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, Shimane, 9 October 2013.
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Introduction
It is my great pleasure to be given an opportunity today to exchange views with
administrative, financial, and business leaders in Shimane 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 Matsue Branch.
On a personal note, my relationship with the San-in region goes back long years. My father
was born in Yonago, Tottori, and I have visited his birthplace several times. The reason why I
feel nostalgic, despite this being my first time in Matsue, is that my roots are in this region.
Japan's economy has long been in a state of deflation, since the financial crisis of the 1990s.
For Japan's economy to escape this situation and restore its vitality, it is most important to
first overcome deflation and change the mind-sets of economic entities such as firms and
households so that they become more proactive. In this sense, the biggest immediate
challenge facing Japan's economy is the overcoming of deflation at the earliest possible
time, and I realize that the role the Bank of Japan has to play is crucial. Based on this
recognition, the Bank introduced a new policy in April, called "quantitative and qualitative
monetary easing" (QQE).
Today, before exchanging views with you, I would like to talk about economic developments
at home and abroad. I will also elaborate on the thinking behind the QQE. Lastly, I will talk
about economic development in this region.
I. Recent developments and outlook for economic activity at home and abroad
Recent developments and outlook for Japan's economy
First, I will focus on Japan's economy. A virtuous circle from income to spending has
gradually been taking hold both in the household and business sectors. In the household
sector, private consumption has been resilient. Sales at department stores have remained
firm and consumption of services such as outlays for travel and sales in the food service
industry have held steady. With underlying active consumption by senior citizens, notably
baby boomers, such resilience in private consumption seems to have been sustained mainly
by wealth effects stemming from a rise in stock prices and an improvement in sentiment
since the turn of the year. It has gradually been supported by the improvement in the
employment and income situation. The employment condition continues to improve
moderately, as the unemployment rate and active job openings-to-applicants ratio recovered
almost to levels seen prior to the Lehman crisis. Against this background, special cash
earnings - such as bonuses - registered a clear increase year on year, and total cash
earnings per employee have begun to bottom out. Reflecting this improvement in the
employment condition, as well as in wages, employees' total cash earnings in Japan as a
whole have been increasing year on year.
In the business sector, corporate profits continue to improve and business fixed investment
has been picking up, mainly in the non-manufacturing sector, as evidenced by real business
fixed investment in the GDP statistics registering a quarter-on-quarter increase for the first
time in six quarters. This is an encouraging development, as we thought that a key to the
sustainability of economic recovery would be business fixed investment. While the relatively
lagging business fixed investment in the manufacturing sector is a matter of concern,
potential demand for such investment seems to be growing as existing capital stock has
become obsolete due to the restraint on business investment up to now, and firms have
subdued their R&D investment. Under such circumstances, if overseas economies start to
pick up gradually and exports increase moderately, an improvement in business fixed
investment in the manufacturing sector - mainly in investment for maintenance and
replacement of existing capital stock, R&D investment, and IT-related investment - is likely to
become evident. In fact, in the recently released September Tankan survey, the business
fixed investment plan in the manufacturing sector for fiscal 2013 was for an increase of
7.0 percent year-on-year, marking a steady increase.
Owing to those developments, the Bank said in its statement released after the Monetary
Policy Meeting in September that "Japan's economy is recovering moderately," using the
words "is recovering" for the first time since the Lehman crisis. Going forward, the Bank
expects that Japan's economy is likely to continue recovering moderately on the back of a
virtuous circle among production, income, and spending. While the economy will experience
a front-loaded increase and subsequent decline in demand prior to and after the
consumption tax hike, it is likely to continue growing, as a trend, at a pace higher than its
potential growth rate.
Main features of present economic recovery
Let me touch on the main features of the current economic recovery. A typical pattern of
Japan's economic recovery in the past was that it started with an increase in exports and
production, thereby centering on the manufacturing sector. However, unlike the pattern of
past recoveries, the major feature of the recovery this time is that it is led by the
nonmanufacturing sector against the backdrop of firmness in domestic demand such as private
consumption and public investment. That might be because, while consumption by senior
citizens and reconstruction-related spending have been underpinning domestic demand,
there also have been effects of various stimulus policy measures under "Abenomics" and
improvement in household sentiment on the back of high expectations for the current
economic policy management, as well as favorable developments in financial markets.
