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Recent Financial and Economic Developments and Monetary Policy1
Summary of a Speech Given by Atsushi Mizuno, Member of the Policy Board, at a Meeting with Business Leaders in Shiga Prefecture on March 13, 2006
April 12, 2006
Bank of Japan
- This article is excerpted and translated from a speech given by Atsushi Mizuno, Member of the Policy Board, at a meeting with business leaders in Shiga Prefecture on March 13, 2006.
Contents
- I. Sustainability of Economic Recovery
- II. Issues Confronting Major Central Banks
- III. Gradualist Approach to Policy Normalization
I. Sustainability of Economic Recovery
The Japanese economy is enjoying a buoyant recovery balanced nicely between domestic and external demand. Since emerging last summer from its long lull, it has quickly entered a virtuous cycle of rising production, incomes, and spending, and the momentum of the rise is picking up.
Since January, the Bank of Japan has said in its Monthly Report of Recent Economic and Financial Developments that "Japan's economy continues to recover steadily." This is the Bank's strongest assessment since the collapse of the bubble economy. Real GDP grew at an annualized pace of 6.0 percent and 5.4 percent quarter on quarter in the first two quarters of 2005, slowed to a 1.4 percent rise in the third quarter, then rebounded to a 5.4 percent rise in the fourth quarter. Even if the present quarter, January-March quarter of 2006, should record zero growth over October-December quarter of 2005, real GDP would still be up 3.2 percent for the current fiscal year of 2005 ending in March 2006. Real GDP growth rate over the four-year period from fiscal 2003 to fiscal 2006 is expected to average more than 2 percent.
The present economic expansion, in force since January 2002, will match the 51-month bubble era as of April 2006. The sustained duration of the recovery can be attributed not only to the strength of overseas economies and completion of corporate structural adjustments, but also to the continued firmness of private consumption. Recent economic statistics show no sign of any significant hidden risks in the economy in terms of private domestic demand, and offer no reason for the Bank to alter its forecast of a long, sustained expansion. Japan's inventory, business fixed investment, and construction cycles are all on an upswing at present, suggesting a strong likelihood that the recovery, barring a major external shock, will exceed the record 57-month expansion from October 1965 to July 1970, the so-called "Izanagi Boom." Needless to say, the Bank will seek to provide firm support from the monetary side in order to further maintain the recovery.
After a severe slump lasting more than ten years, Japan seems finally to have entered a recovery phase driven by private domestic demand. Looking back, I feel that the prolonged post-bubble downturn was more or less a period of adaptation, instead of just a "lost decade," with the Japanese economy reemerging in more dynamic form amid a much-changed economic environment worldwide, including the globalization of the economy, the IT revolution, and the ascent of the BRICs (Brazil, Russia, India, and China).
I will now look in detail at private consumption, housing investment, and business fixed investment, and then touch on the employment situation.
A. Private Consumption
Private consumption has been in a clear comeback mode since the second half of 2003. There have been several factors behind this. One is the emergence of pent-up demand as corporations have somewhat loosened their restraints on labor costs. Demand among older consumers has also turned upward thanks to the introduction of long-term care insurance program, which has relieved their concern over the future. Additionally, consumer sentiment has been buoyed by the sturdiness of housing investment, the wealth effect of higher share prices, and the improvement in the employment and income situation. This has led to a boom in sales of consumer durables such as home electronics. Finally, vigorous spending on services such as restaurants, travel, and long-term care has been observed.
Households with shareholdings have enjoyed a positive wealth effect from latent equity profits and higher dividend income, further abetting the upturn in consumer sentiment. Consumption has become bipolarized or multipolarized. The rich have shown considerable demand for high-end goods such as foreign brands, and department stores have reported strong sales of luxury items such as paintings and high-end watches. It is believed that this stems largely from the wealth effect.
B. Housing Investment
Housing investment has been strikingly robust. New housing starts have maintained a robust annualized pace since the second half of 2005, hitting 1.28 million and 1.25 million units in the third and fourth quarters, respectively.
