toshihiko fukui : toward sustainable economic recovery speech by mr toshihiko fukui, governor of the bank of japan, to the naigai josei chousa kai ( research institute of japan ), tokyo, 28 february 2005. * * * for japan, this year is a crucial one, which may set the future direction of the country's economy. with the full removal of blanket deposit insurance scheduled for april 2005 now imminent, it is important to ensure that the financial system remains stable, the functioning of financial markets is further enhanced, and that the economy is brought firmly onto a sustainable growth track. today, i will talk about the bank of japan's assessment of the economic and financial situation and the thinking behind its conduct of monetary policy. i. recent economic developments the bank releases its assessment of the economy as " the bank's view " in the monthly report of recent economic and financial developments following discussions at monetary policy meetings ( mpms ). in " the bank's view " for february, the bank's assessment was that " japan's economy continues a recovery trend, although there seem to be somewhat weak movements mainly in production. " in other words, the economy is at a temporary pause : production has been weak reflecting exports, which have been more or less flat. production in the it - related sector has been weak due to continued inventory adjustment reflecting lower - than - expected growth in demand for digital appliances and the decline in global demand for pcs and mobile phones. in addition, production in the materials - related industry is lackluster, as spare production capacity is limited. for example, with the surge in demand, especially in exports to other asian economies, steel and chemical industries have been producing close to full capacity and find it difficult to raise their production levels immediately. in the processing and assembly industries, such as automobiles, it has been reported that firms may not be able to increase production due to the limited availability of materials such as steel plates. although these firms cannot increase production significantly, they have been able to raise profitability by expanding margins and improving productivity. corporate profits are at high levels across most industries, although some it - related firms have revised their profit forecasts downward. the ratio of current profits to sales in fiscal 2004 for firms of all sizes in all industries is likely to exceed not only the peaks recorded during the recovery phases of the 1990s but also the high point of the bubble period in the late 1980s. given such improvements in

fixed investment. however, such cases are still limited, with a large number of firms placing priority on reducing interest - bearing liabilities by using their increased profits, and taking a " wait - and - see " attitude toward investment commitments. although many firms are increasing business fixed investment, this is being kept within the limits of their cash flow. as pointed out earlier, firms have been cautious about increasing inventories during this recovery phase. the persistent decline in bank lending is also indicative of firms'hesitancy about making forward - looking commitments. firms became concerned about business risk and financial risk management, having experienced highly volatile economic conditions during the 1990s and financial system instability during the second half of that decade. their incentives to reduce interest - bearing liabilities and increase their capital bases as much as possible are therefore understandable. expanding business lines is not so easy for firms in the current situation where, faced with price - sensitive consumers, they have difficulty in raising product prices in order to pass on the rise in materials and intermediate goods prices caused by the surge in commodity prices at home and abroad. there may also exist some concern about the impact of changes in the economic environment, such as those caused by the low birth rate and rapidly aging society. however, corporate management will not continue to appeal to uncertainty about the economic outlook to justify its hesitancy in making positive commitments for long. amid rapidly changing technology and increasing competition, firms know that they need to maintain high profitability in the medium term by continuously and swiftly reallocating their management resources while continuing to invest in highly profitable areas. the economic environment surrounding firms is now well suited to encourage such commitments. in the labor market, deregulation and changes in people's attitudes and lifestyles have combined with firms'need to adapt to changes in the industrial structure and to improve profitability, with the result that the number of non - regular employees has increased. although indicative of firms'unwillingness to commit themselves to hiring longer - term regular employees, such developments, in so far as they illustrate the increased flexibility of the labor market, also suggest that firms have become better able to adapt to change. in addition, some firms have started to invest in highly profitable areas. they have been studying consumer needs so as to provide attractive new products and new services, and this has contributed greatly to private consumption, which has continued to be firm despite sluggish growth in income. a breakdown by household spending behavior shows that spending is increasing in a wide range of