Indeed, while exports and production remain short of the pre-Lehman crisis levels, tertiary
industry activity index - an indicator of the state of economic activity in the
nonmanufacturing sector - has come close to the pre-Lehman crisis level. A pick-up in business
fixed investment also has taken place mainly in the non-manufacturing sector, as I
mentioned earlier.
The non-manufacturing sector requires more human resources than the manufacturing
sector. At present, improvement in employment and income, mainly in the non-manufacturing
sector, is supporting private consumption in a virtuous cycle. The virtuous circle from income
to spending has been gradually taking hold, and this has supported resilience in domestic
demand. Such development is expected to continue.
Recent developments and outlook for overseas economies
In this recovery, the resilience in domestic demand has been pronounced. Exports are
picking up, although they remain lackluster so far. In considering the future of Japan's
economy, it is important that overseas economies pick up while domestic demand is resilient,
and that the economy move to a phase led by domestic demand and external demand as a
pair of wheels. Let me now turn to the recent developments in overseas economies.
Overseas economies as a whole are gradually heading toward a pick-up. Looking at
respective regions, the U.S. economy is on a moderate recovery trend owing to firm private
demand in the face of the fiscal drag. As for the fiscal situation, government debt increased
significantly, mainly due to large-scale fiscal spending after the Lehman crisis. In response,
there have been moves toward fiscal consolidation, and austerity measures - including an
expiration of various tax reductions and a start to budget sequestration - have been taken
since the turn of the year. In the face of this fiscal drag, U.S. private demand is resilient due
to continuing accommodative financial conditions under low interest rates. For example,
housing investment is picking up as a trend due to low mortgage rates. As a prerequisite for
scaling back the pace of asset purchases, the Fed pointed out that employment conditions
should continue to improve, supported by a moderate recovery in economic growth.
Therefore, on the assumption that the Fed will continue with its proper conduct of monetary
policy, it is unlikely that private demand will decline substantially. In this situation, as the
fiscal drag will gradually fade, the pace of recovery is expected to gradually accelerate.
The greatest uncertainty for the U.S. economy is the consequence of fiscal consultation, an
issue on which the Democrats and the Republicans continue to oppose each other sharply.
As a preliminary budget has not been agreed on, some government institutions have already
been forced to close. The debt ceiling will be reached in the middle of this month, and the
redemption and interest payment of government securities will be stopped if it is not raised. If
that happens, this might have significant adverse effects on the global economy through a
downgrading of U.S. government bonds and an associated rise in premiums transmitting to
markets in other countries, inducing a rise in long-term interest rates, a plunge in stock
prices, and fluctuations in foreign exchange rates. By contrast, if this problem is resolved
successfully, this would eliminate the current uncertainty surrounding the U.S. economy, and
thus might provide a boost toward economic recovery. At any rate, a prompt resolution of the
fiscal consultation issue is critical for the global economy, including Japan.
Turning to the European economy, while it continued to remain sluggish, real GDP growth
registered a quarter-on-quarter increase in the April-June quarter of this year for the first time
in seven quarters, suggesting that the economy is finally leveling off. As for crisis resolution,
policy measures pertaining to the European debt problem have surely seen a material
progression since the summer of 2012, including the introduction of the government bonds
purchase program by the European Central Bank (ECB) and the establishment of the
European Stability Mechanism, through which financial assistance will be provided in the
event that the euro member countries encounter a fiscal crisis. In this situation, there is now
improvement in both business and household sentiment. Some adjustment in the fiscal
austerity program has also mitigated the downward pressure on the economy from the fiscal
side. Moreover, exports are bottoming out, particularly in Germany. It is likely that the
European economy will start picking up gradually as these developments continue.
However, I must say that a fundamental resolution of the European debt problem has only
reached the halfway point. The current stability in European financial markets seems to have
been brought about because the ECB has been buying time through its large-scale monetary
easing. In the meantime, it is necessary to steadily take steps through various structural
reforms and toward forming banking, fiscal, economic, and political unions as presented in a
roadmap for unification of Europe. The time the ECB can buy is limited and might be
gradually becoming costly.
