Toshiro Muto: Bank of Japan's view regarding developments in
economic activity and prices and the thinking behind its conduct of
monetary policy
Summary of a speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at a
meeting with business leaders, Sapporo, 10 January 2008.
* * *
Introduction
Today, I would like to discuss the Bank of Japan's view regarding developments in economic
activity and prices and the thinking behind its conduct of monetary policy.
I. The current situation and the outlook for economic activity and prices
I would first like to talk about the current situation and the outlook for economic activity and
prices.
The pace of growth in Japan's economy is currently slowing, mainly due to the drop in
housing investment. The economy, for the time being, is expected to continue slowing, but is
likely to resume moderate expansion thereafter.
The December Tankan (Short-Term Economic Survey of Enterprises in Japan) indicated that
businesses have become somewhat more cautious. Factors behind this seem to include the
following. First, small firms, in particular, are still unable to pass on higher costs to sales
prices even though the steep rise continues in prices of materials such as crude oil and
grains. Second, housing construction has decreased significantly, reflecting the coming into
force of the revised Building Standard Law in June last year. And third, uncertainty regarding
the future course of the world economy has increased due to subprime mortgage problems.
However, overall, firms are maintaining their growth forecasts for income and profits for fiscal
2007 and their capital investment plans remain solid.
Production has started increasing again after staying flat during the first half of 2007. The
adjustment in inventories of IT-related goods, which had been rising, has more or less come
to an end, and levels of production, shipments, and inventories, including in the IT-related
sector, are essentially well in balance. Despite increased uncertainty regarding the course of
the global economy and especially the U.S. economy, exports to a broad range of regions,
including the oil producing countries and emerging economies, and hence overall, are
continuing to increase. In the December Tankan, large firms' annual projections for export
sales have been revised upward.
Given these developments, it seems reasonable to conclude that the strength in corporate
activity remains intact, although close attention should be paid to how the more cautious
business sentiment will affect corporate spending activity.
Let me now turn to developments in the household sector. Nominal wages per worker have
been somewhat weak. Labor cost restraint by firms is persistent, as they are facing greater
exposure to global competition and capital market discipline. Recently, in particular, sluggish
growth in corporate profits resulting from the surge in materials prices has been leading
firms, especially small ones, to restrain wages. Moreover, the change in the composition of
the workforce, resulting from the fact that the high-salaried baby-boomer generation started
to retire in 2006 and from increases in the share of part-time workers, has also contributed to
the weakness in wages. However, as the economic expansion continues, albeit at a
moderate pace, many firms are feeling a shortage of labor, as suggested by the Tankan
reports, and the number of employees continues to rise. If labor supply and demand
conditions continue to tighten, it is likely that upward pressure on wages will gradually
increase. This implies that employee income, which is the product of the number of
employees and wages, is likely to continue rising moderately.
Against this background, private consumption has been firm. Although weather conditions
have caused sales at department stores and at supermarkets to stay virtually flat, sales of
digital appliances have been strong and the number of new passenger-car registrations has
picked up. Meanwhile, however, various survey results are indicating weaker consumer
sentiment. Factors behind this seem to include rises in prices of daily necessities such as
gasoline, kerosene, and food, while wages remain sluggish. Developments in private
consumption, which may be influenced by the weaker consumer sentiment, should continue
to be monitored carefully.
Meanwhile, housing investment has been showing substantial declines due to the delays in
the confirmation of building applications after the revised Building Standard Law came into
force. Going forward, it is expected that gradual recovery will take place as the delays in the
confirmation process are resolved, but there are uncertainties regarding the pace and extent
of the recovery because condominium sales are becoming sluggish due to the rise in real
estate prices, especially in the Tokyo metropolitan area.
Regarding prices, the domestic corporate goods price index (CGPI) has been rising mainly
due to higher international commodity prices. The year-on-year rate of change in the
consumer price index (CPI, excluding fresh food), which had remained at slightly below 0
percent, posted an increase of 0.1 percent in October 2007, followed by a 0.4 percent
increase in November. As prices of petroleum products and food are increasing, the rate of
growth in the CPI is likely to rise further in the immediate future.
As I noted earlier, the pace of economic growth seems to be decelerating at present. Given
this, the overall supply and demand conditions seem unlikely to tighten for the time being.
However, from a longer-term perspective, prices are likely to continue their upward trend due
to tighter supply and demand conditions as the economic expansion continues.
In sum, negative factors such as (1) the surge in materials prices, (2) the significant decline
in housing investment, and (3) increased uncertainty regarding the course of the global
economy are causing a deceleration in the growth of Japan's economy, which has been
moderate to begin with. For this reason, the virtuous circle of growth in production, income,
and spending is temporarily weakening, but we do not expect that it will break. The current
economic expansion is attributable to the continuing growth in overseas economies and the
progress in the adjustment of various excesses at firms and financial institutions in Japan.
