Masaaki Shirakawa: Recent economic and financial developments and
the conduct of monetary policy
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with
business leaders, Nagoya, 2 September 2008.
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Introduction
I am honored to be here today to speak and to exchange views with business leaders from
the Chubu region, and would like to take this opportunity to express my deep gratitude for
your cooperation with the Bank of Japan's Nagoya Branch. Before we begin, I also would like
to express my heartfelt sympathy to the people in the Tokai area who suffered damage from
the unprecedentedly heavy rain observed last week.
Today, I will speak about issues facing Japan's economy and the Bank's thinking regarding
the conduct of monetary policy.
I. The current situation of Japan's economy
First, I would like to discuss the current situation of Japan's economy. Since the beginning of
2002, the economy has enjoyed a moderate but prolonged period of economic expansion.
Since the end of last year, however, the pace of economic growth has gradually slowed.
Business fixed investment has been leveling off because the rise in energy and materials
prices, which has accelerated since this spring, has depressed corporate profits. Private
consumption has also been relatively weak due to the ongoing price rise, while growth in
wages has remained sluggish. The pace of increase in exports has slowed, because of the
effects of a slowdown in overseas economies. Given this situation, the Bank's assessment at
the Monetary Policy Meeting held on August 18 and 19 was that Japan's economic growth
had been sluggish.
Prices, on the other hand, have been on the rise. The year-on-year rate of increase in the
domestic corporate goods price index (CGPI) exceeded 7 percent in July due mainly to the
rises in prices of steel and petroleum products. This was the highest rate of increase in 27
years, since 1981. The year-on-year rate of increase in the consumer price index (CPI)
excluding fresh food reached 2.4 percent in July. This was the highest rate in 16 years
excluding fiscal 1997, when CPI inflation increased reflecting the rise in the rate of
consumption tax.
Japan currently faces a difficult situation given the sluggishness in the economy and the rise
in prices. This situation has been caused by two factors: the disruptions in global financial
markets and the slowdown in the global economy; and the surge in energy and materials
prices.
II. Disruptions in global financial markets and the slowdown in the global
economy
First, I will address a topic related to the disruptions in global financial markets and the
slowdown in the global economy. Roughly one year has passed since the U.S. subprime
mortgage problem emerged, underlying the disruptions in global financial markets, and the
nature of this problem seems to have evolved over time.
The first stage was the time of "liquidity constraints," when conduits and aggregators of
securitized products and financial institutions faced difficulties in raising funds. Then the
second stage emerged: the time of "credit contraction." In this stage, financial institutions
have tightened their credit standards and their lending attitudes, and this has started to exert
strong downward pressure on the economy.
Most recently, a third stage has emerged. In this stage, delinquency rates of not only
subprime-related products but also commercial real estate loans and consumer loans have
been rising reflecting the sluggishness in the U.S. economy. As a result, a situation in which
the sluggishness in the economy causes financial institutions' asset quality to deteriorate
further - with further adverse impact on the economy - is becoming a focus of concern. To
put it another way, at the third stage there are concerns about a negative feedback loop
between financial markets, asset prices, and economic activity.
U.S. economic growth is likely to remain sluggish for some time, since it is unforeseeable at
present when and how the negative feedback loop will diminish. In Europe, economic growth
is slowing further. In Asia, although the Chinese and Indian economies continue to post high
growth, some of the NIEs and ASEAN economies are showing deceleration in exports and
signs of slowing domestic demand. The growth rate in the world economy taken as a whole
will inevitably slow, although it remains at a high level when compared with the average for
the past three decades.
III. The surge in energy and materials prices and Japan's economy
Next, I will address a topic related to the surge in energy and materials prices. Since Japan
depends heavily on imports of resources, a rise in such prices exerts downward pressure on
Japan's economy through an outflow of income and exerts upward pressure on prices.
The rise in crude oil prices during the current phase has been the largest, even compared
with the two oil crises. During the first oil crisis, crude oil prices surged from 3 U.S. dollars to
12 dollars per barrel - a fourfold rise - and during the second oil crisis they surged from 15
dollars to 40 dollars - an increase of two and a half times. In the current phase, if we start
from 2002, when the level of oil prices was 21 dollars, the present level of 110-120 dollars -
somewhat below the recent peak - is more than five times the level recorded in 2002. As a
result, the size of the income outflow resulting from the surge in oil prices has also been the
largest during the current phase: about 5 percent of real GDP, compared with about 3
percent during the two oil crises.