The Chinese economy continues to grow steadily, although the pace of growth has become
somewhat lower than that in the past. From the time of inauguration, the new government
clearly showed its stance of pursuing structural reforms, by announcing frugality laws and
measures to contain real estate prices. Against such a backdrop, there has been concern
since around the turn of the year that the economy might slow down. However, the
government in July showed its stance of focusing on achieving this year's target of economic
growth of around 7.5 percent and it decided various measures that paid due consideration to
economic growth; thus, looking to the future, it is expected that stable growth at around the
current pace will continue, supported by resilient domestic demand. In terms of further policy
responses, the fiscal situation in China remains relatively sound and there is additional room
for fiscal stimulus. Owing to these developments, the chance of the Chinese economy
decelerating significantly, at least in the short run, is viewed as not great.
In the meantime, what is somewhat worrisome are emerging economies. Looking back, after
escaping from acute symptoms of the Lehman crisis, the global economy recovered, led by
high growth in emerging economies. Behind this, there were mainly two reasons. First, the
trend of domestic demand in those economies was robust due to the consumption spree
associated with a rise in the living standard and to the need to expand social infrastructure.
Second, after the financial crisis, aggressive monetary easing in advanced economies led to
capital inflow to emerging economies, providing additional impetus for emerging economies
to grow. However, recently, the U.S. and European economies have been improving, while
growth momentum in emerging economies is somewhat weak. The first thing that comes to
mind as a reason for this is that, immediately after the financial crisis, emerging economies
also adopted expansionary policy measures, and some "excesses" in business fixed
investment and lending may have emerged during that process. Second, while economic
activity in the United States and Europe has been recovering, concern has been raised that
capital inflow into emerging economies may reverse its course.
Under such circumstances, triggered by speculation that the Fed is likely to scale down the
pace of its asset purchases, financial markets in the emerging economies have recently
become instable, with some, mainly current-account deficit countries, experiencing
depreciation in their currencies. Such instability in financial markets might have adverse
effects on the real economy through tightening financial conditions and deteriorating
business and household sentiment, and this requires attention. Having said that, in my view,
the likelihood that the current situation will become one similar to the Asian currency crisis in
1997-98 seems marginal. The Asian crisis became widespread due mainly to vulnerability of
the banking systems in Asian countries. By contrast, the current situation is limited to market
risk, as exemplified by the heightening of market volatility. Moreover, from the perspective of
safety nets, those economies have accumulated substantial foreign reserves and backstops
were put in place, such as the Chiang Mai Initiative - a swap agreement network to make
short-term foreign currencies available among participating countries. Owing to these
developments, emerging economies have become more resilient against possible capital
outflows. In addition, as seen at the G20 meeting and meetings at the Bank for International
Settlement, frameworks are now in place that enable advanced economies and emerging
economies to have direct discussions.
To sum up, while each country or region has its own risk factors, it is expected that overseas
economies - most notably the U.S. economy - will generally start picking up gradually.
Under such circumstances, exports and production in Japan are expected to increase.
II. Basic thinking behind QQE
I would now like to explain the thinking behind the QQE that the Bank is currently pursuing.
In April, the Bank, with a view to achieving the price stability target of 2 percent in terms of
the year-on-year rate of change in the consumer price index at the earliest possible time,
with a time horizon of about two years, introduced a new policy of "quantitative and
qualitative monetary policy" (QQE). In this policy, the main operating target for money market
operations was changed from the short-term interest rate to the monetary base, which is the
sum of banknotes and currency in circulation as well as commercial banks' current account
balance held with the Bank, and the Bank will double the monetary base in two years. In
doing so, it will purchase massive amounts of Japanese government bonds (JGBs), with all
maturities made eligible for purchases. In addition, in aiming to achieve the price stability
target of 2 percent, the Bank made a commitment that it would continue with such drastic
monetary easing as long as it is necessary for maintaining the target in a stable manner.
The Bank conducts monetary policy based on the principle of "achieving price stability,
thereby contributing to the sound development of the national economy." Therefore, in
achieving the price stability target, it is important to create a virtuous cycle of prices that
gradually increase as the economy as a whole grows in a sustainable fashion and as
people's standards of living improve.
Routes to raise inflation expectations
The QQE is expected to raise prices via the following two different routes. The first is
improving the supply and demand balance of the economy as a whole by stimulating
economic activity. Namely, through elevating the level of economic activity in Japan as a
whole, the supply and demand balances in goods, services, and labor will tighten, leading to
a pickup in prices and wages. The supply and demand balance of the economy as a whole is
gauged as the output gap - namely, the difference between potential GDP, which can be
produced in an average situation for the labor force and for facilities, and actual GDP. There
seems to be a negative output gap - where actual GDP is below potential GDP and there is
an excess in the labor force and in facilities - remaining in Japan's economy. We need to
move this into positive territory. Japan's GDP has been growing at an annualized rate of
about 4 percent for two consecutive quarters. This growth rate substantially exceeds the
potential growth rate, which is estimated to be around 0.5 percent. In this situation, the output
gap has been steadily narrowing and is expected to turn positive.
