Recent Economic and Financial Developments in Japan and the Conduct of Monetary Policy : 日本銀行 Bank of Japan

Summary of a speech given by Tadao Noda, Member of the Policy Board, at a meeting with business leaders in Okayama on November 30, 2006

February 13, 2007
Bank of Japan

Introduction
I. Economic Activity and Prices after the Policy Change and Outlook
II. Key Factors in Projecting the Future Course of the Economy
III. The Future Conduct of Monetary Policy
1. A. Financial Markets after the Policy Change
2. B. The New Framework for the Conduct of Monetary Policy and Policy Conduct in the Future
IV. Closing Remarks

Introduction

Today I would like to start by discussing the Outlook for Economic Activity and Prices, or the Outlook Report, released in October.¹ The report represents the majority view of the nine Policy Board members regarding the outlook for the economy and prices in Japan. I would like to discuss the current state of and outlook for Japan's economy as well as the Bank's thinking behind its future conduct of monetary policy based on the Outlook Report and also my own views as one of the Board members.

This semiannual report, which is released every April and October after the Monetary Policy Meetings, makes public the Bank's outlook for economic activity and prices.

I. Economic Activity and Prices after the Policy Change and Outlook

A. The Continuing Moderate Economic Expansion

First, let me briefly review developments in the economy and prices since the Bank decided to bring the zero interest rate environment to an end at the Monetary Policy Meeting in July 2006.

On July 14, 2006, the Bank brought to an end the zero interest rate environment, which had continued even after the termination of the quantitative easing policy in March, by raising the uncollateralized overnight call rate, the short-term interest rate that is the operating target for money market operations, to around 0.25 percent. Since then, Japan's economy as a whole has continued to expand moderately with an uptrend in exports, although developments in the corporate sector have been somewhat stronger than projected while those in the household sector have been somewhat weaker.

According to the first preliminary GDP estimates for the July-September quarter released recently, although private consumption decreased from the previous quarter, thanks to the increase in business fixed investment and net exports, the real GDP growth rate exceeded that of the previous quarter.²

In what follows, I will explain developments in Japan's economy in detail.

Exports continue to increase against the background of the expansion of overseas economies. The U.S. economy has been firm so far, although the pace of growth is decelerating. According to the preliminary GDP estimates for the July-September quarter released yesterday, the real GDP growth rate was only slightly above 2.0 percent on an annualized quarter-on-quarter basis, which confirmed the deceleration in growth since the beginning of this year, although the growth rate was revised upward compared with the advance estimates. Looking at demand components, the situation remains the same as before the revision, with weak residential investment being the main cause of the deceleration in growth, while private consumption and business fixed investment, the two driving forces of the U.S. economy, continued their high growth. Taking into account other economic indicators as well, at this point I think it is appropriate to say that developments in the U.S. economy are in line with a soft landing scenario; that is, even if adjustments in economic activity continue for a while, the economy will not fall into recession and, at some point, will start expanding at a pace around its potential growth rate. European economies continue to recover steadily, with the corporate and household sectors well in balance, and East Asian economies, particularly the Chinese economy, continue their strong growth. Furthermore, emerging countries such as Brazil, India, and Russia are growing at a fast pace. Therefore, overseas economies as a whole continue to keep expanding, with more economies gaining momentum, and the environment surrounding Japan's exports has been favorable so far.

Turning to domestic demand, business fixed investment has continued to increase against the background of high corporate profits and favorable business sentiment. The September Tankan³ indicates that corporate profits of both manufacturing and nonmanufacturing firms are expected to increase, although the growth is likely to decelerate. The ratios of current profits to sales for fiscal 2006 are expected to be at levels close to their record highs registered in fiscal 2005.⁴ Given such developments in corporate profits, business fixed investment is expected to increase by nearly 10 percent in fiscal 2006, as it did last year.⁵ The current strong business fixed investment has been led by large firms in the manufacturing sector, and recently small and medium-sized firms as well as firms in the nonmanufacturing sector have also been increasing their fixed investments. I can say that business fixed investment is spreading to a wide range of firms.

