Haruhiko Kuroda: Japan's economy - achieving 2 percent inflation
Speech by Mr Haruhiko Kuroda, Governor of the Bank of Japan, at a meeting, held by the
Naigai Josei Chosa Kai (Research Institute of Japan), Tokyo, 1 August 2014.
* * *
Introduction
It is my great honor to have the opportunity to address you today at the Naigai Josei Chosa
Kai.
In April last year, the Bank of Japan introduced quantitative and qualitative monetary easing
(QQE) to achieve the price stability target of 2 percent at the earliest possible time, with a
time horizon of about two years. The last time I addressed you here was only a year ago. At
that time, I mentioned that there was a positive turnaround in three areas since the
introduction of QQE: in financial conditions, expectations, and economic activity and prices.
Since then, QQE has been steadily having its intended effects, and the positive turnaround in
the three areas has continued. Japan's economy has been on a path suggesting that the
2 percent price stability target will be achieved as expected.
Today, I would like to talk somewhat in detail about the Bank's view concerning the current
state of and outlook for economic activity and prices. In doing so, I will be referring to the
interim assessment of the April 2014 Outlook for Economic Activity and Prices (Outlook
Report) conducted at the Monetary Policy Meeting (MPM) in July. I will then talk about some
topics concerning the price stability target of 2 percent.
I. Current situation of and outlook for Japan's economy
Japan's economy has continued to recover moderately as a trend despite a decline in
demand following the consumption tax hike in April. The virtuous cycle among production,
income, and spending has been continuing. Over the coming three years or so, Japan's
economy is expected to grow at a pace above its potential as a trend, although there are
likely to be fluctuations in demand around the scheduled consumption tax hike next year. In
the interim assessment of the April 2014 Outlook Report conducted at the July MPM, real
GDP is projected to grow at 1.0 percent in fiscal 2014, 1.5 percent in fiscal 2015, and
1.3 percent in fiscal 2016 (Chart 1). There are two forces driving GDP growth on which these
projections are based. One is the firmness of private consumption against the backdrop of an
improved employment and income situation despite the consumption tax hike. The other is
that favorable developments in the corporate sector have become more pronounced. Let me
explain these two points in turn.
Improvement in the employment and income situation and private consumption
Let me start with the employment and income situation and developments in private
consumption. In this regard, one more and more often hears about shortages of workers in
various industries including food services and construction. As this example illustrates, the
labor market has been steadily tightening. In fact, the active job openings-to-applicants ratio
indicates that there are more jobs on offer than there are people applying. The ratio is now
above the peak prior to the global financial crisis, reaching 1.10 in June this year, the highest
level since June 1992 (Chart 2). In addition, the unemployment rate has declined to
3.7 percent. This is almost the same level as the structural unemployment rate, which is
estimated to be around 3.5 percent. The year-on-year rate of increase in the number of
regular employees has been around 1.5 percent (Chart 3).
This tightening of the labor market has exerted upward pressures on wages (Chart 4). An
increasing number of firms have raised base pay in the annual wage negotiations this spring,
which was not seen in previous years. This effect has gradually been reflected in regular
wages. You may have heard on the news that amid growing labor shortages hourly wages of
part-time workers have been increasing, and this is borne out by the data, which show that
the year-on-year rate of increase in hourly cash earnings of part-time employees has been
accelerating. As a result, the annual rate of increase in nominal wages per employee has
gradually accelerated. In addition, according to various surveys, summer bonuses are
projected to exceed those of a year ago, and this will also put upward pressures on nominal
wages.
The year-on-year rate of increase in employee income - that is, nominal wages multiplied by
the number of employees - has been around 2 percent, reflecting the aforementioned
developments in employment and wages. Looking ahead, the rate of increase in employee
income is likely to accelerate moderately, since labor market conditions are likely to continue
improving as the economy recovers moderately.
This improvement in the employment and income situation has been steadily working to
underpin private consumption. Of course, the consumption tax hike has affected
consumption, especially purchases of durable goods such as automobiles, which
substantially increased prior to the tax hike as consumers "front-loaded" purchases.
