hirohide yamaguchi : japan ’ s economy and monetary policy speech by mr hirohide yamaguchi, deputy governor of the bank of japan, at a meeting with business leaders, toyama, 21 july 2010. * * * introduction i am honored today to have this opportunity to speak and to exchange views with business leaders in toyama prefecture. i will express my gratitude for your cooperation in interviews with the staffers from the kanazawa branch and the local office in toyama and for the bank of japan ’ s surveys. information from these interviews and surveys is invaluable and utilized fully in assessing economic and financial developments and conducting monetary policy. before exchanging views with you, i will talk about the recent economic and financial developments as well as the conduct of monetary policy. i. global economic developments advanced economies and the balance - sheet problem before talking about japan ’ s economy, i will begin with the developments in the global economy. in the past several years, the global economy experienced a great turmoil. on the financial front, starting with the subprime mortgage problem in the u. s. housing market, the global financial crisis broke out in the autumn of 2008, triggered by the failure of lehman brothers. hand in hand with that, the global economy deteriorated rapidly and significantly. since the spring of 2009, the global economy has been emerging from such plunge. however, the improvement in economic conditions in the united states and europe has been modest, and international financial markets have recently become increasingly volatile triggered by the fiscal problem in greece and some european countries. the financial crisis and the fiscal problem i have just mentioned might seem to be a different phenomenon at a glance, but, in fact, they have a common underlying factor that has shaped a big picture of the global economy in the past several years. that was the problem of “ balance - sheet adjustment ” associated with the burst of a credit bubble in the united states and europe. in those economies, toward the mid - 2000s, households and firms made excessive borrowing on the premise that asset prices such as housing prices would rise and, in retrospect, made excessive investments and consumption. in response, financial institutions lent aggressively and continued to increase credit. in such a process, not only mortgages but also financial activity in general overheated, including new types of transactions such as in securitized products. such phenomenon has spread internationally and capital inflows to european peripheral countries, including recently highlighted greece, have overheated

although interpreting the data is potentially complicated by changes in taxes that shift the incentive to pay bonuses over time. accounting for the mis - measurement of clothing and footwear prices, which existed until 2010 and biased measured annual cpi inflation downwards by around 0. 4 percentage points. see bank of england ( 2011 ), inflation report, february, box on page 39. one way to illustrate the impact of import prices is to consider measures of core inflation adjusted for import intensity. these measures suggest that the current rate of core inflation is being dragged down by import prices by around 1 percentage point. that is a sizeable effect, and reflects, in part, changes in the value of sterling. the core measure referred to here is cpi inflation excluding food, energy, education, alcohol, tobacco and vat, and the measure adjusted for import prices weights each component of the core index by the inverse of its import intensity. bis central bankers ’ speeches over the past few years, core inflation has been particularly subdued, and it remains less than one per cent. we need to see increases in core inflation to have a reasonable expectation that, in the absence of further shocks, overall cpi inflation will return to 2 per cent within the mpc ’ s stated objective of two years. policy strategy delivering the growth in activity, the rise in domestic costs and the firming in core inflation measures necessary to return inflation to target requires monetary policy to be set appropriately both now and prospectively. in this regard, one concern has been the constraint imposed on monetary policy by the effective lower bound on policy rates. in my view, with the healing of the financial sector and the lessening of some of the headwinds facing the economy, that concern has become less pressing with the passage of time. as i made clear in my first open letter in february, were downside risks to inflation to materialise the mpc could decide either to expand the asset purchase facility or to cut bank rate further towards zero from its current level of ½ per cent. 29 in the current circumstances there is no need to wait to raise rates because of a risk management approach and run the risk of inflation overshooting target. at the same time, the timing and pace of prospective interest rate increases need to be put into perspective. headwinds to growth and inflation remain. growth in the parts of the global economy that matter most to the uk is running ¾ percentage points below its historic average. sterling has appreciated around 18 per cent over the past two years and around