Condominium sales in the Tokyo metropolitan area have held at high levels for the past seven years. Since the start of fiscal 2005, contract rates in metropolitan Tokyo have reached a record high, while inventories have fallen to unprecedented lows. According to the Real Estate Economic Institute Co., Ltd., sales of newly built condominiums in metropolitan Tokyo in the fourth quarter of 2005 totaled an annualized 89,000 units, roughly the same level as the previous quarter. The contract ratio1 for new condominiums, reflecting the number purchased in the initial month of sale, was 83.3 percent in the fourth quarter, lower than the third quarter's 84.5 percent but still an impressive figure. However, in January 2006, these figures dropped to an annualized 72,000 units and 77.8 percent. It is possible that the approval process for condominium construction in the coming months could be adversely impacted by the recent scandal involving falsification of earthquake-resistance data, causing deferrals in construction starts.
Anecdotal information gathered from real estate firms has revealed several distinctive features regarding recent condominium sales. First, the children of the baby boomers have now reached the age at which they are purchasing their own properties. Next, singles and households marrying later, and those having few or no children, such as so-called "dual income, no kids (DINKS)" households, are showing a preference for condominiums over freestanding homes. Third, tall condominium towers, a relatively new development, have proven extremely popular. Fourth, a rising number of older buyers have been switching from freestanding suburban homes to condominiums near train stations or in the city center for greater convenience. Finally, many buyers, spurred by rising land values in the center of the city, have acted to buy ahead of expectations that condominium prices will be moving higher as well. The reduction in condominium inventories has been exacerbated by block purchases by real estate funds, but it is believed that this is a temporary phenomenon and that actual demand is the primary reason for the uptrend in condominiums.
Most of the major developers have already secured the necessary land for planned condominium sales through fiscal 2007, and the condominium market is thus expected to remain firm for some time. On the other hand, it appears that many smaller developers have had a difficult time acquiring land. Perhaps for this reason, the supply of new properties is on the wane in central Tokyo but trending upward in neighboring areas such as Saitama and Chiba prefectures. Real estate firms have generally confirmed that condominium sales in the overall Tokyo metropolitan area remain solid, but they have expressed concern as well over whether suburban properties will actually sell. I will be monitoring developments carefully for any sign of overheating in the metropolitan Tokyo condominium market and hints as to the sustainability of the condominium boom.
C. Business Fixed Investment
Earnings at leading corporations have been trending upward, and a turnaround is seen in the caution that had characterized corporate activity. Firms have been boosting their capital investment both at home and abroad, not simply for repairs and renewal but also for higher capacity in the face of increasing global competition, a trend that is believed to continue through at least next fiscal year of 2006. This rise in capital investment has been accompanied by a gradual increase in forward-looking demand for funds. As a result, bank lending excluding special factors is moving slowly but steadily upward on a year-on-year basis, as shown in a 1.4 percent rise in February 2006.
D. Employment
Regarding the employment environment, the jobs-to-applicant ratio reached 1.03 in January 2006, which exceeded the highest level of 1.02 recorded in September 1992. The government's Monthly Labour Survey show that, thanks to bountiful corporate earnings, winter bonuses of 2005, which were special payments from November through January 2006, were up 1.6 percent year on year, basically keeping pace with the 1.8 percent gain of the previous winter and the 1.7 percent increase of summer 2005. Regular payments grew gradually on a rise in wages for full-time workers. Workers' incomes as calculated from full-time worker numbers and nominal wages climbed 0.9 percent year on year in the third quarter of 2005, another 1.6 percent in the final quarter, and 0.5 percent in January 2006. In preparation for the retirement of the baby boomer generation, corporations are increasingly seeking top-quality experienced workers as well as boosting their hiring of new graduates, and may have to raise their base pay in the annual spring wage negotiations with workers' unions. Consequently, the revival in corporate activity is spreading to the household sector.
II. Issues Confronting Major Central Banks
It is useful to look at monetary policy as practiced by other central banks in considering the policy options for the Bank. I concentrate here on three points: the rise in asset prices amid general price stability, the use of price indicators to explain monetary policy, and the balance with fiscal policy.