The effects of rises in crude oil prices, such as the resultant outflows of income and
decreases in production capacity, cannot be offset unless export prices are raised to the
same extent as import prices. Nevertheless, there seem to be many aspects where the
situation can be improved through our own efforts. In fact, economic and price developments
differed markedly between the periods immediately after the two oil crises emerged.
During the first oil crisis, Japan's economy suffered from a combination of runaway inflation
and economic stagnation - in other words, stagflation. The economy suddenly contracted,
and CPI inflation peaked at an annual rate of 25 percent. Contrarily, during the second oil
crisis, the economy continued to grow at a rate of 3-5 percent and the CPI posted only a
single-digit increase.
Of the various factors behind the difference in Japan's economic and price performance
between the two oil crises, two seem to be most important.
The first factor was the difference in the economic and price situation immediately before the
crises as well as the policy response. Already prior to the first oil crisis, the economy was
overheated and the financial environment was overly accommodative, having increased the
inflation expectations of households and firms. Against this background crude oil prices
surged, making matters even worse. On the other hand, when the second oil crisis occurred,
the economy was not overheated, the financial environment was not overly accommodative,
and monetary tightening was initiated in a timely manner. This kept inflation expectations low
and thus succeeded in avoiding the second-round effects - a rise in prices of non-petroleum
goods and services triggered by a rise in crude oil prices.
The second factor was that Japan succeeded in transforming its economic structure while
accepting the change in the relative-price structure due to the surge in crude oil prices. After
the first oil crisis, Japanese firms pursued resource saving, and as a result, crude oil
consumption per unit of output - the amount of crude oil used to produce a unit of value
added - decreased in 1980 by 22 percent compared with the period of the first oil crisis.
Meanwhile, Japanese firms made use of the change in the operating environment, seeking to
develop energy-saving products.
This experience clearly suggests policies necessary to cope with the current rise in crude oil
prices. First, the second-round effects should be avoided so that inflation is contained within
the rise in import costs and passing of the rise in import costs on to output prices. And
second, it is crucial to promote a change in economic and industrial structures to make them
compatible with the new structure of relative prices.
It should, however, be noted that the current rise in crude oil prices has characteristics
different from the past crises. In the past oil crises, supply constraints were the main cause of
the rise in crude oil prices. In the current phase, on the other hand, the major cause was a
change in the structure of the world economy resulting from the rapid rise of emerging
economies. Looking at the current rise in crude oil prices from a somewhat longer-term
perspective, we can also observe that it and the subprime mortgage problem share a similar
background and thus have not occurred independently.
IV. Issues facing the global economy and Japan's economy in the medium to long
term
Looking back on major trends in the global economy, we find that the rise in crude oil prices
nearly coincides with the overheating in the markets for securitized products, including those
backed by subprime loans. In the period that saw the onset of these two events, especially in
and after 2003, the world economy enjoyed a positive combination of high growth and stable
prices. A major factor supporting this combination was that the entry of emerging economies
into the market economy expanded global supply capacity, providing an environment for low
inflation. In this situation, accommodative monetary policy continued worldwide.
In these favorable circumstances, however, problems that can be seen today in the world
economy started to emerge. First, the rapid growth of emerging economies whose energy
consumption was inefficient multiplied the demand for resources such as crude oil. In
addition, in these economies, improvement in the level of income increased the demand for
general merchandise such as food, and this raised inflation rates there. And second, as
represented by the emergence of the U.S. subprime mortgage problem, investors and
financial institutions eased their credit standards amid the prolonged, favorable economic
environment and accommodative financial conditions, and this resulted in expansion of credit
and a rise in asset prices.
Although the causes of the subprime mortgage problem and the rise in crude oil prices are
complex, they seem to share a similarity in that neither might have occurred without a
continuation of high economic growth and accommodative financial conditions worldwide.
This fact would seem to hold several implications for the future development of the
economies of both Japan and the world.
First, the world economy should be regarded as being in a process of transition to a
sustainable growth path. An economic slowdown entails hardships in every economy.