The positive influence of the strength in the corporate sector has been gradually feeding through into the household sector. As is evident from the Tankan, firms are increasingly feeling a shortage of labor, and as a result the ratio of job offers to applicants has been exceeding 1.00 and the unemployment rate has recently declined to around 4 percent. In such labor market conditions, although the pace of increase in wages is moderate,⁶ overall household income is increasing steadily due to the increase in the number of employees, and private consumption is on a moderate upward trend. Although some indicators for private consumption were somewhat weak in the summer, this seems partly attributable to temporary factors such as unfavorable weather and weak consumer sentiment resulting, for example, from the fall in stock prices around June.

With the increases in domestic and external demand, production has been increasing, although moderately, and inventories as a whole have been more or less in balance with shipments.

The current phase of economic expansion began in January 2002 and has lasted for four years and ten months (58 months). It is said that this is now the longest economic expansion in postwar history, exceeding the Izanagi boom, which lasted for 57 months during 1965-70.

2Japan's real GDP growth rate for the July-September quarter was 0.5 percent on a quarter-on-quarter basis and 2.0 percent on an annualized quarter-on-quarter basis, exceeding the equivalent numbers for the previous quarter, which were 0.4 percent and 1.5 percent respectively. Looking at the contribution of demand components to real GDP growth on a quarter-on-quarter basis, while the contribution of private consumption was minus 0.4 percentage point, making a negative contribution compared to a positive contribution of 0.3 percentage point in the previous quarter, both business fixed investment and net exports contributed greatly to the overall growth with each accounting for 0.4 percentage point. In addition, inventories contributed 0.3 percentage point.
3The Tankan, which is an abbreviation for Tanki Keizai Kansoku Chousa (Short-term Economic Survey of Enterprises in Japan), aims to provide an accurate picture of corporate activity in Japan, thereby contributing to the appropriate conduct of monetary policy. The Tankan is a nationwide business survey that covers overall corporate activity and is conducted on a quarterly basis (in March, June, September, and December). It consists of two parts: one is an opinion survey on firms' current and future business sentiment and the other a quantitative survey on the results and plans for firms' business activities.
4 The September Tankan shows that the current profits of manufacturing and nonmanufacturing firms for fiscal 2006 are expected to increase by 1.8 percent and 1.9 percent from the previous year, respectively. Market participants, however, expect that they are likely to be revised upward given the results of semiannual book closings for the first half of fiscal 2006 and also the level of foreign exchange rates on which projections of profits in the Tankan are based. For example, according to the September survey of a major securities company, the current profits of listed companies for fiscal 2006 are expected to increase by nearly 10 percent from the previous year. Furthermore, the September Tankan shows that the ratios of current profits to sales are expected to be 5.58 percent for manufacturers and 3.19 percent for nonmanufacturing firms, both registering levels close to the record highs marked in fiscal 2005, which were 5.68 percent and 3.20 percent, respectively.
5According to figures for fixed investment including land purchasing expenses of firms of all industries and sizes in the September Tankan, after the year-on-year percentage change turned positive with an increase of 3.5 percent in fiscal 2003, it rose to 5.5 percent in fiscal 2004 and reached 8.9 percent in fiscal 2005. The year-on-year change in fixed investment for fiscal 2006 is expected to be 8.3 percent according to firms' investment plans at this point.
6This point will be focused on in "II. Key Factors in Projecting the Future Course of the Economy."

B. The Upward Trend in Prices

As we have seen, the economy continues to expand, and in this environment prices continue to be on a moderate uptrend.

Domestic corporate goods prices have risen by around 3 percent from a year earlier, mainly reflecting rises in international commodity prices. Looking at prices of goods at different stages of demand, prices of raw materials and intermediate goods have continued to rise, and in addition, final goods prices, which had been declining significantly, have recently been at the level of a year earlier. As for the year-on-year rate of change in the CPI (excluding fresh food, on a nationwide basis), although retroactive revisions following the rebasing of the index last August had caused the rate of change to be revised downward, it has been on a positive trend even in terms of the 2005 base-year series, albeit marginally so.