A. Rise in Asset Prices amid General Price Stability
Central banks conduct monetary policy in accordance with their assessment of overall economic trends and do not focus solely on asset prices. Central banks in the United States and Europe vary to some extent in the emphasis that they place on asset price movements, but the latent risk of asset price inflation has become a considerable dilemma for all recently. General prices have remained stable thanks to the increase in inexpensive foreign imports stemming from globalization. With the liberalization of foreign capital movements, housing and share prices in each nation have become less sensitive to monetary policy, and have tended to remain in constant uptrend even in the event of a monetary tightening by that nation's central bank.
Behind the asset price rise in the leading economies are a number of structural factors, including the widening distribution of international investment, the higher investment spending emanating from emerging economies and oil-producing nations, the insufficient number of investment-grade nations, and the surplus in global savings. Additionally, overseas money continues to pour into Japanese stock markets as foreign investors reconsider their unduly low appraisal of the Japanese economy, the unwinding of Japan's persistent excesses in capacity, employment, and investment, and expectations of an end to deflation and of an improvement in productivity relative to other nations in the medium to long term.
East Asian nations have been pouring their excess savings into U.S. Treasuries and other financial assets in developed economies. Thanks to this influx in long-term capital, bond yields in the United States and Europe have trended downward and have thus allowed the United States and the United Kingdom to finance their current account deficits, creating a serious imbalance. In this regard, two scenarios emerge. In one, as East Asians begin to enjoy a more comfortable living standard, they draw down their high savings and increase their investment, shifting the locomotive of economic growth to domestic demand and thus sending real interest rates higher. In order to correct foreign imbalances in such case, the United States would either have to raise its savings rate or turn to a weak-dollar policy. Alternatively, in the second scenario, East Asians raise their savings rate due to concern over their aging societies and thus reduce their investment activity, keeping real interest rates at low steady levels. Consequently, the United States and Europe would be able to enjoy price stability as at present without having to boost real interest rates to any great extent.
If an overly accommodative monetary policy stance in the United States and Europe were to exacerbate the rise in asset prices, central banks in those regions could find themselves in an even more serious situation. That is, the upswell could extend beyond financial markets such as stocks and bonds into general asset prices such as housing and crude oil and other raw materials. In such case, it is doubtful that the narrowing in the risk premium would prove sustainable. At some point, one would expect an adverse impact on the real economy as the upswing in asset prices either enters a correction or spills over into general prices. It is well known that a prolonged period of low, steady real interest rates will eventually give way to a rise in asset prices. Given the continued solid prospects for the world economy in 2006, not only the Federal Reserve but also other major central banks need to normalize their state of monetary policy before raw material and asset prices became uncontrollable and unsustainable bubble emerged.
A local equity bubble might have been formed in Japanese emerging stock markets around the end of 2005 and beginning of 2006 due to speculative investment by individuals and the rising impact of margin trading by semiprofessional investors. This served as a reminder of the adage that a bubble will always arise in a different manner than earlier cases. The biggest lesson from the bubble's collapse in the early 1990s was the vital importance of a forward-looking monetary policy taking into account the signals sent by a broad range of asset prices.
B. Problem of Using Price Indicators as a Monetary Policy Guide
Nearly all central banks use the consumer price index (CPI) as a monetary policy indicator regardless of whether there is an actual inflation target or a numerical definition of "price stability." The Fed, for example, watches the core personal consumption expenditure (PCE) deflator, meaning that it is looking mainly at household spending. The GDP deflator is generally considered an inappropriate guide for monetary policy since it directly reflects changes in terms of trade.
Even in the case of the CPI, there is the problem of whether to focus on the core rate or the headline rate. Needless to say, while the core CPI is useful in identifying broad price trends, the stability in the headline CPI is the critical factor in the end. Most countries with an inflation target or numerical price stability definition employ the headline rather than the core figure as their guide.
The Fed feels that the core PCE deflator indicates the overall trend in prices. As opposed to Japan, where there is little difference between the core and headline inflation figures, the gap in the United States is striking: in January, headline inflation came to 4.0 percent as opposed to a core CPI rate of 2.1 percent, a disparity of 1.9 percentage points. This is only slightly less than the 2.7 percentage point difference in September 2005 amid the upsurge in oil prices, when headline inflation reached 4.7 percent and the core CPI rate 2.0 percent.
