Hiroshi Nakaso: Japan's economy and monetary policy
Speech by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, at a meeting with
business leaders, Ehime, 9 March 2015.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
It is my pleasure to have the opportunity today to exchange views with administrative,
financial, and business leaders in Ehime Prefecture. I would like to take this opportunity to
express my sincerest gratitude for your cooperation with the activities of the Bank of Japan's
Matsuyama Branch.
The Bank thinks that it is of overriding importance for Japan's economy to overcome
protracted deflation and attain sustainable growth. To achieve this, the Bank introduced
quantitative and qualitative monetary easing (QQE) in April 2013 and expanded it in October
2014. Under this policy, Japan's economy has been making steady progress toward
achieving the price stability target of 2 percent. Nevertheless, some have expressed doubts,
arguing that it will be difficult to achieve 2 percent inflation in about 2 years, or that if inflation
is generated artificially, this would undermine people's standard of living. Today, I would like
to talk about recent economic developments in Japan and then explain the Bank's monetary
policy conduct and price developments. I hope this will also help to dispel the doubts I just
mentioned.
I. Current situation of and outlook for economic activity at home and abroad
To start with, let me talk about the current situation of Japan's economy. The decline in
demand following the consumption tax hike has had somewhat prolonged effects on the
economy, especially on sales of durable consumer goods such as automobiles and
household electrical appliances reflecting the large extent of front-loading of purchases.
However, Japan's economy has continued its recent moderate recovery trend, with a
virtuous cycle from income to spending operating steadily in both the household and
corporate sectors. I will discuss the current situation of and outlook for overseas economies
and business operations, the household sector, and the corporate sector in order.
Overseas economies and Japan's exports
First, overseas economies, led by advanced economies, have been recovering on the whole,
although performance in some parts remains lackluster. With the decline in crude oil prices
likely to exert a positive effect, overseas economies, led mainly by advanced economies, are
expected to continue recovering moderately, and positive effects of the recovery are
expected to gradually feed through to emerging economies and commodity-exporting
economies. In this context, it is worth noting that in the World Economic Outlook (WEO)
Update published in January, the IMF revised its outlook for the world economy downward
due to the deceleration of global growth to date, but it maintains its view that global growth
will increase gradually: after registering 3.3 percent in 2014, global growth is expected to
reach 3.5 percent in 2015 and 3.7 percent in 2016 (Chart 1). Japan's exports - after showing
some continued weakness despite the depreciation of the yen - have been picking up
recently, increasing for two consecutive quarters (Chart 2). The depreciation of the yen now,
with a delay, appears to be starting to have a positive effect on export volumes. Regarding
the outlook, exports are expected to increase moderately against the background of the
continued moderate recovery in overseas economies.
Employment and income situation and household spending
Turning to the household sector and starting with the employment and income situation,
labor market conditions have continued their steady improvement. The unemployment rate
has declined to around 3.5 percent, which is roughly the same level as the structural
unemployment rate, and the active job openings-to-applicants ratio now stands at 1.14,
marking the highest level since April 1992 (Chart 3). Against the background of this
tightening in labor market conditions, the year-on-year rate of increase in total cash earnings
per employee has been accelerating moderately, albeit with fluctuations (Chart 4). Given
these developments in employment and wages, employee income has risen moderately.
Against the background of steady improvement in the employment and income situation,
private consumption as a whole has remained resilient, although recovery in some areas has
been sluggish (Chart 5). Housing investment, which saw large front-loading prior to the
consumption tax hike, has started to bottom out. Meanwhile, consumer confidence, which
had become increasingly cautious since last summer, has recently bottomed out (Chart 6).
The employment and income situation is likely to continue to improve steadily, since wages
are expected to rise in the annual wage negotiations this spring. Amid this situation, private
consumption is expected to remain firm and housing investment is projected to regain its
firmness.
Corporate profits and developments in fixed investment
Finally, let me turn to the corporate sector. Corporate profits have continued to improve
thanks partly to the depreciation of the yen to date. Looking at the Financial Statements
Statistics of Corporations by Industry, coupled with an increase in sales, the ratio of firms'
current profits to sales has recently reached around 5 percent for all industries and firms of
all sizes - a high level that exceeds that prior to the global financial crisis (Chart 7).
Corporate profits are expected to continue to be on an improving trend as falling crude oil
prices and the yen's depreciation to date are likely to contribute to pushing up profits.