However, many department stores, food supermarkets, and food services firms, for example,
report that the decline in consumption has been broadly in line with expectations, and the
extent of the decline has been narrowing gradually. This suggests that private consumption
continues to remain resilient as a trend. The Consumer Confidence Index bottomed out in
April and has been improving for two consecutive months since then. The effects of the
decline in demand following the consumption tax hike are likely to wane gradually from
summer, partly due to an expected increase in summer bonuses. Given that the effects of
the decline in demand following the consumption tax hike are expected to gradually wane,
private consumption is likely to remain resilient underpinned by the increase in employee
income. Nevertheless, since the effects of the decline in real income due to the consumption
tax hike might gradually manifest themselves, the Bank will continue to carefully examine
future developments.
Firms' proactive stance and business fixed investment
The second driving force of Japan's economic recovery is that favorable developments in the
corporate sector have been continuing and recently have become more pronounced.
Business sentiment has stayed at a highly favorable level despite the decline in demand
following the consumption tax hike. The business conditions DI in the March Tankan survey
- the Short-Term Economic Survey of Enterprises in Japan - prior to the consumption tax
hike improved to plus 12, reaching the highest level since the November 1991 survey
(Chart 5). This improvement reflects the front-loading of demand prior to the consumption tax
hike. The future DI in the March Tankan showed a substantial decline to plus 1 due to the
decline in demand following the consumption tax hike. However, despite deteriorating due to
the consumption tax hike, the business conditions DI in the June Tankan still registered a
value of plus 7. This is notably higher than the DI forecasted in the March Tankan. Moreover,
this is the same level as in June 2007, prior to the global financial crisis, indicating that the DI
remains at a favorable level. Thus, business sentiment has stayed at a favorable level even
after the consumption tax hike, indicating that the stance of the corporate sector remains
proactive. In addition, corporate profits have continued to improve. Corporate profit
projections in the June Tankan survey show that the level of current profits in fiscal 2014 will
remain at a level almost as high as in fiscal 2013. Moreover, the projections have been
revised upward compared to those in the March survey. It appears that firms have started to
become confident that their profitability will not be greatly affected by the consumption tax
hike.
This proactive stance and high profits of firms have favorably affected business fixed
investment. In the GDP statistics, real business fixed investment has been registering a
quarter-on-quarter increase for four consecutive quarters since the April-June quarter of
2013. Particularly the increase in the January-March quarter of this year was substantial at
7.6 percent (Chart 6). This was partly attributable to renewal demand stemming from the
ending of support for some software programs and to the front-loading of demand for
construction machinery prior to the strengthening of gas emission regulations. However,
even excluding these temporary factors it can be said that business fixed investment has
become firm. Moreover, a clear recovery can finally also be seen in business fixed
investment in the manufacturing sector, which had been lagging. Business fixed investment
is expected to follow an increasing trend against the backdrop of improving corporate profits,
albeit with some fluctuations. In fact, the June Tankan survey shows that aggregate
investment in fiscal 2014 is scheduled to increase, with large-scale enterprises planning to
invest more than in recent years (Chart 7). In addition to the improvement in business
sentiment and corporate profits, there are several factors that are conducive to an increase in
business fixed investment. Let me point out three.
First, firms' accumulation of capital stock slowed because they restrained business fixed
investment during the period of protracted deflation. Therefore, we are now in a situation in
which business fixed investment is likely to increase from a cyclical perspective. The
production capacity DI in the June Tankan survey indicates that the extent to which firms feel
that they have excess capacity has steadily narrowed and that on an aggregate basis firms'
sense of having excess capacity has almost disappeared (Chart 8). As a result of past
restraint in business fixed investment, capital stock has generally become older. There are
cases in which such old capital stock hampers smooth production when firms try to increase
their production levels. This will also boost business fixed investment, mainly renewal
investment.
Second, firms have been struggling to secure employees due to the tightening of the labor
market, and wages have been increasing. On the other hand, firms' funding costs for
business fixed investment have been at low levels and financial institutions' lending attitudes
have been accommodative. We may therefore be gradually approaching a stage in which
firms find it advantageous to invest in labor-saving machinery and equipment rather than to
hire new employees. These investments will lead to a more efficient utilization of labor amid
a tightening labor market and eventually raise labor productivity.
Third, more than a year has passed since the correction of the excessive appreciation of the
yen and firms have been reviewing the location of their global production bases. In the phase
of yen appreciation after the global financial crisis, the share of firms' overseas investment
increased, and this trend continued for some time even amid the correction of the excessive
appreciation of the yen. This is because firms need a certain period of time between the
decision to invest at home or abroad and the actual subsequent implementation. Recently,
there have finally been signs that firms are planning to increase the share of domestic
investment. For example, some firms regard Japan as the base for the manufacturing of and
research and development for strategically important products, as well as for improving
production processes, and have been investing or planning investment in these areas.
