bank of japan ’ s august report of recent economic and financial developments1 bank of japan, communication, 15 august 2000. * * * the bank ’ s view2 japan ’ s economy is recovering gradually, with corporate profits and business fixed investment continuing to increase. with regard to exogenous demand, net exports ( real exports minus real imports ) continue to follow a moderate upward trend due to steady developments in overseas economies, and public investment remains at a high level reflecting the progress in the implementation of the supplementary budget for fiscal 1999. as regards domestic private demand, business fixed investment is increasing. the recovery in private consumption continues to be weak as a whole through lack of notable improvements in employment and income conditions, although there are somewhat positive signs in some indicators. housing investment is mostly unchanged. reflecting such developments in final demand, industrial production is increasing. corporate profits and sentiment continue to improve, and the number of firms that take positive action, such as increasing the amount of fixed investment, is increasing, especially in high - growth sectors. income conditions of households still remain severe, but regular and overtime payments as well as new job offers continue to increase in line with the recovery in corporate activities, and compensation of employees has stopped decreasing. as for the outlook, public investment is likely to start decreasing in the near future, but net exports are expected to continue increasing gradually, reflecting the expansion in overseas economies. in the corporate sector, firms still strongly feel that they have excess equipment and that they should reduce their debts to restore financial soundness. however, it is very likely that fixed investment in highgrowth sectors, including those related with information technology services, will increase as corporate profits continue to recover. moreover, an improvement in corporate profits will increase household income and this in turn is expected to boost private consumption. however, the pace of recovery in household income will be modest for the time being, since firms ’ perceptions of excess employment still persist, and thus significant changes have not been observed in their efforts to reduce personnel expenses. overall, the economy is likely to recover gradually, led mainly by business fixed investment, unless there are major adverse external shocks. in addition, the favorable financial environment created partly by the bank ’ s sustaining easy monetary stance is expected to continue underpinning the economy. with regard to prices, import prices are rising, reflecting an increase in international commodity prices such as crude oil prices since april. domestic wholesale prices, notwithstanding the rise in prices of petroleum products reflecting the increase in crude oil prices,

##pating the current excessive deflationary expectations of the public by raising their inflationary expectations. can we really raise inflationary expectations just by announcing an inflation target? even if we can, there is the danger that long - term interest rates may rise to the point where they have an adverse impact on the economy. what is the significance of setting numerical targets, be it money supply or inflation, for monetary policy? the answer is to prevent market participants from engaging in unnecessary speculation by clearly showing the bank ’ s commitment to its policy objective. if so, without entering the tricky area of setting specific and concrete targets, the bank can incorporate the usefulness embodied in inflation targeting by making explicit the key elements of monetary policy conduct. it was this line of thinking that was behind the bank ’ s explicit announcement that it would “ continue with the current policy until deflationary concerns subside. ” c. underwriting and the outright purchase of government bonds by the bank behind the request that the bank underwrites government bonds, there seems to be the intention that the bank, through underwriting, should ensure the smooth issuance of government bonds, thereby containing a rise in long - term interest rates. if this is the case, then the bank holds firm against complying with such a request. once a central bank engages in the automatic financing of a fiscal deficit, sooner or later the time will come when it cannot put a brake on money expansion, thereby inducing vicious inflation. this is one valuable lesson that we have learned from history and constitutes the main reason why the underwriting of long - term government bonds is prohibited not only in japan but also in other industrialized countries. an increase in the outright purchase of long - term government bonds eventually leads to the same situation as in underwriting. over time, long - term interest rates are determined reflecting the views of market participants on the future state of the economy and prices. if the bank were to prevent long - term interest rates from rising despite market pressures, it would have no choice but to increase the purchase of government bonds. then, inflationary expectations would intensify, putting further pressures on long - term interest rates. such a vicious circle would repeat itself and the amount of government bonds that had to be purchased would increase infinitely. this would eventually be the same as the underwriting of government bonds. if a limit on either the amount or the period is set for the underwriting or the outright purchase of government bonds, can we obtain favorable results while