The second route is raising people's inflation expectations. While some may be unfamiliar
with this terminology, these are inflation rates that the public foresees. As deflation has
continued for nearly 15 years in Japan, the view that prices are unlikely to rise has become
embedded. In a state of deflation, holding cash and deposits, as well as related assets,
becomes a relatively better investment. In this situation, businesses and households have
been refraining from consumption and making investment, and the economy's vitality has
been lost. In order to escape from such a situation, it became necessary to dispel such
deflationary expectations entrenched among the public; namely, to raise their inflation
expectations. To this end, the Bank, upon making a strong and clear commitment that it
would achieve the price stability target of 2 percent with a time horizon of about two years,
decided on drastic monetary easing both in terms of quantity and quality to underpin the
commitment. By doing so, the QQE aims to drastically change the deflationary expectations
of economic entities such as businesses and households. Specifically, how do these two
routes work on the real economy? I will explain this next.
Impact on interest rates: logic behind real interest rates
While the QQE has a number of transmission channels, what is important above all is to
influence real interest rates. Real interest rates are calculated by subtracting expected rates
of inflation from nominal interest rates. In other words, if businesses and households
consider that prices will rise and sales as well as wages will likewise rise in the future, the
interest burden in real terms will be smaller than what nominal rates may suggest. As the
spending behavior of businesses and households will be greatly influenced by real interest
rates, if real rates can be lowered, both private consumption and business investment will be
stimulated and the level of economic activity will heighten. As a result, supply and demand
balances will tighten in goods and services markets, as well as the labor market, and prices
will rise accordingly.
It is considered that nominal interest rates, notably long-term interest rates, will be
determined according to the outlook for economic activity and prices. Therefore, intrinsically,
if the real economy and prices improve and inflation expectations increase, nominal interest
rates will rise. Were nominal interest rates to rise in parallel with a rise in inflation
expectations, real interest rates would not change. That is, to lower real interest rates, it is
necessary to raise inflation expectations while containing a rise in nominal rates. It is for this
reason that the QQE, while lifting the public's inflation expectations by changing their
expectations, undertakes market operations to contain a rise in nominal rates as much as
possible through the massive purchase of the JGBs. This is a highly difficult policy to
conduct, and it requires subtle balancing.
Interest rate developments after introduction of QQE
So far, this policy conduct has been successful. Inflation expectations appear to be rising on
the whole. While it is difficult to directly observe inflation expectations, taking break-even
inflation rates measured by inflation-linked government bonds and various surveys on
households, economists, and market participants as a whole, people's inflation expectations
seem to have been rising.
By contrast, Japan's long-term interest rates have been hovering in a stable fashion. Given
that market operations to contain an increase in nominal interest rates as much as possible
are what the Bank is trying to achieve by purchasing massive amounts of JGBs in the JGB
market, it is essential to have market participants' cooperation. Therefore, from the very day
the Bank introduced the QQE in April, it started a dialogue with market participants.
Subsequently, there were phases in which the volatility in the JGB market heightened as
market participants digested the QQE's contents, and long-term interest rates rose in
reflection of the cautious attitude of market participants toward JGB investment. In response,
based on its dialogue with market participants, the Bank has been improving its methods of
purchasing JGBs.
As a result of these efforts, the JGB market regained stability, and now long-term interest
rates in Japan remain stable at low levels of less than 0.7 percent. Amid the upticks in
longterm interest rates overseas in response to a rise in the U.S. long-term interest rates, on the
back of speculation over the Fed's scaling down of its pace of asset purchases, the stability
in Japan's long-term interest rates has been conspicuous. With JGB yields, which form the
basis for bank lending rates, having been stable at low levels, contractual lending rates,
which show developments in lending rates to firms and households as a whole, have
remained at historic low levels.
