bank of japan ’ s monthly report of recent economic and financial developments1 bank of japan, communication, 16 / 02 / 99. the bank ’ s view2 the economic deterioration in japan has become moderate against the background of the increase in public investment. business fixed investment has been declining significantly. as for housing investment, housing starts are bottoming out but remain at a low level. recovery in private consumption has been weak on the whole, although partial improvement in sales of goods has been observed. meanwhile, net exports ( exports minus imports ) basically remain on a gradually increasing trend, and public investment is increasing considerably. reflecting this development of final demand and the continued progress in inventory adjustments, industrial production, which had been on a downtrend, is leveling off. corporate profits continue to decline. employment and household income conditions are still deteriorating as the unemployment rate is at a historically high level, and winter bonuses have decreased significantly. conditions in corporate finance are currently improving, but firms apparently cannot remove their anxiety about the availability of funds in the future. consequently, corporate and household sentiment remains cautious, and a recovery has not yet been observed in private demand. as for the future developments, the increase in public investment is likely to underpin the economy toward the first half of fiscal 1999 with the implementation of the government ’ s economic measures. furthermore, the bank ’ s monetary and financial measures and the government ’ s measures to alleviate the credit crunch will continue to be in effect. nevertheless, an immediate self - sustained recovery in private demand is hardly expected, since corporate profits and household income are still deteriorating and the constraints from corporate finance are likely to persist for some time due to cautious lending attitudes of private banks. moreover, attention should be paid to ( 1 ) the effects of the continued appreciation of the yen since autumn 1998 ; ( 2 ) those of the recent rise in long - term interest rates ; and ( 3 ) the uncertainty in financial and economic developments abroad. to lead japan ’ s economy into a steady recovery, it is important to prepare an environment where firms and households can regain confidence in japan ’ s economic future by, for instance, promptly restoring the stability of the financial system. with regard to prices, reflecting the large output gap, domestic wholesale prices are on a downtrend, and corporate service prices are weakening. consumer prices have increased above the previous year ’ s level due to the rise in prices of perishables. excluding this temporary effect, consumer prices basically remain weak. as for the

necessary, will make adjustments without hesitation in order to achieve the price stability target. what i would like to emphasize here is our strong commitment to achieving the price stability target of 2 percent. if japan ’ s economy follows a path toward the 2 percent target as we have projected, we will steadily pursue the current qqe. if not, we will make adjustments so as to achieve the 2 percent. in closing, let me briefly touch on the growth potential of japan ’ s economy. the bank ’ s qqe policy aims at escaping from a protracted deflationary equilibrium and achieving an economy in which people act on the assumption of inflation of about 2 percent. what has been happening in japan ’ s economy for the past 15 years is that declines in product prices led to a decline in firms ’ sales, which led to a further decline in prices through compressed wages and stagnant consumption, resulting in a vicious cycle. in such a deflationary economy, it is only rational for individual firms or persons to maintain the status quo, or to prefer cash, and therefore they did not consider it worth the risk, relative to the potential rewards, to embark on new business ventures. what we are aiming at is to break through this “ coordination failure ” and revive people ’ s animal spirits. this will be an important element in raising growth expectations and the growth potential. however, there is another important element to consider. as mentioned earlier, given that slack in the economy has shrunk, as seen in the tightening of labor market conditions, it also has become clear that it is imperative to strengthen supply capacity in order for japan ’ s economy to grow in the medium to long term. growth in the aggregate supply capacity of japan ’ s economy has been declining due partly to a declining trend in population and aging, as well as the slowing accumulation of capital stock under deflation. these trends, however, did not manifest themselves in the form of labor shortages or supply capacity constraints because demand had been weak. yet, in the past year or so, with the increase in demand thanks to large - scale monetary easing, fiscal spending, and the rejuvenation of private - sector activities, the supply capacity constraints that were lurking below the surface have now become apparent. in my view, with the supply capacity constraints having surfaced, this will be a golden opportunity to resolve the medium - to long - term challenges facing japan ’ s economy. these challenges, of which the public is well aware, include