Export activity, which is supported by overseas economies, and production at present are
continuing to increase, so that the driving force of the virtuous circle remains intact. The
extent of progress in corporate restructuring varies depending on the industry and size of
firms concerned, but looking at the corporate sector as a whole, firms are not under pressure
to adjust production capacity, labor, and inventories. Under these circumstances, business
fixed investment and private consumption are maintaining their upward trend. In addition,
going forward, housing investment seems likely to gradually recover, since the sharp
decrease in housing investment is mainly due to the procedural change following the coming
into force of the new law. Given these circumstances, our current view is that Japan's
economy will maintain its moderate upward trend.
II. Developments in overseas economies
It should be noted, however, that there are certain risks regarding the outlook I just
mentioned. In particular, one important risk factor is whether the world economy will continue
its sustained growth, since this is the basis for the virtuous circle driving Japan's economic
expansion.
Since summer 2007, global financial markets have been volatile due to the U.S. subprime
mortgage problems, and uncertainty regarding the future of the world economy, especially
the U.S. economy, has been increasing.
The deceleration in the growth of the U.S. economy is becoming somewhat more
pronounced. Housing investment continues to decrease substantially, and the drop in home
sales and accumulation of unsold houses are becoming increasingly severe. According to
survey results, banks are applying tighter terms and conditions not only on mortgage loans
but also on real estate loans for business properties and on corporate and consumer loans.
Recently released labor market statistics indicate that the pace of increase in employment
has decelerated and the unemployment rate has risen.
In this situation, however, private consumption and business fixed investment are so far
continuing their moderate upward trend, although the pace of increase is decelerating. It
seems likely that the U.S. economy will register relatively low growth rates in the short run
but will gradually return to a path with growth rates close to the potential rate as the housing
market correction progresses. However, the risk should be borne in mind that depending on
future developments in the housing market correction and in global financial markets, private
consumption and business fixed investment may fall below expectations through negative
wealth effects, credit tightening, and deterioration in business and consumer sentiment,
thereby leading to further deceleration in U.S. economic growth.
The European economy continues to expand, with business fixed investment and private
consumption maintaining their upward trend. However, the possible adverse effects on
financial conditions of global financial market disruptions may pose a downside risk.
Meanwhile, emerging economies and oil producing countries have been expanding robustly
and are playing a more significant role as pillars of world economic growth.
Thus, it seems reasonable to expect that thanks to the widening base of growth the world
economy will continue to expand robustly. However, downside risks to this outlook are
growing, reflecting intensified adjustment in the U.S. economy and in global financial
markets.
At the same time, attention should also be paid to the risk of inflation. In the United States,
inflationary pressures are remaining, reflecting continued high levels of resource utilization,
namely in labor and production capacity. In China, the economy continues to expand
strongly, and there are signs of overheating, especially in fixed investment, despite various
measures taken by the authorities to cool down the economy. The strong growth of the
global economy and other factors, such as geopolitical risks and the speculative inflow of
funds to commodity markets, are causing international commodity prices to remain elevated,
as evidenced by the fact that crude oil prices temporarily rose above 100 dollars per barrel at
the beginning of the year. Thus, countries around the world face difficult monetary policy
challenges in the presence of both downside risks to the economic outlook and upside risks
to inflation.
III. Developments in global financial markets
Global financial markets remain unstable, reflecting the downgrading of securitized products
and persistent concern about possible further losses at financial institutions. The functioning
of markets for securitized products has remained impaired as evidenced, for example, by
continued decreases in the amount outstanding of asset-backed commercial paper (ABCP)
issued and sluggish trading of collateralized debt obligations (CDOs). Corporate bonds have
been issued at a reasonable pace, but the corporate bond market is still undergoing
adjustment as seen in increased issuance spreads. Stock markets are still unstable, and
stock prices declined substantially around the turn of the year.
The volatility in global financial markets seems to reflect a market correction following the
laxity in risk evaluation that had developed during the long period of benign economic and
financial conditions. This adjustment is therefore expected to require some time to work itself
out, and during the process financial institutions will have to bear a certain amount of losses.
Since summer 2007, organizations such as the International Monetary Fund (IMF) and the
Organisation for Economic Co-operation and Development (OECD) have released their
estimates of the size of losses incurred from financial products related to subprime mortgage
loans, but it is difficult to accurately grasp the amount of final losses, since the correction in
the housing market is ongoing. Financial institutions in the United States and Europe have
been posting considerable losses, and many have announced measures to boost their
capital to compensate for these losses. How successful these measures are in helping
financial institutions and the financial system to restore their credibility will need to be
monitored closely.
Short-term funding markets in the United States and Europe were under elevated pressures
in late 2007 as financial institutions tried to secure end-of-year funds. To address this
situation, on December 12 central banks in the major economies announced joint measures
to ensure the stability of global financial markets. The Federal Reserve established a
temporary Term Auction Facility. Under this facility program, the Federal Reserve can
auction term funds against a wide variety of collateral, thereby providing funds with longer
maturities to more financial institutions. Moreover, it established foreign exchange swap lines
with the European Central Bank and the Swiss National Bank, and based on this, U.S. dollar
auctions were carried out in Europe. The Bank of England and the Bank of Canada actively
conducted operations to provide ample term funds with maturities beyond year-end.
