in november and december, the highest year - on - year rate of increase recorded since the publication of such statistics began. with stock prices remaining low and economic conditions deteriorating sharply, financial institutions are becoming increasingly conscious of future rises in credit costs as well as their capital constraints. this is further worsening the severity of financial institutions'lending attitudes. also in the area of trade credits, small firms are facing tighter settlement conditions. with the tightening of financial conditions and the decline in corporate profits, an increasing number of firms are indicating that their funding conditions are severe, and are scaling down their fixed investment plans. in this sense, an adverse feedback loop between economic and financial activity is starting to operate in japan. in addition to the state of the financial crises in the united states and western europe and the degree of recovery in the world economy, the appropriateness of the level of capital held by japanese financial institutions will also be important in judging how financial conditions will change and whether the adverse feedback loop between financial and economic activity will intensify. in japan, bank lending accounts for the majority of corporate funding. banks also serve an important role in direct financing, since they underwrite a large proportion of cp and corporate bonds issued by firms. therefore, the amount of risk that banks can assume becomes an important issue. in other words, given that banks'capacity to take on risk is determined by the level of capital they hold, whether that level is sufficient has an important bearing on developments in corporate financing. this could be conceptually summarized as follows. even if the business condition of banks deteriorates and losses expand, the financial intermediary function of banks will not be harmed as long as losses can be sufficiently absorbed by capital. in other words, capital serves as a buffer in the financial intermediary function. if, however, the ratio of losses to capital exceeds a certain critical point, there is a possibility that the financial intermediary function will become significantly impaired ; in other words, the relationship between the scale of capital and the financial intermediary function is nonlinear. this was observed after the economic bubble burst in japan. for several years, the workings of the financial intermediary function did not become an issue, although increases in nonperforming loans were recognized as a big problem. however, in the latter half of the 1990s, a credit crunch materialized where lending could not be increased due to capital constraints. with regard to the current situation of the financial system in japan, the level of

the unemployment rate has declined to the range of 3. 0 – 3. 5 percent, which we think corresponds to full employment ( chart 7 ). reflecting the tight labor market conditions, base pay increases – that is, acrossthe - board wage increases mainly reflecting inflation and decided in the annual labormanagement wage negotiations – returned in 2014 for the first time in two decades. base pay increases have continued this year, marking the third consecutive year of such increases. in the corporate sector, profits have increased to record levels, partly helped by the correction of the excessive appreciation of the yen and the decline in energy prices. against this background, firms have maintained their positive stance with regard to fixed investment. as for prices, the year - on - year rate of change in the all - item cpi excluding fresh food is about 0 percent, reflecting the decline in energy prices, but the underlying trend in inflation has steadily improved. cpi inflation for all items excluding fresh food and energy, which had been in the range of about minus 0. 5 to minus 1. 0 percent before the introduction of qqe in april 2013, has been positive for 30 consecutive months since the latter half of 2013 and in recent months has been about 1 percent ( chart 8 ). this is the first time since the second half of the 1990s, when japan ’ s economy fell into deflation, that such sustained inflation has been observed. moreover, looking at price changes across all items, the share of price - increasing items minus the share of price - decreasing items has been rising clearly since the introduction of qqe, and is currently near its peak. this indicates that firms have maintained their bis central bankers ’ speeches willingness to increase prices, and a virtuous cycle between a moderate rise in inflation and wage growth has remained in place. meanwhile, i admit there has been a fair amount of criticism in japan of the negative interest rate policy adopted by the bank in january 2016. the situation seems not dissimilar to the one in europe. such criticism can be divided into two broad strands. the first is that the negative interest rate policy may have an adverse impact on economic activity and prices by squeezing banks ’ profits, which could hamper the functioning of financial intermediation. however, in the case of japan, the concern that the negative interest rate policy will undermine financial intermediation is unfounded, at least at this moment. first, as i explained, the process of deleveraging in japan was completed by