With regard to the effects of the rebasing of the CPI, the rate of increase in the new series turned out to be smaller than the market had expected, and this big surprise to the market has been referred to as the "CPI shock."⁷ Taking a closer look, however, the lower-than-expected rate of increase is merely due to a combination of a number of technical factors related to calculation methods. Therefore, I do not think it means that the environment surrounding prices and the direction of prices, in other words the underlying trend in prices, has changed all of a sudden.

The September Tankan indicates that firms are facing the strongest constraints in terms of employment levels and production capacity since the bursting of the bubble, and resource utilization, namely in production capacity and labor, is rising steadily. One of the gauges used to assess the effects of such resource utilization on prices is the output gap in the economy, or the GDP gap, and although the estimates are subject to a certain margin of error, the gap is now estimated to be positive. Since the economic expansion has been continuing, I think prices are in a situation where they can easily rise. On these grounds, I think there is no need at this point to change the basic assessment that prices are on a moderate upward trend.

Now I would like to talk about recent developments in land prices, which are briefly touched upon in the October Outlook Report. Land prices remained low for a long time after the bursting of the bubble, but in recent years, their upturn, particularly in major cities, has been gradually becoming more broad-based. Given these developments, some market participants think that real estate investment has started to overheat and that the economy might be going through some kind of a real-estate bubble. Speaking from my own experience, however, the recent rise in land prices basically indicates that people's view on future economic activity has improved and they are increasingly expecting higher returns from investment in real estate projects. It is true that some price rises seen in areas such as Tokyo cannot be explained rationally by using the income approach to value, but these price rises are observed only in certain confined areas. On a nationwide basis, land prices are still on a downward trend. Thus, Japan is not in a situation of what we would call a bubble, where land is seen as intrinsically valuable, prices rise without any underlying economic rationale, and high land prices are observed not just in some confined areas but on a broad basis. Therefore, there seems no need at present to be especially concerned about possible rises in land prices. However, unlike general prices, land prices tend to rise quite rapidly once they start to rise and I therefore think we should continue to watch developments in land prices carefully.

7In August 2006, the CPI was rebased from a 2000 base to a 2005 base, and year-on-year figures back as far as January 2006 were revised retroactively. It was generally expected in the market that this rebasing would cause the year-on-year rate of increase in the CPI to decline by 0.2 to 0.3 percentage point, but from January 2006 to July it actually declined by around 0.5 percentage point on average. However, the difference between the 2000-base CPI and the 2005-base CPI is expected to decrease in the future, as most of the effects stemming from changing the calculation methods for, for instance, mobile telephone charges, will disappear after the first year. For more details, please see the box on "Rebasing of the Consumer Price Index (CPI)" in the October Outlook Report.

C. Accommodative Corporate Financing Environment

The environment for corporate finance continues to be accommodative.

The Bank's decision to bring the zero interest rate environment to an end in July seems to have had a limited effect on corporate finance so far. With regard to the financing environment in terms of bank lending, the September Tankan suggests that the lending attitude of banks as perceived by firms continues to be accommodative, although it was slightly less accommodative than in the June Tankan conducted before the Bank brought the zero interest rate environment to an end. While the September Tankan also indicates that there is an increased perception among firms that interest rates on bank loans have risen, the average contracted interest rates on new loans and discounts are rising very slowly, suggesting that the policy change has not affected the lending market directly. Considering these developments, the effects of the policy change on firms' borrowing conditions remain limited to date, and therefore the environment for corporate finance continues to be accommodative. In addition to favorable conditions for borrowing from banks, I think the environment for financing through the market, such as for the issuance of CP and corporate bonds, is favorable.⁸

While firms continue to have high levels of cash flow and maintain ample financial resources, I can say that credit demand in the private sector has been increasing gradually because firms are increasing their spending, especially on business fixed investment and dividend payments. Under these circumstances, the amount outstanding of lending by private banks has been on an increasing trend.