However, in view of the background of high energy and materials prices, which I mentioned
earlier, a certain pace of adjustment in the world economy seems necessary for them to
meet the conditions - such as stable resource prices - for moving to another stage of
development.
Second, from the viewpoint of the conduct of monetary policy in general, the risks that may
arise from prolonged accommodative financial conditions warrant attention. Looking back at
previous bubbles in financial activities and asset prices, including Japan's asset price bubble,
we can see that many have occurred following a period of price stability and continued low
interest rates. It is difficult, however, to recognize the emergence and bursting of a bubble as
they happen. Given this, we should keep in mind the view that excessively accommodative
financial conditions often cause large swings in the economy after a certain time lag,
although such a view may not appear well grounded.
And third, in view of the background of the current rise in energy and materials prices, the
probability that these prices will fall back to the previous low levels is likely to be small,
although the pace of increase seen to date may not continue. It therefore seems
inappropriate to consider the current surge an "oil crisis," which implies a "temporary supply
shock." In this situation, it is all the more important - even more so than during the periods of
the two oil crises - for Japan's economy to transform firms' production structure into one that
is compatible with the new structure of relative prices for better resource allocation, and to
react positively to the change in the operating environment and create areas of high
competitiveness.
In this regard, Japanese firms have already started to undertake a range of projects, in
response to the surge in energy and materials prices and growing interest in environmental
issues. These include the reduction in use of structural steel and facilitation of the reuse of
scrap, the use of alternative energy, and the introduction of energy-saving equipment. In
these areas, large firms in particular have been increasing capital spending to improve
efficiency. With regard to development of new products, automakers, for example, have been
working to develop energy-saving products such as hybrid cars and electric cars, and sales
of hybrid cars are growing steadily. Some electric manufacturers are increasing production of
products related to alternative energy, such as solar batteries.
V. The outlook for Japan's economy and the conduct of monetary policy
In view of the issues I have discussed, I would now like to talk about the outlook for Japan's
economy and the Bank's conduct of monetary policy.
The Bank's main scenario is that growth will likely remain sluggish for the time being against
the backdrop of high energy and materials prices and weaker growth in exports due to a
slowdown in overseas economies. The sluggishness in Japan's economy has arisen against
the background of the broad adjustments in the world economy that I mentioned earlier. In
this situation, the point that should be examined is whether or not Japan's economy will
experience a deep adjustment phase. I believe that the possibility of this occurring is small.
Let me explain the thinking behind this projection. First, as a result of firms' restructuring
efforts, which continued in the 1990s up until recently, the "three excesses" - namely, in
production capacity, employment, and debt - have been eliminated, and Japan's economy
has become more resilient to shocks that weaken economic growth. Second, losses incurred
by Japanese financial institutions due to the subprime mortgage problem are limited
compared to those of U.S. and European financial institutions and Japanese financial
markets continue to be stable, which suggests that the functioning of the financial system
remains intact. And third, Japan's financial conditions have been accommodative. Although it
is a cause for concern that financing conditions of firms in construction and real estate
industries and small firms in general are becoming increasingly severe, financial conditions
taken as a whole have been accommodative. The short-term real interest rate calculated by
subtracting the CPI inflation rate from the call rate has been negative, as the policy interest
rate - the uncollateralized overnight call rate - has been at a low level of 0.5 percent. Firms'
financing costs have also remained low. This accommodative environment for corporate
finance is expected to continue to support business activity.
Because of this, it is reasonable to expect, as the main scenario, that Japan's economy will
return gradually to a moderate growth path as commodity prices level out and overseas
economies move out of their deceleration phase.
Let me now discuss developments in prices. Currently, the year-on-year rate of increase in
the CPI exceeds the upper limit of the range of "understanding of medium- to long-term price
stability" - that is, the level of inflation that each member of the Policy Board understands,
when conducting monetary policy, as being consistent with price stability over the medium to
long term. The assessment of price stability should, however, be based on whether it can be
sustained in the medium to long term. From this point of view, the issue that requires
particular attention is whether second-round effects will emerge. This largely depends on
whether people's confidence in price stability is maintained, which ultimately is determined by
the stance of monetary policy. We consider that the second-round effects are unlikely to
emerge in the near term, given the current level of the domestic output gap, the inflation
expectations of households, and firms' price-setting behavior. Developments in wages are
one of the important indicators pointing to the emergence of second-round effects, and so far
wage growth has been relatively weak. In sum, the rate of increase in consumer prices will
likely remain elevated over the coming months, since the pass-through of earlier increases in
import prices is expected to continue for a while. Thereafter, however, the rate of increase is
expected to decline gradually in line with the expected moderation in the rises in international
commodity prices and the resultant subsiding of firms' raising of sales prices.