With corporate profits improving, business fixed investment has been on a moderate
increasing trend (Chart 8). As for the outlook, with corporate profits continuing to be on an
improving trend, business fixed investment is likely to continue following a moderate
improving trend against the background that (a) the sense among firms that they have
excess capital has been waning, (b) firms are expected to increase labor saving investment
due to the tightening of labor market conditions, and (c) with the depreciation of the yen,
Japanese firms appear to have started to increase the share of fixed investment at home. In
fact, with regard to the last point, at the meeting of general managers of the Bank's branches
in January there were reports of cases where firms were increasing their production and
fixed investment at domestic bases against the backdrop of the yen's depreciation.
Production decreased for two consecutive quarters in the April-June quarter and the
JulySeptember quarter last year, but due in part to subsequent progress in inventory
adjustments, it started to increase again in the October-December quarter and continued to
increase in January this year (Chart 9). Against the backdrop of an increase in final demand,
production is expected to moderately increase going forward.
Therefore, with a virtuous cycle from income to spending operating in both the household
and corporate sectors, Japan's economy has continued its moderate recovery trend. Going
forward, this virtuous cycle is likely to continue operating with the fall in crude oil prices to
date and the government's economic stimulus working as boosting factors, and thus Japan's
economy is expected to continue its moderate recovery trend. In terms of the Bank's Policy
Board members' forecasts released in the January interim assessment of the October 2014
Outlook Report for Economic Activity and Prices (hereafter the Outlook Report), the real
GDP growth rate was projected to be minus 0.5 percent in fiscal 2014, but 2.1 percent in
fiscal 2015, and 1.6 percent in fiscal 2016 - in other words, it was expected to grow above
the potential growth rate, which is estimated to be around 0.5 percent or lower (Chart 10).
II. Japan's price developments and monetary policy
I will next talk about the Bank's conduct of monetary policy and the price situation in Japan.
As I mentioned at the outset, the Bank, in order to achieve the price stability target of
2 percent at the earliest possible time, with a time horizon of about 2 years, introduced QQE
in April 2013 and expanded it at the end of October 2014.
Aim of quantitative and qualitative monetary easing
Let me summarize the transmission mechanism of QQE. The starting point of the
mechanism is converting people's deflationary mindset and thereby raising inflation
expectations through the strong commitment by the Bank to achieve the 2 percent target. At
the same time, the Bank has been exerting downward pressure on nominal interest rates
through its massive purchases of JGBs in order to encourage a decline in real interest rates
and stimulate private demand such as business fixed investment. The idea is that, together
with the increase in inflation expectations, this will lead to an increase in inflation rates.
This might give rise to the question why it is necessary not only to stimulate aggregate
demand but also to raise inflation expectations. The reason is that the price stability that the
Bank ultimately aims at is not one that is achieved temporarily but one that is achieved on a
sustainable basis. If aggregate demand is stimulated, inflation may rise to temporarily reach
2 percent, but will not be sustained in a stable manner as long as people make decisions or
engage in economic activity on the basis of low inflation. By contrast, if medium- to long-term
inflation expectations rise to 2 percent, that is, people make decisions and engage in
economic activity based on the assumption of 2 percent inflation, the inflation rate will
gravitate to 2 percent even if it fluctuates due to business cycles and changes in commodity
prices. That is, over the cycle, prices will hover at around 2 percent on average. To this end,
in order to sustain the price stability target of 2 percent in a stable manner, it is necessary for
inflation expectations to rise to 2 percent and be anchored at that level.
Expansion of quantitative and qualitative monetary easing
Based on this aim, QQE has been producing its intended effects and the year-on-year rate of
change in the CPI (excluding fresh food) increased from minus 0.5 percent immediately
before the introduction of QQE to a range of 1.0-1.5 percent through summer last year
(Chart 11). Meanwhile, people's inflation expectations also increased on the whole and there
was steady progress in dispelling the deflationary mindset (Chart 12).
However, since summer last year, due mainly to the substantial decline in crude oil prices as
well as somewhat weak developments in demand after the consumption tax hike, the
yearon-year rate of increase in the CPI has slowed (Chart 11). If this situation had continued,
there was a risk that conversion of the deflationary mindset, which has so far been
progressing steadily, might be delayed. If this risk had manifested itself, this would have
interfered with the transmission mechanism of QQE, which starts with the rise in inflation
expectations. To preempt the manifestation of such risk and to maintain the improving
momentum of expectation formation, the Bank expanded QQE in October.