Despite the accommodative financing environment, the money stock in terms of M2 plus CDs has been increasing at a very slow pace recently, with the year-on-year growth rate remaining at the 0.0-1.0 percent level. This seems to be mainly due to households and firms shifting funds from bank deposits, which since April 1, 2005 are no longer fully protected under the blanket guarantee of deposits, to financial assets not included in the money stock, such as investment trusts and Japanese government bonds, as the financial system has regained stability and the return on financial assets other than bank deposits has risen. As we can see, given that recent developments in the money stock do not necessarily correspond to developments in economic activity and prices and to the financial environment, the Bank considers there is no need to be particularly concerned about the recent decrease in the rate of money stock growth at this point.

8Even though the Bank brought the zero interest rate environment to an end, credit spreads between CP and short-term government securities and between corporate bonds and long-term government bonds remained broadly unchanged.

D. Japan's Economy Projected to Continue Sustainable Growth

The Bank's projection in the October Outlook Report is that, from the second half of fiscal 2006 through fiscal 2007, Japan's economy is likely to experience a sustained period of expansion -- although moderate expansion -- with domestic and external demand increasing and the positive influence of the strength in the corporate sector feeding through into the household sector. However, given that the current phase of economic expansion has lasted for nearly five years, if it continues, the expansion is expected to mature and growth is likely to gradually slow. The majority of the nine Policy Board members in the October Outlook Report expect that the real GDP growth rate is likely to slow gradually from the 3.0-4.0 percent level for fiscal 2005 to around 2.5 percent for fiscal 2006 and around 2.0 percent for fiscal 2007, approaching the potential growth rate of the economy.^9,10

The basic thinking regarding the outlook for economic activity and prices has not changed much from the projection in the Outlook Report released in April 2006. The outlook presented in the October Outlook Report rests on the following underlying assumptions and mechanisms. First, exports are likely to remain on the increase against the background of the expansion of overseas economies. Second, strong corporate performance is likely to continue, and business fixed investment is likely to continue increasing because firms are factoring increasing overseas demand into their investment decisions. Third, it is likely that the positive influence of the strength in the corporate sector will continue to feed through into the household sector via channels such as increases in household income and dividends. And fourth, the extremely accommodative financial conditions are likely to continue to support private demand.

Given this economic outlook, I think the environment surrounding prices is likely to change gradually. The output gap, which I have referred to earlier, is positive and is likely to widen at a moderate pace with a higher level of resource utilization, namely in production capacity and labor. Although unit labor costs continue to decline, they are expected to stop declining and start increasing slightly in line with the deceleration in productivity growth and clearer increases in wages resulting from the prolonged economic expansion. In addition, it should be noted that results of various surveys show that firms and households are gradually shifting up their inflation expectations for both the short term and the medium to long term.¹¹

With regard to the outlook for prices in terms of price indices, the domestic corporate goods price index (CGPI) is likely to continue its upward trend, although it will be influenced significantly by the prices of crude oil and other commodities and foreign exchange rates. The CPI (excluding fresh food, on a nationwide basis) is also likely to maintain its upward trend, although the upward movement is likely to be very moderate. According to the Policy Board members' forecasts of the year-on-year rate of increase in the CPI in the October Outlook Report, the rate of change is expected to rise gradually from close to zero percent in fiscal 2005 to the 0.0-0.5 percent range in fiscal 2006 and then to around 0.5 percent in fiscal 2007.¹²

As I have explained earlier, our projection is that Japan's economy is likely to experience a sustained period of expansion with domestic and external demand increasing and the positive influence of the strength in the corporate sector feeding through into the household sector, although the growth rate is likely to slow gradually as the economic expansion matures. It should be noted that this outlook is the most likely projection at this point and some upside and downside risks exist. Although I do not think that these risks are very likely to manifest themselves, we should be well aware of such risks in projecting the future course of Japan's economy. In what follows, I would like to talk about key factors to the economy and give my views regarding them.

