will start to move toward resolution in the united states. apart from the subprime loan problem in the united states, there are cases in other advanced economies where fluctuations in asset prices are exerting adverse effects on the financial systems. with turmoil in global financial markets continuing, downside risks to the u. s. and the world economy continue to be high. the current state of inflation and its outlook i will now turn to the topic of developments in prices in japan. the twelve - month increase in the cgpi recorded 5. 6 percent in june due mainly to the rises in prices of steel and petroleum products. this was the highest rate of increase since february 1981. cpi inflation excluding fresh food had remained around zero until around the fall of last year but started to increase thereafter, mainly due to the rises in petroleum products and food, reaching 1. 5 percent in may. excluding fiscal 1997, when cpi inflation increased reflecting the increase in the rate of consumption tax, this was the largest increase since march 1993. although it is still low relative to other countries i have mentioned, this is a big change considering the long trend of price stability experienced in japan. to examine the outlook for inflation, i would now like to analyze the situation in terms of the three most important factors affecting prices, which are domestic supply and demand conditions, import prices, and inflation expectations of firms and households. the first factor, domestic supply and demand conditions, is currently more or less balanced. assuming that the economic outlook to which i just referred is realized, the situation will remain roughly the same going forward. this indicates that domestic supply and demand conditions are unlikely to be a factor causing a large fluctuation in prices. the second factor, import prices, has already affected the cgpi and the cpi to a considerable degree through increases in energy and material prices and passing on of such cost increases to sales prices, and it will likely continue to be an important influence. the third factor, inflation expectations, is theoretically an important factor affecting the inflation rate. the key is whether the increases in energy and materials prices will bring about a " second - round effect " of further increases in wages and prices through heightening of the inflation expectations of firms and households. in fact, after the first oil shock in the 1970s, this " second - round effect " significantly increased prices and led to the situation often called " runaway inflation. " so far, the annual increase in wages has remained at around 1 percent and, even considering

bank of japan ’ s december report of recent economic and financial developments1 bank of japan, 20 december 2001. * the bank ’ s view * * japan ’ s economy is deteriorating broadly, as private consumption is weakening in addition to a decline in exports and business fixed investment. with regard to final demand, net exports ( real exports minus real imports ) continue to decline and business fixed investment is also decreasing. housing investment remains sluggish and public investment is on a downward trend. moreover, private consumption is weakening recently. industrial production continues to decline considerably, reflecting these developments in final demand and the still strong excessiveness in inventories mainly in materials. corporate profits are falling and business sentiment keeps on worsening. the weakness in household income is becoming noticeable amid the decrease in the hours worked and the rise in unemployment, and consumer confidence is becoming cautious. turning to the outlook, as for exporting conditions, inventory adjustments in it - related goods worldwide are showing steady progress, and this has strengthened the view that adjustments will be mostly completed by around next spring. however, as final demand of it - related goods still remains stagnant, a distinct recovery in exports of the sector is unlikely for the time being. moreover, the world economy has decelerated further since the terrorist attacks of september 11, and there is considerable uncertainty about future economic developments especially for the u. s. therefore, such concern still exists that downward pressure may be exerted on japan ’ s exports and production once again depending on the developments in overseas economies such as the u. s. meanwhile, with respect to domestic demand, business fixed investment is expected to follow a downward trend amid the fall in corporate profits. private consumption will also continue to be weak along with deteriorating employment and income conditions and the more cautious consumer sentiment. government spending is basically projected to follow a downward trend while domestic private demand generally weakens on top of the uncertainty about exporting conditions. consequently, it may take quite a while for economic activity as a whole to stop declining, even though the decrease in industrial production may moderate somewhat in line with the progress in inventory adjustments such as of it - related goods. overall, japan ’ s economy will inevitably continue to deteriorate for a while. in this situation, continuous attention should be paid to the risk of a negative impact on the economy induced by developments in foreign and domestic financial markets. with regard to prices, import prices continue to decline reflecting the softening of international commodity prices. domestic wholesale prices are declining