Overseas economies and Japan's exports
Let me turn to developments in exports. Exports have recently more or less leveled off
despite the correction of the excessive appreciation of the yen (Chart 9). The relatively
lackluster performance of exports is essentially due to cyclical factors, including the
sluggishness in emerging economies with strong economic ties with Japan such as the
ASEAN countries. At the same time, however, structural factors may have also played a
certain role. Such factors include the accelerated relocation of production overseas by
Japanese firms reflecting the appreciation of the yen and a decline in international
competitiveness in sectors such as IT-related goods in which Japanese firms have
traditionally had a competitive advantage. In addition, temporary factors putting downward
pressure on exports seem to have had an impact through early spring, although this impact
has been waning. Such temporary factors include the effects of the unusually severe winter
weather in the United States and the fact that firms placed priority on domestic shipments in
response to the front-loading of demand prior to the consumption tax hike.
Future developments in exports to a great extent will depend on the performance of overseas
economies, which are expected to continue to recover moderately, led by advanced
economies. This is also confirmed by the World Economic Outlook by the International
Monetary Fund: global economic growth, which slowed to 3.2 percent in 2013, is projected to
accelerate gradually to 3.4 percent in 2014 and 4.0 percent in 2015 (Chart 10). Japan's
exports are likely to increase moderately due mainly to this recovery in overseas economies.
In fact, this view is underpinned by the fact that the DI of overseas supply and demand
conditions for products in the June Tankan survey has improved and that external demand
for machinery orders has been on an increasing trend.
II. Price developments and the path toward achieving the price stability target
Current state of and outlook for prices
Let me turn to price developments. The year-on-year rate of change in the consumer price
index (CPI, excluding fresh food) was negative at minus 0.4 percent in April last year when
QQE was introduced. It subsequently turned positive and, after excluding the direct effects of
the consumption tax hike, reached plus 1.3 percent in June this year (Chart 11). The
yearon-year rate of change in the CPI after excluding the direct effects of the consumption tax
hike is likely to be around 11⁄4 percent for some time. This is because, on the one hand, there
will be inflationary pressure due to the improvement in the output gap as the economy
recovers; on the other hand, upward pressure from import prices, mainly energy prices, will
likely wane. Subsequently, the year-on-year rate of change in the CPI is expected to follow
an upward trend again from the second half of this fiscal year and reach about 2 percent
around the middle of the current projection period from fiscal 2014 through fiscal 2016, that
is, in or around fiscal 2015. Thereafter, Japan's economy is likely to gradually shift to a
growth path that sustains the price stability target of 2 percent in a stable manner. In the
interim assessment of the Outlook Report at the July MPM, projections for the year-on-year
growth rate in the CPI (excluding fresh food) were plus 1.3 percent for fiscal 2014, plus
1.9 percent for fiscal 2015, and plus 2.1 percent for fiscal 2016, after excluding the direct
effects of the consumption tax hikes (Chart 1).
At the time of the introduction of QQE many did not expect the inflation rate to increase to the
level we see now. However, the Bank's projections have changed little since the April 2013
Outlook Report, published shortly after the introduction of QQE. QQE has been having its
intended effects and prices have been rising as the Bank expected. The mechanism to raise
inflation that we envisaged at the time of the introduction of QQE consists of the following
elements.
The first element was to dispel people's deflationary mindset and raise inflation expectations
by making a strong and clear commitment to achieve the price stability target of 2 percent at
the earliest possible time and implementing large-scale monetary easing measures to
underpin the commitment. The second element consisted of putting downward pressure on
the entire yield curve through massive purchases of government bonds. Third, the first two
elements would lower real interest rates - that is, nominal interest rates minus the expected
rate of inflation - and provide strong stimulus to the economy. Fourth, with the resultant
recovery in Japan's economy, prices would rise and, as a result, inflation expectations would
rise further. And finally, with the recovery in the economy, rising prices, and rising inflation
expectations working in a mutually reinforcing manner, observed inflation and expected
inflation were expected to rise as a trend to reach 2 percent in a stable manner.