As people's inflation expectations appear to be rising on the whole while long-term interest
rates remain stable, real interest rates are expected to be on a declining trend. Under such
circumstances, prices in Japan - when assessed by the year-on-year rate of change in the
consumer price index excluding fresh food - turned positive in the middle of this year and
accelerated to 0.8 percent in August. Looking ahead, as the aggregate supply and demand
balance in the economy is expected to improve and inflation expectations to rise further, the
year-on-year rate of change in the CPI is likely to reach close to the price stability target of 2
percent from the latter half of fiscal 2014 through fiscal 2015. While we recognize that lifting
inflation expectations through monetary policy is an extremely ambitious approach in
unchartered waters, we would like to meet the longstanding challenge of overcoming
deflation on all counts by steadily gaining the fruits of pursuing the QQE.
Concluding remarks
In conclusion, I will touch on the economies of Shimane Prefecture and the San-in region.
Shimane Prefecture seized the historical watersheds of "1300 years of the Kojiki - Japan's
oldest chronicle" in 2012 and "Izumo Taisha's Sengu - a period of massive repair work - of
the Heisei Period" in 2013 as golden opportunities, and has been making efforts all over the
prefecture to establish a sightseeing brand. Its aggressive PR activities are also seen in the
metropolitan area. Together with the recent boom in visitors to spiritual places and the
opening of the Matsue Expressway, tourism demand has been increasing to a substantial
degree. According to the Bank's Matsue branch, the economic effect of an increase in
tourism demand in 2013 stemming mainly from Izumo Taisha's Sengu was estimated to be
slightly less than 30 billion yen. Given that Shimane's gross prefectural production is slightly
more than two trillion yen, the increase in tourism demand will be a substantial boost for the
regional economy, for which the average growth rate over the past 10 years has been about
zero percent.
In addition to firm tourism, business conditions in the non-manufacturing sector, including the
construction industry, which has been underpinned by an increase in public and private
construction, have been generally improving. Business conditions have also been improving
in the manufacturing sector due mainly to strong production in electronic parts for
smartphones and tablet computers as well as automobile-related goods, and increased
production in food & beverages and construction-related materials, reflecting an increase in
domestic demand such as tourism and public investment. As a result, the economy of
Shimane Prefecture has been moderately recovering. According to the recently released
September Tankan survey, business conditions in the San-in region reached the highest
level since 1991, confirming that economic recovery has been spreading. The business
conditions have been at almost the same level compared with those nationwide.
During Japan's longest post-war economic recovery, between 2002 and 2007, an
improvement in business conditions in the San-in region was markedly sluggish compared
with that of the national average. There were several reasons behind this. As the economic
recovery at that time was led by external demand reflecting an expansion in the global
economy, the region was not able to benefit much from the recovery. In addition, the effects
of a cut in public investment during the period weighed heavily on the regional economy, in
which the contribution of construction industry to the regional economy as a proportion was
high. By contrast, the reason why business conditions in the San-in region have been
improving in tandem with those nationwide during this recovery phase seems to be that the
feature of this recovery - namely, that firm domestic demand has been inducing an
improvement in economic activity in the non-manufacturing sector - has similarly occurred in
the San-in region. In addition, the structure of the regional manufacturing sector - namely, a
relatively high contribution to the regional economy as a proportion, compared with
nationwide, of the food & beverages industry and lumber & wood products industry, which
are highly domestic demand-dependent - has partly bolstered production in the
manufacturing sector. Against such a backdrop, due mainly to a moderate increase in
production, a virtuous circle from income to spending has also started to operate in this
region, mainly in the business sector.
The Bank will steadily pursue the QQE to ensure that this fledgling virtuous circle seen
nationwide, inclusive of this region, will keep operating firmly in the future. In doing so, we
believe it is critical to carefully examine economic activity and prices while firmly gauging
developments in regional economies through the Bank's nationwide branch network,
including the Matsue branch. From this perspective, we would like to continue to seek your
cooperation with respect to research and other activities of the Matsue branch.
This region has plenty of "resources" - namely, the ample resources of tourism and of
agriculture, forestry, and fisheries, as well as a concentration in the manufacturing sector
with advanced technologies. For Shimane's economy not to make the current recovery a
transient one, it is critical to effectively utilize these resources to improve growth potential. In
this regard, it is expected that, with the tourism industry and other regional industries working
together, there will be further promotion of initiatives related to "local production for local
consumption" in a broad sense - namely, to "effectively make use of regional resources to
spur production and expand regional consumption." With heartfelt hope for further
development through these initiatives in the economy of the region of my roots, I would like
to conclude my speech.
Thank you.