The Bank of Japan and the Swedish Riksbank welcomed the action and issued a press
release stating that they would also appropriately provide liquidity to money markets in their
respective countries. The Bank of Japan did not make any particular changes to its
framework of money market operations because we have been providing funds with various
maturities against a wide variety of collateral and are able to gauge funding needs by
monitoring market participants' daily financing activities, and we can thus fully address the
situation under the current framework.
The joint action was based on the central banks' common understanding that, given the
continued volatility in global financial markets, it was necessary to appropriately address
elevated pressures in short-term funding markets and thereby facilitate the market
adjustments in an orderly manner. Since the announcement of the measures, the central
banks involved have been implementing market operations accordingly, and as a result
interest rates on term instruments declined toward the end of 2007 in the United States and
Europe. I believe these efforts will contribute to ensuring the stability of global financial
markets.
IV. Conduct of monetary policy
I would now like to explain the Bank's thinking regarding the conduct of monetary policy
based on the outlook for economic activity and prices and risk factors I have described.
As I have often noted in the past, the Bank has been taking monetary policy actions in
accordance with changes in the economic and price situation and has no predetermined view
regarding future actions. In making judgments on policy actions, we try to accurately forecast
future developments in the economy and prices, taking account of the time lags until policy
actions actually influence the economy and prices - the so-called transmission lag of
monetary policy. This is the essence of a forward-looking monetary policy.
Let me explain this in the context of the current economic situation in Japan where, as I
mentioned, the economy for the time being is likely to decelerate while the year-on-year rate
of increase in the CPI will gradually rise due to increases in the prices of petroleum products
and food. In conducting monetary policy, it is necessary to anticipate how these
developments will affect future economic activity and prices. For example, in the current
context, monetary policy judgments should be made based on the careful analysis of the
following issues, which will be incorporated in the future assessment of the economy and
prices: (1) whether the slowdown is temporary and the economy can be expected to return to
its growth path, or whether there is a possibility that it will last longer than expected; (2)
whether price rises could exert a negative influence on the economy, leading to future
downward deviations in the economy and prices; and (3) whether, on the contrary, price rises
could push up future prices through their influence on households' inflation expectations or
firms' price-setting behavior. It goes without saying that forecasts always entail uncertainty,
making it all the more important to assess their likelihood as well as the risks of upward or
downward deviations. We are determined to conduct appropriate monetary policy with the
aim of achieving sustainable growth under price stability while carefully assessing our
projections, their likelihood, and upside and downside risks.
If, as a result of such assessment, it is judged that Japan's economy will continue its
sustained expansion under price stability, interest rates, which currently are extremely
accommodative, will be adjusted gradually. It is conceivable that 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, there is a medium- to long-term risk of larger
swings and an inefficient allocation of resources as firms and financial institutions
overextend themselves. However, with regard to specific policy actions, we would like to proceed
with discretion based on an open-minded, forward-looking assessment of the economic and
price situation.
Closing remarks
Thus far, I have explained the current situation and the outlook for Japan's economy as well
as the Bank's thinking on the conduct of monetary policy. In closing, I would like to devote
attention to the economy of Hokkaido.
The most notable characteristic of Hokkaido is its rich and boundless natural environment.
However, as a consequence, Hokkaido's economy relies to a large degree on public works
such as road construction and flood prevention. The reduction in these works as a result of
the financial difficulties of the central and the local government means that economic growth
has been sluggish relative to other parts of Japan.
However, promising initiatives that take advantage of Hokkaido's rich natural resources are
currently underway. Primary industry accounts for a large share of Hokkaido's economy, and
in agriculture, for example, the promotion of organic farming and the introduction of a
certification system for "Hokkaido Brand" products are achieving progress against the
background of rising concerns about food safety. Moreover, with numerous colleges and
research institutions working on bio-technologies, there are moves to produce new products
that combine Hokkaido's rich resources in agriculture, forestry, and fisheries with new
biotechnologies.
Furthermore, the Hokkaido Toyako Summit will be held in July this year with environmental
problems as one of the major themes. Hokkaido has already implemented a number of steps
to take the lead in addressing environmental issues. For example, in the area of energy
supply, work has been in progress in fields such as wind and solar power generation,
biomass power generation in central Hokkaido - which has a large dairy farming industry -
and the utilization of snow-ice cryogenic energy in regions with heavy snowfall, using snow
and ice stored in winter for air-conditioning in summer. All of these efforts take full advantage
of the region's distinguishing features and are friendly to the environment.
The summit is a perfect opportunity to showcase Hokkaido's industries and natural
environment, not only domestically but also to the rest of the world. I hope this will bring
about steady progress in the revitalization of the regional economy.