The outlook for economic activity and prices, however, entails considerable uncertainty, and
various risk factors are influencing the outlook. Global financial markets, which I mentioned
earlier, are likely to remain unstable for the time being, and there are downside risks to the
world economy. Regarding the outlook for Japan's economy, there is a risk that domestic
demand may weaken as a result of the outflow of income due to the high energy and
materials prices. The Bank is therefore attentive to the downside risks to economic growth,
although the economy does not face the need to adjust production capacity and employment.
As for prices, the Bank is focusing on the upside risks to inflation. As I mentioned earlier,
energy and materials prices have been rising for a long time and this rise should not be
regarded as "temporary." Moreover, given that Japan's economy has not faced such a high
level of inflation in recent years, the Bank should pay attention to the risk that possible
changes in the inflation expectations of households and firms' price-setting behavior may
generate second-round effects.
As I have explained, the current situation requires the Bank to carefully monitor both
downside risks to economic growth and upside risks to inflation. Furthermore, it should be
mindful of the risk that if the downside risks to the economy turn out to decrease, prolonging
the period of accommodative financial conditions may lead to swings in economic activity
and prices, as the recent experience of the world economy suggests. The Bank continues to
carefully assess the future outlook for economic activity and prices, closely considering the
likelihood of its projections as well as factors posing upside or downside risks, and will
implement its policies in a flexible manner. Moreover, since global financial markets are
expected to remain unstable and there are various uncertainties in the outlook for economic
activity and prices, it is essential for the Bank to ensure the stability of the Japanese financial
markets.
Closing remarks
Thus far, I have spoken about the issues facing Japan's economy and the Bank's thinking
regarding the conduct of monetary policy.
It takes about one and a half to two years for the effects of monetary policy to permeate
throughout the economy. It is therefore extremely important to make macroeconomic
projections for the period covering this lag. You may be able to imagine the difficulty in
making an accurate projection. However, speaking from my own experience as a
policymaker, it is not easy even to grasp the current state of the economy. To succeed in
doing so, a close analysis of both macroeconomic indicators and microeconomic information
is essential. The indicators and information have both advantages and disadvantages.
Macroeconomic indicators are important, but do not show the most recent developments due
to the lag between the relevant period and the time of release. On the other hand,
microeconomic information that is gathered through interviews with firms has an advantage
of a minimal lag. The latter also includes information that cannot be expressed numerically,
such as business sentiment. However, it also has drawbacks: there often is a significant
disparity in the view of business conditions among firms and industries; and there may be
also a tendency for respondents to play down positive news regarding their business.
The Bank, keeping in mind both the advantages and limitations of the two types of
information, strives to gather as much microeconomic information as possible using no small
amount of operating resources. To explore the activities of various economic entities in
depth, the Bank's 32 branches and 12 local offices throughout Japan perform an important
role. Their analyses of regional economic developments and the behavior of firms and
financial institutions in the respective region are concentrated in the Bank's Head Office
through, for example, the meeting of general managers of the Bank's branches. The
branches make reports based on the results of the Tankan (Short-Term Economic Survey of
Enterprises in Japan) for the respective region, analyses of regional economic indicators,
and interviews with firms and financial institutions in the region. The information gathered
from the branches is summarized in the Bank's Regional Economic Report, which is released
quarterly. The branches also disseminate information locally in their respective areas through
the monthly release of a report on recent economic and financial developments and quarterly
release of the Tankan for the respective region.
The staff of the Bank's branches and offices, including the general managers, may have
asked you on occasion to devote some time to completing interviews and Tankan surveys. I
wish to express my deep thanks for your kind cooperation, and would like you to know that
these interviews and surveys provide an essential foundation for the Bank's conduct of
monetary policy. We seek your continued cooperation with us to this end, and please know
that your opinions and requests are always welcome.
Thank you very much for your kind attention.