There has been much discussion over whether policymakers should look at the core CPI excluding energy prices. It is true that this might offer a simpler picture of inflationary pressures than the headline figure if it were certain that oil prices would eventually return to their past average. However, the recent ascent in oil prices seems to stem largely from greater demand from China and other developing economies. If it is assumed that this rise in oil and raw material prices is a long-term trend, the CPI excluding energy prices would appear to be the better choice.
C. Balance with Fiscal Policy
Japan is not the only country where fiscal reform looms as a major issue. Fiscal deficits are running ahead of early-year projections in the United States and all three core euro area nations (Germany, France, and Italy). Fiscal stimulus measures such as income tax breaks are unlikely for the next few years in any of the developed economies, most of which are aiming to improve their fiscal situation through revenue cuts and tax hikes. In order to ensure a sustained economic recovery, it is vital to maintain not only an appropriate monetary policy but sound fiscal discipline as well. Japan's Council on Economic and Fiscal Policy has made reform of both expenditures and revenues a top priority, and there is general agreement on the focus on achieving the government's fiscal consolidation.
The global economy is expected to remain firm for the foreseeable future, but there is a risk that fiscal reform could prove to be economic overkill depending on the government's approach. The major central banks need to keep such a risk in mind. Still, their main aim for now should be a normalization of monetary policy in order to quell latent inflationary fears. The most important goal for a central bank is price stability, and central banks overseas may have no choice but to continue tightening if inflationary pressures remain a worry.
III. Gradualist Approach to Policy Normalization
A. End of the Quantitative Monetary Easing Framework
The Bank has decided at the Monetary Policy Meeting (MPM) on March 8 and 9, 2006 to terminate the quantitative monetary easing policy framework that had been maintained for the past five years. In addition to shifting the policy target from the outstanding balance of current accounts held at the Bank back to the uncollateralized overnight call rate, the Policy Board vowed to guide that rate effectively to zero percent until the next MPM. The Policy Board took this step based on its assessment that the conditions set for lifting the policy have been met. In other words, the Japanese economy remains in steady recovery mode and looks set to remain so for some time thanks to increasingly buoyant consumption as the healthy growth in the corporate sector spreads to households. Moreover, the output gap in the economy as a whole has improved gradually, wages are rising, and price expectations in both the corporate and household sector are veering higher, a sign that the uptrend in the CPI (excluding fresh food) is here to stay. Given the new policy framework, it is natural that the bond markets themselves should enter a new phase.
I believe that the objective of the quantitative monetary easing policy changed with the times. When the policy was first implemented in March 2001, the aim was to stabilize the financial system and to avert a deflationary spiral caused by concerns about the financial system. Some market participants argued that the Bank agreed to take on the role of "deflation fighter" by expanding the volume of its Japanese government bond (JGB) outright purchasing operations and raising its current account balance. They also argued, in the face of the theoretical defense and communications by the Bank as it edged its current account balance higher, that quantitative monetary easing had become extremely political in nature.
Behind the adoption of this unprecedented policy was the marked uneasiness in Japan's financial system at the time and, as a result, the very real threat of a deflationary spiral. If the economic situation in March 2001 had been as it is at present, with a stable financial system and core CPI growth of around zero, I believe that the Bank never would have employed a quantitative monetary easing policy. I do feel that the determined increase in the current account balance through January 2004 to the 30 to 35 trillion yen range helped head off a meltdown in the financial system amid a severe stock market slump. However, the implementation of the full removal of blanket deposit insurance in April 2005 was only undertaken once the system had been deemed stable, meaning that the massive present volume of the current account balance no longer had much meaning. Based on this analysis, I had been proposing at MPMs since April 2005 that the Bank reduce its current account balance step by step by around 3 to 5 trillion yen while maintaining the quantitative monetary easing framework.