Currently, a growing number of firms are experiencing labor and capacity shortages,
indicating an improvement in the output gap, and inflation expectations are rising. Reflecting
these developments, the year-on-year rate of change in the CPI (excluding fresh food) has
risen to the range of 1.0-1.5 percent. On the other hand, financial conditions are
accommodative: 10-year government bond yields have been in the range of 0.5-0.6 percent,
and interest rates on new bank loans have been at historic low levels of below 1 percent on
average. Against this backdrop, the improvement in the output gap and the rise in inflation
expectations are likely to continue, and CPI inflation is expected to approach the price
stability target of 2 percent. However, if the outlook changes due to the manifestation of
some risk factors and it is judged necessary for achieving the price stability target, the Bank
will make adjustments without hesitation. I would like to emphasize that, under QQE, given
the Bank's clear and strong commitment to the 2 percent inflation target, it is a matter of
course that the Bank will make adjustments if necessary to ensure the target is achieved.
In the following, let me talk somewhat in detail about two factors that determine the future
trend in inflation, namely, the output gap and medium- to long-term inflation expectations.
Rising prices as a result of an improvement in the output gap
Let me start with the output gap, which indicates the state of labor and capacity utilization.
Currently, the economy is being led by domestic demand such as private consumption and
public investment, and it is the nonmanufacturing sector that is at the forefront of the
recovery. Since the nonmanufacturing sector is more labor-intensive than the manufacturing
sector, this has resulted in a tightening of labor market conditions. In the construction, retail,
and service sectors, some firms have found it difficult to expand their business due to labor
shortages. According to the Tankan survey, excess capacity has almost disappeared. With
the high level of capacity utilization, there have been more frequent disruptions of the smooth
operation of production. All in all, the output gap has been moderately improving to reach
around 0 percent recently and has turned positive in the January-March quarter of this year
due partly to the front-loading of demand prior to the consumption tax hike (Chart 12). With
the economy expected to continue growing at a pace above its potential, that is, with growth
in demand exceeding growth in supply capacity, the positive output gap is likely to expand
gradually. Therefore, inflationary pressure from the output gap is likely to steadily increase.
Rising medium- to long-term inflation expectations
Let me move on to inflation expectations. Medium- to long-term inflation expectations appear
to have been rising on the whole (Chart 13). This, in turn, has started to affect wage and
price setting. For example, as seen in wage negotiations this spring, the rise in inflation is
increasingly being taken into account in wage setting between management and labor.
Moreover, firms' price-setting strategies have been changing. Under deflation, many firms
pursued low-price strategies by putting priority on cost reductions since there had been a
strong preference among consumers for low-priced products. Recently, however, an
increasing number of consumers have been purchasing goods and services even at
somewhat higher prices as long as their quality was in line with their price. In response,
some firms have started to raise sales prices while increasing value added in terms of the
quality and functionality of the goods and services they provide. In the output prices DI of the
Tankan survey, until recently the share of firms responding that their output prices are
"falling" exceeded that responding that their output prices are "rising;" however, in the June
survey the two shares were identical (Chart 14). Thus, the mechanism in which the rise in
observed inflation alters people's inflation outlook and behavior, which in turn raises
observed inflation, continues to operate. This means that people's inflation expectations will
likely follow an uptrend and inflationary pressure from the rise in inflation expectations will
also increase.
III. Discussion points regarding the price stability target of 2 percent
We at the Bank believe that so far Japan's economy has been on a path suggesting that the
2 percent price stability target will be achieved as expected. However, given that prices have
risen due to the consumption tax hike, we often hear the question from consumers why, on
top of that, the Bank is aiming at 2 percent inflation. In addition, with supply constraints such
as labor shortages becoming more pronounced, some ask whether it is desirable to have
inflation while growth remains low. Let me respond to these questions.
Why aim at 2 percent?
I said earlier that the year-on-year rate of change in the CPI (excluding fresh food) after
excluding the direct effects of the consumption tax hike has been hovering at around
11⁄4 percent. However, the rate of change including the direct effects of the consumption tax
hike was plus 3.3 percent in June, which was as high as the rate of increase in December
1990. Focusing on this point, some argue that it is not necessary to raise inflation further.
However, it should be noted that the impact of the consumption tax hike on consumer prices
is a "one-off" at the time of the hike, and the impact on the year-on-year rate of change in the
CPI will disappear after one year. The Bank is not aiming at achieving the price stability
target of 2 percent temporarily. What the Bank aims at is to achieve an economy in which
inflation is about 2 percent on average year after year. In such an economy, people behave
on the assumption that inflation is about 2 percent. This is the reason why the Bank judges
the trend in prices excluding the direct effects of the consumption tax hike.
