Toshihiko Fukui: The outlook for Japan's economy and the conduct of
monetary policy
Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei
Chousa Kai (Research Institute of Japan), Tokyo, 10 May 2007.
* * *
Introduction
In the year since I last spoke to you here, Japan's economy has continued to expand moderately.
Semiannually in April and October, the Bank of Japan explains its projection for the nation's economy
in its Outlook for Economic Activity and Prices, or the Outlook Report for short. In the latest Outlook
Report, which was released at the end of April, the Bank projected that from fiscal 2007 through fiscal
2008, the economy is likely to continue its sustained expansion, growing at a rate slightly above its
potential. Today, I will focus on the Bank's view concerning developments in economic activity and
prices based on the projection in the Outlook Report, and I will also explain the basic thinking
regarding future monetary policy conduct.
I. Developments in overseas economies
I would first like to touch upon developments in overseas economies, which form the basis for the
Bank's outlook for Japan's economy. Overseas economies taken as a whole continue to expand, with
momentum being gained across a wide range of economies, and are likely to keep expanding. In the
United States, although the pace of economic growth has recently been decelerating due mainly to
ongoing adjustments in the housing market, the economy is likely to realize a soft landing and move
onto a growth path at a rate near its potential as adjustments, particularly in household spending,
become less severe. In the euro area, economic recovery has been solid, as the increase in
production and improvement in corporate profits have led to recovery in business fixed investment and
private consumption. Looking at East Asia, the Chinese economy continues to expand strongly with
both exports and business fixed investment showing high growth, and the NIEs and ASEAN
economies continue to expand at a moderate pace on the whole as domestic demand remains firm,
despite a lull in exports. It was also the consensus view among delegates at the G-7 meeting in April
that the global economy continues to expand robustly and is becoming more balanced.
II. Current situation of Japan's economy
Against the background of the generally favorable developments in overseas economies, Japan's
economy has continued to expand moderately. Although exports to the United States are somewhat
weak, overall exports continue to increase steadily reflecting the expansion of overseas economies.
Business fixed investment continues to increase as corporate profits remain high. Production
decreased in the January-March quarter of 2007 in reaction to the high growth in the previous quarter
led by production in automobile-related goods, but it seems to be on a trend of 1 percent
quarter-onquarter growth.
As for the household sector, although growth of wages per worker has been somewhat sluggish due
mainly to weak regular payments, employee income has continued to rise moderately supported by
the increase in the number of employees. Property income such as dividends is also increasing. In this
situation, growth in private consumption has recently resumed its upward movement, after sluggish
growth over the summer of 2006 due to unfavorable weather conditions and consumers' reluctance to
buy before the introduction of new products.
In sum, although the pace of improvement in the household sector has been somewhat slow relative
to the strength in the corporate sector, Japan's economy as a whole is expanding moderately.
On the price front, domestic corporate goods prices have recently been about the same as their levels
of three months earlier. The year-on-year rate of change in the consumer price index (CPI) excluding
fresh food has recently been around 0 percent due to the drop in crude oil prices.
III. Characteristics of the current economic expansion
Let me now review the characteristics of the current economic expansion, in order to project the future
course of the economy. The economic recovery began in January 2002, and its most distinctive
feature is that the economy has been growing amid rapid globalization. Japanese firms - which have
regained competitiveness as adjustment of excesses in production capacity, employment, and debt
proceeds - have been increasing exports, against the background of global economic expansion and
growing prevalence of international division of the production process. They have increased exports of
a wide variety of goods - including capital goods and parts, automobiles, IT-related goods, and
consumer goods - to an increasing number of countries. This strong performance of Japanese firms in
the global market has led them to expect higher demand growth, thus accelerating business fixed
investment.
Economic growth achieved in this way has affected the distribution of the profits of economic growth to
households. Faced with intensifying global competition and greater exposure to the discipline of the
capital market, firms have changed the way they distribute profits. In an ever-changing competitive
environment, they have been constraining increases in fixed costs and thus have continued to be
cautious about increasing wages, particularly regular payments. Meanwhile, employees, having
experienced a severe employment situation and currently facing intensifying global competition, have
tended to prefer stable employment to a wage increase. Wage growth has therefore remained
moderate despite the continuing high corporate profits.
Nonmanufacturing firms, which have relatively little access to the global market, are also experiencing
a severe market environment. In the nonmanufacturing sector, not only has deregulation led to
increased supply with new entrants into the market, but also the decline in public expenditure has
reduced demand. Given that changes in wages have become more closely linked to the level of
corporate performance, the pace of increase in wages has been slower among nonmanufacturing than
among manufacturing firms, reflecting their lower profits.