9The Bank estimates the potential growth rate for Japan's economy to be in the 1.5-2.0 percent range. Any estimate of the potential growth rate, however, are subject to a certain margin of error, and varies over time depending on changes in the economic structure and the pace of technological innovation, and it may therefore be revised retroactively as new data become available.
10In the October Outlook Report, the forecasts of the majority of the Policy Board members for the real GDP growth rate for fiscal 2006 are in the range of 2.3 and 2.5 percent, with the median at 2.4 percent, and for fiscal 2007 they are in the range of 1.9 and 2.4 percent, with the median at 2.1 percent.
11For example, according to the September 2006 issue of the Opinion Survey on the General Public's Views and Behavior, a public opinion poll conducted by the Bank, about 80 percent of respondents expect that prices will be higher a year later. With regard to the pace at which prices are projected to increase, the average is 5.1 percent, slightly higher than 4.8 percent in the previous survey conducted in June 2006.
12In the October Outlook Report, the forecasts of the majority of the Policy Board members for the year-on-year rate of increase in the CPI (excluding fresh food, on a nationwide basis) for fiscal 2006 is in the range of 0.2 and 0.3 percent, with the median at 0.3 percent, and for fiscal 2007 it is in the range of 0.4 and 0.5 percent, with the median at 0.5 percent.

II. Key Factors in Projecting the Future Course of the Economy

A. Downside Risks to Overseas Economies

As we have seen, so far the global economy has been firm on the whole. It is broadly expected to continue expanding because the U.S. economy, which carries the greatest weight in the global economy, is headed for a soft landing¹³ despite the ongoing adjustment in the housing market. As we take a closer look, however, we cannot deny that risks exist in individual economies.

Let us examine developments in overseas economies more closely. We will start with the U.S. economy. It is becoming increasingly clear that the housing market, which had given cause for concern, is cooling. Residential investment decreased sharply in the July-September quarter from the previous quarter in the latest GDP estimates. However, judging from recent data on housing sales, it appears that the sharp deterioration in residential investment is coming to a halt, and some economists point out that it looks as though the worst is behind us. Nevertheless, it seems that the housing market is still undergoing adjustment. Housing starts in October fell below 1.5 million units on an annualized basis, the lowest level since July 2000. In addition, it is still unclear whether housing prices have bottomed out, although they recovered slightly in October after declining for two consecutive months. The majority of market participants seem to believe that the effects of the cooling of the housing market on overall private consumption are likely to be limited. However, this view may be based merely on the current situation where the effects are not yet observed, given that private consumption is currently being underpinned by factors such as the robust employment situation, the drop in gasoline prices, sustained low levels of long-term interest rates, and a rise in stock prices. Uncertainty regarding the extent to which the adjustment in the housing market will affect private consumption remains, and if a greater-than-expected downward adjustment in housing prices occurs, it may lead to a further slowdown of the U.S. economy via, for example, a deceleration of growth in private consumption. Although such a deceleration in private consumption may not be likely, attention needs to be paid to future developments, including the results of the upcoming Christmas and year-end sales.

For the U.S. economy, another risk is the possibility that inflation expectations may strengthen, since high levels of resource utilization, namely in production capacity and labor, continue to be observed in the United States. Various price indices as well as the GDP deflator have recently been decreasing, mainly due to the drop in gasoline prices. Reflecting this, the Fed's statement released after the FOMC meeting in October no longer noted that prices of energy and other commodities were factors sustaining inflation pressures. Yet, I think that it would be premature to conclude that the fundamental inflation pressures, which the Fed watches out for, have lessened. Wage inflation pressures are, in fact, growing stronger. This is evident from the fact that the unemployment rate for October fell to its lowest level in the past five and a half years, labor productivity growth in the nonfarm sector for the July-September quarter leveled off from the previous quarter, and unit labor costs remained high. Recent remarks by senior Fed officials and the minutes of the FOMC meeting in October suggest that the Fed continues to be concerned about inflation. Nevertheless, we must keep in mind the risk that if markets start to think that the Fed is falling behind in containing inflation pressures, this may result in a rise in long-term interest rates, which in turn may negatively affect the housing market further, as during the housing market recession in 1990. Furthermore, this may adversely affect not only the U.S. economy but also the global economy, for instance through the reaction of financial markets.