Based on what I just mentioned, let me explain why we aim at 2 percent inflation. Japan's
economy has been suffering from deflation for about 15 years, since fiscal 1998. That being
said, the average annual rate of change in terms of the CPI during that period was around
0 percent - specifically, it was minus 0.3 percent. However, since the change in the CPI is
biased upward, it overstates actual inflation. Therefore, a CPI growth rate of 0 percent means
that the economy is actually experiencing deflation. In addition, since interest rate levels in a
deflationary environment tend to be correspondingly low, interest rates are likely to face the
zero lower bound when the economy experiences a negative shock. This will limit room for
monetary policy responses using short-term interest rates. Taking these points into account,
it is now widely accepted around the world that it is desirable to target inflation somewhat
above 0 percent. Many advanced economies, such as the United States, the euro area, and
the United Kingdom, have set a target of about 2 percent. It could be said that this level has
become a global standard.
The Bank decided on the price stability target of 2 percent and announced it in January last
year. The Bank subsequently introduced and has been pursuing QQE in order to achieve the
2 percent target at the earliest possible time and maintain it in a stable manner. Based on
this unwavering determination and corresponding actions by the Bank, firms and households
will be able to base their behavior on the assumption of 2 percent inflation. If the perception
that inflation will be around 2 percent becomes entrenched, then people will expect inflation
to return to about 2 percent in the medium to long term even if it temporarily fluctuates due to
shocks to the economy. This is what is meant by "inflation expectations are anchored." This
is an important element to prevent the economy from falling into deflation or to avoid inflation
rates from continuing to rise substantially beyond 2 percent. The Bank will continue to pursue
its monetary policy aiming at achieving 2 percent inflation and anchor inflation expectations
at that level.
Achieving the 2 percent inflation target and Japan's growth potential
Next, let me talk about the growth potential of Japan's economy. The potential growth rate of
Japan's economy - that is, the rate of growth at which Japan's economy can grow in the
medium to long term in a sustainable manner - has been declining due to such factors as the
aging and decline of Japan's population, as well as the slowdown in capital stock
accumulation during the period of protracted deflation (Chart 15). Against this background,
some have voiced the concern that Japan's growth rate will not increase due to supply
constraints such as labor shortages. Others have argued that it is not desirable to have
inflation under low economic growth.
These concerns should be considered by separating short-term economic developments and
the medium- to long-term growth potential. In the short term, even if the expansion of specific
industries or firms is constrained by supply-side problems, the economy as a whole can grow
above its potential by raising utilization rates and improving the efficiency of labor and
capital. The aforementioned projections by the Bank of economic activity and prices through
fiscal 2016 are based on such assumptions.
In the medium to long term, efforts to raise supply capacity are necessary, since the growth
potential of the economy will be determined by supply capacity. In this regard, as a growth
strategy to stimulate private investment, the government formulated the Japan Revitalization
Strategy and revised it in June. The Bank strongly hopes that the government will push
ahead with the steady implementation of the strategy and that private firms will actively
respond. The Bank believes it important that, in parallel with its efforts to achieve the
2 percent price stability target, the various initiatives to strengthen Japan's growth potential
make steady progress. However, the Bank is of the view that, regardless of the pace of the
rise in the potential growth rate, the price stability target of 2 percent should be achieved at
the earliest possible time. The reason is not that the Bank believes it desirable to have
inflation at any cost. Rather, the Bank believes achieving 2 percent inflation as soon as
possible and anchoring inflation expectations at that level will elicit proactive behavior from
firms and households. This in itself will then contribute to raising the growth potential of the
economy. In a deflationary environment, firms had an incentive to hoard cash and became
reluctant to take risks by investing in their business or in research and development. This is
also one reason the potential growth rate declined. When firms' and households' inflation
expectations are anchored at 2 percent, firms will have greater incentives to take risks. This,
in turn, should help to raise the potential growth rate through improvements in productivity as
a result of capital investment and research and development. In fact, this has already started
to happen: capital investment and investment in research and development have been
increasing amid the steady progress toward the price stability target of 2 percent since last
year. By achieving the price stability target of 2 percent at the earliest possible time, the Bank
is seeking to create an environment in which firms and households can get on with their
economic activities. I would like to conclude my speech today by expressing my strong hope
that Japan's economy will regain its vitality and start to grow strongly again.
Thank you for your attention.
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