In order to maintain competitiveness in the severe market environment, firms have continued to
restrain labor costs. As a result, the pace of recovery in the household sector seems to be slower than
people's expectations, despite the strength in the corporate sector.
These features of the current economic expansion may also be affecting the environment surrounding
prices. As firms have been restraining wages and also increasing productivity, upward pressure on
prices seems to have been contained. Also, given that the driving force of current economic growth
has been the corporate sector, especially globally active firms, and that the positive influence of the
strength in the corporate sector has been relatively slow in feeding through into the household sector,
supply and demand conditions for consumer goods and services are likely to improve more slowly
than overall supply and demand conditions. In other words, while, from the demand side, growth in
consumer demand is likely to be moderate given the slow pace of the flow of income from the
corporate sector to the household sector, supply is likely to increase given the rise in imports due to
economic globalization coupled with new entrants coming into the market as a result of deregulation.
Looking at firms' perception of resource utilization, an indicator for supply and demand conditions, the
weighted average of the diffusion indices of production capacity and employment conditions in the
Tankan (Short-Term Economic Survey of Enterprises in Japan) suggests that the pace of
improvement in resource utilization in consumption-related industries, such as retailing and services, is
slower than the average for all industries. In recent years, the sensitivity of consumer prices to a rise in
the utilization of resources such as production capacity and labor, or to changes in the output gap, has
been declining, and this seems to have been due not only to deregulation and technological innovation
but also to economic globalization.
Another characteristic of the current economic expansion is that the financial environment has
continued to be extremely accommodative, and this has been supporting private demand. This
accommodative financial environment, together with the expansion of the global market and the
progress in adjustment of excess production capacity mentioned earlier, has also underpinned the
increase in business fixed investment. Interest rates have been very low relative to economic activity
and price conditions. For instance, comparison of the real GDP growth rate with the real short-term
interest rate - although the latter varies depending on how the expected inflation rate is estimated -
shows that while the GDP growth rate has been around 2 percent, the real short-term interest rate has
been in the range of around 0-0.5 percent if the actual year-on-year change in the CPI is used as the
expected inflation rate. The lending attitudes of financial institutions have been positive reflecting
expansion of risk-taking capacity as a result of improvement in their financial condition, and in this
situation, the amount outstanding of lending by private banks has been increasing. In sum, the
financial environment continues to be accommodative, both in terms of interest rates and availability of
funds. The yen in terms of the real effective exchange rate has been moving at around its lowest level
since the 1985 Plaza Accord, and this has been supporting growth in Japan's exports. Increases in
asset prices, such as a more widely observed upturn in land prices, particularly in major cities, also
seem to be exerting upward pressure on private demand.
IV. Outlook for Japan's economy
Next, I would like to elaborate on the outlook for Japan's economy based on the assessment of the
current economic situation that I have described. From fiscal 2007 through fiscal 2008, Japan's
economy is likely to continue its sustained growth of around 2 percent, somewhat above its potential.
Given that the expansion of the global market and the accommodative financial environment - the two
distinctive features of the current economic expansion - are likely to continue, the virtuous circle of
production, income, and spending is expected to remain intact.
In the corporate sector, business fixed investment is expected to keep increasing as exports continue
to rise and corporate profits remain high. According to the March Tankan, firms' business fixed
investment plans for fiscal 2007 are strong for initial estimates. As for the household sector, household
spending is expected to follow a moderate upward trend as the positive influence of the strength in the
corporate sector feeds through into the household sector slowly but steadily. Although firms are likely
to continue to restrain labor costs, upward pressure on wages is likely to increase gradually as firms
feel a growing shortage of labor. In fact, wages for temporary and part-time workers are rising, and an
increasing number of firms are planning, for the first time in many years, to raise their starting salaries
for new graduates. In this spring's wage negotiations, labor unions demanded slightly larger wage
increases than hitherto and firms' management tended to accommodate them, at least to a certain
extent. Firms may become more eager to hire or retain skilled workers in order to maintain and
enhance their quality control expertise and their ability to provide value-added goods and services,
both of which will give them a competitive edge in the long term. Acceleration in wage growth, coupled
with the ongoing rise in the number of employees, will likely lead to a more firmly established uptrend
in employee income. Property income of households is also expected to continue to increase due
mainly to the rise in dividends, since households have been increasing their investments in financial
instruments such as stock investment trusts. Furthermore, how baby boomers, who have started to
retire, will spend their retirement benefits and savings should be watched closely. Thus, private
consumption is likely to follow a moderate upward trend as the positive influence of the strength in the
corporate sector feeds through into the household sector via various channels.
