI, to create further monetary easing effects even
under zero interest rate conditions.
Thereafter in October 2003, the Bank clarified its commitment to maintaining the quantitative
easing policy. Specifically, the Bank specified two conditions. First, the year-on-year rate of
increase in the core CPI must register zero percent or above over a few months. Second, the
prospective year-on-year rate of increase in the CPI must not be zero percent or below.
These two conditions, as necessary conditions for terminating the policy, constitute a firm
commitment: in other words, the Bank commits itself to continuing the policy until they are
fulfilled. At the same time, the Bank made it clear that these two conditions are not sufficient
conditions in the sense that the Bank will not necessarily make an automatic decision to
terminate the policy as soon as they are fulfilled. To put it in a nutshell, the Bank will decide
whether to terminate the policy by examining developments in economic activity and prices
and judging whether the situation justifies asserting that the year-on-year rate of change in
sustainable
the CPI is registering zero percent or higher on a basis--in other words, whether
the commitment has effectively been fulfilled as a whole.
Of course, the timing of terminating the quantitative easing policy crucially depends on
developments in economic activity and prices. Based on the projections regarding economic
activity and prices mentioned earlier, the probability of terminating the policy is likely to
gradually increase over the course of fiscal 2006.
At that juncture, the Bank will shift the operating target for money market operations back to
short-term interest rates from the outstanding balance of current accounts at the Bank.
Since, as I pointed out earlier, the quantitative easing policy is effectively becoming closer to
a maintenance of zero interest rates, a change in the policy framework itself does not imply
an abrupt change in monetary policy. Although the future course of monetary policy
obviously depends on developments in economic activity and prices, an accommodative
financial environment is likely to be maintained, as long as upward pressures on prices
continue to be to a large extent contained and the economy follows a sustainable and
balanced growth path, as projected in the April 2005 Outlook for Economic Activity and
Prices.
Conclusion
The Japanese economy has emerged from a pause and continues to recover, albeit at a
moderate pace. The Bank is determined to carry out monetary policy so as to support
private-sector initiatives, and thereby realize sustainable economic growth and stable prices.