Communications by the Bank's Policy Board members since September 2005 provoked a response from government officials that any attempt to end the quantitative monetary easing policy would be premature, a reaction that was widely reported. Market participants thus came to believe that political pressures would prevent any such action by the Bank despite the steadily improving fundamentals. This led to a temporary retreat in market participants' fears of higher interest rates. Subsequently, economic statistics, including real GDP growth in the fourth quarter of 2005, confirmed the Bank's economic and price forecasts, and the government began to show more tolerance for a monetary policy change in March 2006. This led to a substantial, bearish flattening in the JGB yield curve from late February.
I believe personally that remarks by government officials regarding monetary policy were taken by market participants as "orders," causing meaningless volatility in the markets and unnecessarily large losses. This reiterates the importance of maintaining a focus on prospects for the economy and prices while remaining aware of bond market developments.
The quantitative monetary easing policy represented a commitment by the Bank that it would not alter its unprecedented policy framework until the year-on-year rate of change in the CPI (excluding fresh food) registered zero percent or higher on a sustainable basis. Slowly but surely, the consensus forecast for JGB yields tended to be based on an assumption that short-term interest rates would be maintained at zero for an extremely prolonged period. I believe that the slide in 10-year yields below 0.5 percent around June 2003 might have represented a JGB bubble, and that the boom in certain of Japan's emerging stock markets in late 2005 might have been a localized equity bubble.
B. Monetary Operation Measures
One of the side effects of quantitative monetary easing over the past five years has been a notable decline in the functioning of the money markets. This may have caused distortions in capital markets due to failures in funds management and financing activities. Thus, even if overnight call rates remain at near-zero levels, short-term interest rates may come under upward pressure due to three technical factors. One is the reduced frequency, scale, and period of funds supplying operations. Second is speculation regarding a future rate hike by the Bank. And third, since this is the first prospect for a rate increase after the introduction of real time gross settlement (RTGS), banks may move now to obtain term instruments. It can be expected that volatility in the short- to medium-term JGB markets remain at lofty levels for some time. As such, I feel that the Bank should take a gradualist approach as it reduces its current account balance, keeping careful watch over the situation in the money markets.
The main goals in the conduct of monetary policy in the post-quantitative monetary easing period will be to ensure that the ensuing adjustment in the bond markets remains orderly and to maintain a proper balance between transparency and flexibility. The problem is how to prevent an undue rise in market expectations of a rate increase. It will be no easy matter to suppress such expectations while maintaining the Bank's latitude in policy.
The change in the quantitative monetary easing framework is only little more than one step in the process of monetary policy normalization. I believe that the most crucial issue for the Bank in this process will be whether it can remain confident of a continued economic recovery through fiscal 2007. It has now moved to a zero interest rate policy without a specific commitment. Given that a good number of investors had predicted that the Bank would wait until April to end the quantitative monetary easing policy, the bond markets could be highly sensitive to positive economic news or an equity rise in the months ahead. The outlook for monetary policy is completely open at the moment, but a scenario can be envisioned in which upward pressure on short-term interest rates encourages an early rate hike.
C. "Understanding" of Medium- to Long-Term Price Stability
For those responsible for conducting monetary policy, the problem of defining price stability is a perpetual theme. Former Fed Chairman Alan Greenspan said at a Federal Open Market Committee (FOMC) meeting in July 1996 that "price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions." This concurs with the basic view at the Bank. Central banks, including the Bank, all make efforts to explain their thinking on monetary policy in an easily understandable manner to the markets and the public. However, their actual methods will vary in accordance with the differences in the economic environment and institutional framework.
When the Bank introduced its new policy framework on March 9, it outlined its fundamental thinking on price stability as well as clarify the actual range of inflation representing the understanding of long-term price stability among the various Policy Board members. The members will thus assess the economic and price situation on the basis of the Bank's thinking on price stability as well as the understanding of medium- to long-term price stability and carry out monetary policy accordingly. This does not mean that the Policy Board has set a specific numerical target for price stability and is planning to take action within a set time period. It is important to understand that the definition of "price stability" is very conceptual and, accordingly the definition of the end of deflation can also be very misleading, because it can vary from person to person.