In this situation, the environment surrounding prices is expected to gradually improve. If the economy
continues to grow at a rate exceeding its potential for the next two years, the rate of utilization of
resources such as production capacity and labor will further increase. In other words, the output gap
will continue to indicate tighter supply and demand conditions. As the strength in the corporate sector
leads to further increases in employee income, it is natural to expect that supply and demand
conditions for consumer goods and services will improve and that this will exert upward pressure on
consumer prices. Moreover, unit labor costs (labor costs per unit of output), although currently still
declining with the growth rate of wages hovering around 0 percent, are likely to stop falling and start
showing modest increases reflecting gradual rises in wages. Although inflation expectations in the
private sector have shifted down due mainly to past falls in the prices of petroleum products, prices in
general are still expected to increase moderately.
Taking these developments into account, the year-on-year rate of change in the CPI is likely to be
around 0 percent in the short run depending on developments in crude oil prices, but is expected
gradually to rise in the longer run. However, the pace of increase is likely to be moderate, given that
the sensitivity of prices to changes in the output gap is declining due to factors such as economic
globalization and deregulation. The year-on-year rate of increase in the CPI is expected to be slightly
above 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008.
V. Upside and downside risks to the outlook for economic activity
I have so far outlined the most likely projection for the next two years or so. However, the economy
constantly faces various risks, and due attention should be paid to the possibility that economic activity
and prices might deviate from this projection should particular risks materialize.
In the April 2007 Outlook Report, we pointed out the following as upside and downside risks to the
outlook for economic activity: developments in the global economy; supply and demand conditions for
IT-related goods; and possible larger swings in financial and economic activity. Let me elaborate on
each risk.
The first risk concerns developments in the global economy, which is expected to keep expanding with
momentum being gained across a wide range of economies. In the United States, adjustments in the
housing market, including problems in the market for subprime mortgage debt, are still ongoing, and
some leading indicators of business fixed investment have been showing somewhat weak
developments. If adjustments in the housing market turn out to be greater than expected or business
fixed investment weakens, economic growth may decelerate further. On the other hand, there is a risk
that inflationary pressures in the United States may persist longer than expected, given that the rate of
change in the core CPI has been somewhat elevated reflecting higher utilization of resources. If
inflationary pressures do not subside, there is a risk that not only the U.S. but also the global economy
and financial markets may be adversely affected, for instance, through the reaction of long-term
interest rates and foreign exchange rates to this situation. In China, there is an upside risk of the
economy growing faster than expected, particularly fixed asset investments and exports. Whether this
risk can be reduced and the Chinese economy can realize stable growth even after the 2008 Olympic
Games in Beijing should be the focus of attention.
The second risk concerns supply and demand conditions for IT-related goods. Inventory adjustments
of IT-related goods are continuing, and this seems to be the result mainly of specific domestic factors,
namely, the slow improvement in the balance of inventories and shipments for electronic parts,
particularly those related to cellular phones. Global demand for IT-related goods has so far been on an
upward trend due partly to the rapid growth in emerging-market economies, such as the BRICs, and
thus inventory adjustments should basically come to an end in or after the middle of 2007. However, if
expected global demand is revised significantly downward in response to, for instance, a deceleration
in the global economy, there is a possibility that adjustment pressures on inventories may intensify,
since the pace of increase in global supply tends to be rapid in the IT-related sector.
The third risk concerns possible larger swings in financial and economic activity based on optimistic
assumptions regarding, for example, financial conditions. Japan's current economic circumstances,
with the financial positions of both firms and financial institutions improving and real interest rates
remaining very low, are such as potentially to encourage assertive financial and economic activity. As
for foreign exchange rates, the real effective exchange rate is at the lowest level since the 1985 Plaza
Accord, and the upward trend in land prices in major cities has become increasingly distinct as seen in
Land Price Publication
the fact that commercial land prices in Tokyo and Osaka in March's showed a
double-digit increase from the previous year. These developments in foreign exchange rates and
asset prices may also cause activity of both firms and financial institutions to accelerate. Should
greater assertiveness be based on optimistic assumptions regarding future profitability, such as too
rosy expectations for the growth rate, financing costs, foreign exchange rates, and asset prices, the
result could well be a misallocation of resources in the long run as agents become over-extended in
financial markets or pour funds and other resources into inefficient economic activities. Such behavior
may push up economic growth and asset prices in the short run, but it can lead to later downward
adjustments and hamper the sustainability of economic growth.