Let me explain in more detail. In the short term, falling crude oil prices will lower inflation, but
in the longer term, they will have a positive effect on economic activity in an oil-importing
country like Japan and hence push up prices. The reason is that the fall in energy prices will
lead to a rise in corporate profits and households' purchasing power; that is, Japan's terms of
trade improve. Given that Japan's crude oil imports in fiscal 2013 amounted to almost
15 trillion yen, a back-of-the-envelope calculation shows that with the decline in crude oil
prices from about 100 dollars per barrel up until last summer to the recent level of about
50 dollars per barrel, the oil price decline represents an increase in annual income to Japan's
economy of more than 7 trillion yen. This is why, from a longer-term perspective, falling oil
prices will have a positive effect on economic activity and will push up prices. Thus, other
things being equal, the fall in crude oil prices will initially lead to a decline in the inflation rate
but the inflation rate will then start to rise once the impact of falling oil prices on the
year-onyear rate of change in prices dissipates.
Therefore, if falling oil prices lower inflation but inflation expectations remain unaffected and
inflation keeps heading toward 2 percent as a trend, there is no need to respond through
monetary policy. On the other hand, if falling crude oil prices do affect medium- to long-term
inflation expectations and it is judged difficult to achieve 2 percent inflation in the future, a
monetary policy response will be necessary. As I mentioned, the Bank did not embark on
additional easing as an automatic response to falling crude oil prices; rather, with the
yearon-year rate of increase in the CPI being sluggish due mainly to falling oil prices, the Bank
carried out additional easing to preempt the manifestation of any risk that the conversion of
the deflationary mindset might be delayed and the underlying trend in inflation be adversely
affected.
Assessing the underlying trend in inflation
In conducting monetary policy, it is critical to accurately assess the underlying trend in
inflation. So, how should developments in the underlying trend in inflation be assessed?
While inflation reflects temporary fluctuations such as those in commodity prices, the
underlying trend in inflation is determined by the output gap and medium- to long-term
inflation expectations. Therefore, in order to assess the underlying trend in inflation, it is
critical to evaluate these two factors. Medium- to long-term inflation expectations are
reflected not only in market-based indicators, such as the break-even inflation rate gauged
from inflation-indexed bonds, or in data from various surveys of firms, households, and
economists. Instead, since the term "inflation expectations" refers to the inflation rate
expected by the general public - and hence expectations underlying people's
decisionmaking and economic activity - inflation expectations are reflected in everyday economic
activities such as firms' price-setting behavior, wage negotiations between management and
labor, and households' consumption patterns. Looking at wages, base pay increased for the
first time in a long time in last year's annual spring wage negotiations between management
and labor based on the assumption that general prices would increase. In addition, instead of
simply searching for low-priced goods, consumers have started to purchase somewhat
higher-priced goods provided that the quality matches the price, and firms' price-setting
stance has changed accordingly. These developments provide evidence of a rise in inflation
expectations, indicating that there has been steady progress in changing the deflationary
mindset.
In examining price indicators, it is necessary to monitor not a single index but various
indicators to assess the underlying trend in inflation. The Bank has been examining
indicators such as the headline CPI, the CPI less fresh food (the so-called core CPI), the CPI
less food and energy (the so-called core-core CPI), the trimmed mean CPI, which excludes
highly volatile items, and the ratio of the number of items that registered a price increase to
that of items that registered a price decrease. The Bank even analyzes developments in
each CPI item component as necessary. In presenting the projections for prices, the Bank
uses the CPI (excluding fresh food) as an indicator that tends to represent the underlying
trend in inflation adequately under normal circumstances. However, this index includes
energy prices and thus will temporarily decline when, as currently the case, crude oil prices
have been declining substantially, so that it becomes difficult to assess the underlying trend
in inflation using only this index. Therefore, in the January interim assessment, in addition to
the forecasts for the CPI (excluding fresh food), the Bank showed the estimated contribution
of energy items to the index.
Future price developments and monetary policy
Based on what I have explained so far, let me talk about the outlook for prices. The
year-onyear rate of increase in the CPI (excluding fresh food), after 0.9 percent in fiscal 2014, in the
January interim assessment of the Outlook Report is projected to be only 1.0 percent in fiscal
2015 due to the effects of the substantial decline in crude oil prices to date (Chart 10).