Monetary policy must aim for price stability not for the foreseeable future but for the medium to long term. An upturn in final goods prices remains unlikely given the relentless downward pressure on import prices due to globalization. If the pace of growth in the CPI remains mild, it might be difficult to win the understanding of the government and market participants for a precautionary rate hike to head off an overheating in the domestic economy or excessive rise in asset prices.
D. Monetary Policy Outlook
In the statement released after the MPM on March 9, when the Policy Board announced the change in the policy framework, it was noted, "On the future path of monetary policy, there will be a period in which the overnight call rate is at effectively zero percent, followed by a gradual adjustment in the light of developments in economic activity and prices." This indicates that the Bank will take a forward-looking approach to monetary policy based on an overall assessment. On this point, I see several challenges.
One of the factors behind the expansion in overseas economies over the past several years has been the sustained accommodative monetary policy environment amid stable low inflation. One of the standards for assessing the degree of tightening or loosening of monetary policy, along with the strength of the real economy, has been the concept of the "equilibrium real interest rate." The definition of the term can vary with the purpose of the analysis and other factors, but traditionally refers to the real interest rate level that is neutral with respect to the economy (or the output gap). The equilibrium real interest rate, also known as the natural rate of interest, is roughly equivalent to the potential real GDP growth rate.
In its Outlook for Economic Activity and Prices released in October 2005, the Bank estimated the potential growth rate to be approximately 1 percent. However, the recent equity market uptrend and high rate of real GDP growth may signal that the potential growth rate has veered upward. Some private-sector economists have suggested that this rate may now be around 2.0-2.5 percent. I personally feel that, with the gains in overall productivity, one cannot deny the possibility that the rate may have risen to around 1.5-2.0 percent. An upturn in the potential real GDP growth rate would mean an upturn in the equilibrium real interest rate.
If an economy-neutral policy interest rate is defined as the sum of the equilibrium real interest rate and the desirable inflation rate, an upswing in the economy-neutral equilibrium real interest rate would signify that the upside for the Bank's accommodative policy interest rate is also to move higher. The continuation of zero interest rates, along with the falloff in real interest rates due to the rise in expected inflation, would amplify the accommodative effect of monetary policy. Of course, if expectations that the Bank will maintain the uncollateralized overnight call rate at zero for a long period grow too excessively, the stimulus effect may overheat, causing outsized swings in the economy. This could greatly increase the scale of adjustments needed in monetary policy. A crucial issue for the Bank in the months ahead will be how much of a decrease in real interest rates to tolerate from the perspective of sustained economic growth.
From another standpoint, there is a belief that monetary policy should be conducted on the basis of a "minimax approach" designed to minimize the worst-case imaginable losses. That is, a central bank should operate not on the basis of a subjective probability distribution but only to avoid the worst-case scenario. This is similar to the second of the two perspectives described under "Examining Economic Activity and Prices from Two Perspectives" in the Bank's statement "The Introduction of a New Framework for the Conduct of Monetary Policy" introducing the Bank's new policy framework.
Many government officials appear to feel that the Bank should fully heed the risk of falling back into deflation once again and thus avoid a premature policy change. However, I myself feel that the risk of falling back into deflation once again is equal to that of an overheating in the economy and upsurge in asset prices, and that the Bank should give ample thought to this latter risk. Even for a policy oriented toward risk management, the pitfalls of an ultra-low interest rate policy increase as the policy is prolonged. There has been much talk in financial markets over a "safety margin" for inflation, that is, the necessary level of inflation that would preclude a future return to a deflationary state. However, if the goal is monetary policy that can respond flexibly in the event of an economic slowdown, what is needed is a minimum interest rate level. I believe that with the termination of quantitative monetary easing, the Bank should now aim for a healthy balance between transparency and flexibility in its monetary policy conduct.
Even with the windup of quantitative monetary easing, the Bank needs to base its policy judgment not on a single price indicator but on an overall assessment. Since prices look to remain under control, the Bank should be able to maintain a gradualist approach toward policy normalization. In addition, the Bank must not forget the painful lessons learned in the course of its own response during the bubble years, nor the idea that the workings of the markets will support the revitalization of the economy and structural reform. In this sense, the Bank needs to maintain a forward-looking conduct of monetary policy with a good balance between transparency and flexibility.