VI. Upside and downside risks to the outlook for prices
These upside and downside risks to the outlook for economic activity may affect prices if they should
materialize, but there are also upside and downside risks unique to price developments that could
cause prices to deviate from the projection. In the April Outlook Report, two risks are noted:
uncertainty concerning the sensitivity of prices to changes in the output gap, and developments in the
prices of crude oil and other commodities.
The sensitivity of prices to changes in the output gap has been declining in recent years due partly to
economic globalization. This tendency has been taken into account in the projection for prices
mentioned earlier, but the sensitivity of prices may turn out to be lower than assumed in the projection.
If, despite prolonged economic expansion, wage growth were to remain low relative to the pace of
productivity gains, downward pressure on prices from labor costs would persist. Moreover, if the
positive influence of the strength in the corporate sector feeds through into the household sector
slower than expected due to sluggish wage growth, supply and demand conditions for consumer
goods and services may not improve in line with the diminishing slack in the economy. In such a
situation, prices may not be responsive to the improvement in the economic situation.
On the other hand, if the economy continues to grow at a pace exceeding the potential through fiscal
2008, it is likely that the rate of utilization of resources such as production capacity and labor will rise
further and the output gap will show further tightening of supply and demand conditions. Inflation
expectation, which has been low and stable, may increase with higher resource utilization, particularly
in labor. Moreover, although firms are likely to continue to restrain labor costs, they may change their
attitude with the aim of hiring or retaining skilled workers. These potential changes would exert upward
pressure on prices.
Prices of crude oil and other international commodities may deviate either upward or downward from
the projection depending on factors such as geopolitical risks. Close attention should be paid to
developments in these prices, since they will have a substantial effect on domestic corporate goods
prices and consumer prices.
VII. Conduct of monetary policy
Let me now explain how the Bank will conduct monetary policy based on the outlook for the economy
and prices I have outlined, giving due regard to the possibility of upward or downward deviation.
In March 2006, when the quantitative easing policy was terminated, the Bank introduced the "New
Framework for the Conduct of Monetary Policy." It consists of three elements. The first is releasing the
"understanding of medium- to long-term price stability," the second, assessment of the economic and
price situation from two perspectives taking account of the "understanding of medium- to long-term
price stability," and the third, outlining the Bank's thinking on the future course of monetary policy.
The "understanding of medium- to long-term price stability" 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. Each member, with this understanding in mind, judges whether
Japan's economy will achieve sustainable growth under price stability, and makes policy decisions
based on this judgment. At the Monetary Policy Meeting at the end of last month, we conducted a
review of the "understanding," in accordance with the decision that it should be reviewed, in principle,
annually. First, the basic understanding concerning price stability was reviewed, and it was reaffirmed
as follows.
(1) Price stability is a state where various economic agents including households and firms may
make decisions regarding economic activities without being concerned about fluctuation in
the general price level.
(2) Given that the effects of monetary policy take time to work through the economy and that the
volatility of output may actually be amplified when attempts are made to absorb every
shortterm change in prices resulting from various shocks, the Bank should forecast developments
in economic activity and prices from a sufficiently long-term viewpoint and strive to realize
price stability over the medium to long term.
Furthermore, in examining the "understanding of medium- to long-term price stability," the following
points were considered. First, the significance of measurement bias in the CPI. Second, the necessary
extent of the "safety margin" that acts as a buffer against the risk of falling into a vicious circle of
declining prices and deteriorating economic activity. And third, possible changes in the level of inflation
perceived by households and firms as consistent with price stability. As for the first point, it seemed
that measurement bias remained insignificant even taking into account last year's rebasing of the CPI.
Regarding the second point, the "safety margin," the risk of the economy falling into a deflationary
spiral seems to have further decreased, since the strength of the corporate sector and robustness of
the financial system have further improved. Finally, on the third point, the level of inflation perceived by
households and firms as consistent with price stability is unlikely to have changed much, since
changes in the inflation rate have been small.
Based on these considerations, it was agreed, as was also the case a year ago, that the
"understanding of medium- to long-term price stability" expressed in terms of the year-on-year change
in the CPI, takes the form of a range approximately between 0 and 2 percent with most Policy Board
members' median figures falling on one side or the other of 1 percent.
The next step, the examination from two perspectives, involves assessment of the outlook for the
economy and prices from two standpoints - whether the main scenario leads to the attainment of our
objective and how other relevant risks should be evaluated.