Nevertheless, we are of the view that the underlying trend in inflation will rise steadily.
Specifically, the output gap, which determines the underlying trend in inflation, is likely to
continue improving as Japan's economy continues to grow above potential as a trend. In
addition, inflation expectations will also likely rise steadily. In fact, at the annual spring wage
negotiations between management and labor this year, labor unions have requested larger
wage increases than those of last year and firms' management has generally taken a
positive stance toward such an increase. Since work patterns have become more diverse, an
increase in wages can take various forms such as an increase in base pay, bonuses, or
various allowances, but whatever form it takes, the transformation of people's deflationary
mindset is likely to make further progress if total wages actually rise. In addition, on a
yearon-year basis, the effect of the decline in crude oil prices falls away after a year. Therefore,
while the year-on-year rate of change in the CPI (excluding fresh food) is likely to be small in
the first half of fiscal 2015 due to effects of the decline in crude oil prices to date, assuming
that crude oil prices will rise moderately from their current level, it is expected to accelerate in
the second half of fiscal 2015 as the effect of the fall in crude oil prices dissipates, and is
expected to reach around 2 percent in or around fiscal 2015. Subsequently, for fiscal 2016
the year-on-year rate of increase in the CPI (excluding fresh food) is projected to reach
2.2 percent as the economy continues to grow above the potential growth rate and the output
gap improves in positive territory. Since crude oil prices have recently been fluctuating
substantially, the 2 percent inflation rate, depending on developments in crude oil prices,
may be achieved somewhat sooner or later than envisaged. That said, however, let me
reiterate that in our view, what matters is the underlying trend in inflation.
Going forward, the Bank will continue with QQE, aiming to achieve the price stability target of
2 percent, as long as it is necessary for maintaining that target in a stable manner. Of course,
the Bank will make adjustments as necessary to achieve the price stability target at the
earliest possible time, if there are changes in the underlying trend in inflation.
Regional economies after the 2 percent target has been achieved
As explained, the Bank believes that the price stability target of 2 percent can be achieved
through continuing with QQE. On the other hand, some have argued that QQE may lead only
to higher inflation, which would undermine people's standard of living. Therefore, let me talk
about why it is necessary to aim at 2 percent.
Under deflation, the real value of cash and deposits increases simply by holding them.
Therefore, hoarding cash and deposits becomes a better investment than actual investment.
In Japan, as a result of protracted deflation, firms' investment in business facilities and in
research and development remained restrained, which deprived the economy of potential
growth and led to a loss of vitality. Such subdued business fixed investment is one reason
that Japan's potential growth rate has been on a declining trend (Chart 13). However, in an
economy in which prices rise steadily at a rate of 2 percent, the situation changes drastically.
That is, since the real value of cash and deposits will erode over time, firms need to make
effective use of their funds in hand in the form of investing in business facilities and in
research and development as well as recruiting and developing human resources. Proactive
behavior such as venturing into new business areas will also increase. Such developments
will enhance firms' competitiveness and productivity, and consequently result in restoring the
vitality of Japan's economy as well as raising the growth potential. Japan's economy as a
whole will likely expand accompanied by a virtuous cycle among income, spending, and
production. What the Bank is aiming at is not to reach a state in which only prices rise, but
one in which the economy expands with corporate profits and wages rising, and the price
stability target of 2 percent is achieved.
At present, Japan's economy is still in the process of overcoming protracted deflation. The
gains from the improving economic situation differ substantially between large and small
firms and between urban and regional areas rather than being evenly spread. Going forward,
as the economy as a whole continues to grow with the virtuous cycle continuing to operate,
corporate profits and employee income are likely to improve further and the gains of the
economic recovery are expected to spread.
Of course, achieving the price stability target of 2 percent in itself will not solve the
challenges regional economies face and raise their growth. Population decline and aging are
progressing more rapidly in regional than in urban economies, necessitating medium- to
long-term initiatives to raise growth in the regions. Economic growth is determined by the
growth rate of the population and the growth rate of per capita value added. As for the
population growth rate, there were only eight prefectures, among them Tokyo and Aichi, in
which the population increased in the year to October 2013. In addition, regional areas
relatively have a higher population share of those aged 65 or older and a lower working-age
population share - those aged 15-64 - than urban areas. Wages reflect value added per
worker, and there are only five prefectures - all in metropolitan areas - in which wages are
above the national average: Tokyo, Kanagawa, Aichi, Kyoto, and Osaka.
It is not going to be easy to stem the population decline and achieve a population increase in
regional areas while the population of Japan as a whole continues to fall. This means that it
is necessary to first raise the productivity of firms located in the regions and enhance the
value added that they produce. In fact, regional areas could take a number of initiatives to
enhance value added in ways that differ from those of metropolitan areas, such as combining
primary, secondary, and tertiary industries into "a sixth industry," product branding, and using
local history, culture, and the natural environment to promote tourism. Rising productivity will
enable firms to raise wages, which in turn could lead to a virtuous cycle encouraging people
to stay in or move to regional areas, since regional areas in fact offer many attractions, such
as allowing people to live close to their workplace and to live in an environment that
facilitates raising children.
As mentioned earlier, in an economy in which the price stability target of 2 percent is
sustained in a stable manner, it is advantageous to make effective use of cash and deposits
for investment or human resource development rather than hoarding them. The Bank would
like to reach this point as soon as possible and support firms' initiatives. In addition, the Bank
decided in January to extend the Fund-Provisioning Measure to Support Strengthening the
Foundations for Economic Growth and the Fund-Provisioning Measure to Stimulate Bank
Lending by one year and to increase the maximum amount of funds for the former.
Concurrently, the Bank decided to introduce a new framework for enabling financial
institutions that do not have a current account at the Bank and thus were not eligible, such as
credit cooperatives and agricultural cooperative associations, to use these fund-provisioning
facilities through their central organizations. I hope that these facilities will be used
extensively for the development of regional economies.
Conclusion
In concluding, let me touch on the economy of Ehime Prefecture.
Looking at the current state of the economy of Ehime Prefecture, while private consumption
has been somewhat slow to pick up, overall, a virtuous cycle from income to spending has
been operating just as in Japan as a whole, with production at a high level and the
employment and income situation improving steadily.
In addition, partly due to falling crude oil prices, corporate profits have generally been
favorable. However, as I mentioned earlier, the gains from the economic recovery have been
unevenly distributed in terms of industries and firm size. Specifically, reflecting the
depreciation of the yen, there have been significant improvements in orders and profits in
shipbuilding, maritime industries, and other manufacturing industries with a global presence,
whereas improvements in business sentiment have remained moderate in the pulp and
paper industry as well as among many nonmanufacturing small firms due mainly to the
increase in input prices.
There are also various initiatives to boost Ehime's economy. There have been encouraging
examples. The "Imabari towel" product branding is famous for its considerable success and
the industry has made a remarkable comeback. Recently, shipbuilding firms have built new
large-scale docks, and some firms in the region have enhanced their production and
research and development bases in the region. In addition, firms have also been active in
expanding sales channels through cooperating with administration and financial institutions.
The united efforts by related parties will substantially contribute to raising the productivity of
the regional economy.
In the tourism sector, there were ambitious initiatives last year incorporating cycling and the
arts into existing tourism resources to enhance the profile and attractiveness of the region,
such as "Setouchi Shimanowa 2014" in areas around the Shimanami Kaido bicycle path and
"Dogo Onsen Art" in Dogo Onsen. In addition, Shikoku region was featured in the web
version of the well-known Michelin Green Guide, boosting the region's international profile.
While tourists from abroad tend to concentrate on metropolitan areas, Hokkaido, and
Okinawa, promoting the region's attractions not only to domestic but also to overseas tourists
has the potential to substantially boost the regional economy.
Furthermore, the regional revitalization plan of Saijo City was the only plan in Shikoku region
to be designated as a model of vitalization of the local economy. Regarding the vitalization of
the local economy, the government asked prefectures and municipalities to establish during
fiscal 2015 their own long-term vision to overcome population decline and formulate regional
versions of the government's comprehensive strategy for vitalizing local economies. Ehime
Prefecture, with a population that is declining and aging faster than Japan's population as a
whole, will also need to implement comprehensive policy measures to raise the value added
of regional industries in order to increase the productivity of the regional economy and to
attract those in their prime of life or raising children to the prefecture.
I believe that specific initiatives will be considered through further cooperation between the
administration and the private sector, and the Bank's Matsuyama Branch will conduct
analyses of the regional economy so as to contribute to such examination as much as
possible.
In closing, I wish all the best for the further development of the regional economy.
Thank you.
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