From the first perspective, we examine the prospects for economic activity and prices for one to two
years ahead - this time, through fiscal 2008 - and assess whether the most likely outlook is for the
economy to follow a path of sustained growth under price stability.
Through fiscal 2008, the economy, as I said earlier, is likely to continue its sustained expansion with a
virtuous circle of production, income, and spending in place. The year-on-year rate of change in the
CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to
rise in the longer run. Such developments can be regarded as in line with the "understanding of
medium- to long-term price stability" that each member of the Policy Board has in mind. In sum, we
judged that, through fiscal 2008, Japan's economy is likely to realize sustainable growth under price
stability.
This outlook is based on the assumption that market participants and firms make decisions by
factoring in future changes in monetary policy. Thus, adjusting the level of the policy interest rate will
become necessary for the economy and prices to continue to follow the projection. The pace of
necessary adjustment, however, will depend on the degree of future improvements in the economy
and price situation. We do not, therefore, have any predetermined schedule.
The second perspective extends the time horizon and assesses the risks considered most relevant to
the conduct of monetary policy. In this assessment, we take account of the cost incurred should risks
materialize, even though the probability of this happening may be low. In this regard, both upside and
downside risks need to be borne in mind. In terms of the upside risks, we need to be mindful of the
stimulative effect of monetary policy being further amplified with the improved prospects for economic
activity and prices. If, for instance, the expectation takes hold that interest rates will remain low for a
long time regardless of developments in economic activity and prices, then firms and financial
institutions may over-extend themselves based on such expectation, resulting in medium- to long-term
risks of larger swings in the economy and inflation rate, and of misallocation of funds and resources.
On the other hand, if the downside risks mentioned earlier should materialize, the improvement in the
economic situation may stall. It is also possible that prices will continue not to rise despite the
improvement in economic conditions. Nevertheless, the risk of the economy falling into a vicious circle
of declining prices and deteriorating economic activity seems to have further decreased, since the
strength of the corporate sector and the robustness of the financial system have been enhanced.
Based on this outlook and assessment of risks, we have decided to maintain the current basic thinking
regarding the conduct of monetary policy, employed since the termination of the quantitative easing
policy in March 2006. The Bank adjusted the level of the policy interest rate in July 2006 and in
February 2007. Adjustments were made in view of the outlook for the economy and prices, with the
Bank judging that sustained economic growth would continue with a virtuous circle of production,
income, and spending in place, and that consumer prices would be likely to increase moderately in the
long run in line with the "understanding of medium- to long-term price stability." Based on this
assessment, we have been realizing the idea of "adjusting the level of interest rates gradually in the
light of developments in economic activity and prices." With inflationary pressures weak, the pace of
adjustment has been slow and the accommodative financial conditions ensuing from very low interest
rates have been maintained. The Bank's basic thinking in this regard will remain the same in the
conduct of future monetary policy. In sum, while confirming that Japan's economy remains likely to
follow a path of sustainable growth under price stability in light of the aforementioned "understanding"
and assessing relevant risk factors, the Bank will adjust the level of interest rates gradually in
accordance with improvements in the economic and price situations.
Concluding remarks
Lastly, I would like to touch upon the Bank's communication of information concerning the conduct of
monetary policy. The Bank will continue to explain carefully to the public its assessment of economic
activity and prices and its basic thinking on the conduct of monetary policy in line with the "New
Framework for the Conduct of Monetary Policy," through, for example, the Outlook Report.
In relation to this point, there are voices that call for the Bank to communicate information on the
specific time schedule of a policy change, but we neither believe it possible nor consider it appropriate
to do so. The Bank considers that there are two key pieces of information that it should provide,
namely, its assessment of economic activity and prices, and its basic thinking on the conduct of
monetary policy. Taking into consideration such information provided by the Bank, market participants
carry out transactions based on their views regarding economic activity and prices; the Bank in turn
obtains information regarding market participants' views on economic activity and prices from interest
rates formed in financial markets as a result of transactions carried out by market participants, and
uses it in making its assessment of economic activity and prices. We think such a two-way
communication process is important. If, however, the central bank were to indicate a specific time
schedule for a policy change, market participants would carry out transactions based not on their own
views regarding economic activity and prices but on the Bank's indication. Therefore, we think it is vital
that the central bank's communication to the public should be limited to the extent I have just outlined
for the market to fully perform its function of price discovery and allocating resources efficiently. The
Bank will continue to conduct monetary policy appropriately and to contribute to achieving sustainable
economic growth under price stability.