It goes without saying that the United States is the most important economy for Japan's external demand. The share of the United States in Japan's exports has been decreasing but is still the largest in total, accounting for more than 20 percent. The share is even higher if exports destined for the United States via East Asian economies such as China are included. Attention should be paid to the possibility that, depending on the extent of the deceleration of the U.S. economic expansion, other economies may amplify, rather than compensate, the deterioration in Japan's external demand. Considering the significant role that external demand has been playing in the current phase of economic expansion, I would like to emphasize the obvious fact that the future course of Japan's economy continues to depend largely on external demand, especially from the U.S. economy.

With regard to European economies, economic recovery is likely to continue against the background of the ongoing recovery in private consumption and continuing strong performance in the corporate sector. However, we should be slightly cautious about the outlook because some indices for business sentiment have either peaked out or started to decline and also because the cumulative effects of the tightening of monetary policy by the ECB and the effects of the recent appreciation of the euro on the economies need to be assessed carefully. China also continues to expand strongly at a high growth rate of over 10 percent, and there is a possibility that this growth might accelerate through fiscal 2007, depending on developments in fixed asset investments and exports. On the other hand, there is also a possibility that the pace of growth may decelerate, because pressures from countries such as the United States for further revaluation of the renminbi may increase. Furthermore, international commodity prices, such as crude oil prices, which have recently been stable, may influence global economic developments depending on their future movements.

As I said, I do not think that the likelihood that the downside risks to overseas economies materialize is high. However, if overseas economies deviate sharply downward from the expected trajectory, this may affect not only external demand directly, but also Japanese business fixed investment, as firms have factored expanding external demand into their investment plans in reinforcing their capacity to supply goods and services.¹⁴ Therefore, I think that the future path of overseas economies should continue to be watched closely.

In relation to this, given the rapid increase in the supply of electronic parts and devices in Japan, attention should be paid to the possibility that their production may enter an adjustment phase due to the recent accumulation of inventories, depending on the future developments in overseas economies.

13According to the World Economic Outlook released in September 2006 by the International Monetary Fund (IMF), in which the forecast for global growth was revised upward from that made in April, the global economy is projected to continue high growth, 5.1 percent in 2006 and 4.9 percent in 2007.
14For details on how Japanese manufactures take external demand into account in increasing business fixed investment, see Ishizaki and Kawamoto, Kin'nen no Seizo-gyo no Setsubi Toshi Zoka ni tsuite [The Recent Increase in Business Fixed Investment by Japanese Manufactures], Bank of Japan Review 2006-J-17 (November 2006), which is available only in Japanese.

B. The Risk of Household Income Remaining Sluggish despite Strong Corporate Performance

Next, I will talk about developments in the household sector. The Bank's economic outlook is based on the view that, in the future course of economic expansion, the positive influence of the strength in the corporate sector will feed through into the household sector. In other words, the Bank expects that continuing strong corporate performance will increase household income, thereby increasing the momentum of private consumption.

Looking at recent developments in household income, the year-on-year rate of change in household income has in fact been positive since 2004. Taking a closer look, however, the increase is due largely to the increase in the number of employees, while the contribution of the increase in wages per worker is very limited. Despite a noticeable tightening of labor market conditions, wages have barely increased, particularly regular payments, which constitute the core of wages and have a great influence on private consumption.

The main reason for this seems to be that firms continue to restrain labor costs. For example, Nippon Keidanren (Japan Business Federation), in its December 2005 report, noted with regard to wages that in the context of the globalization of Japan's economy, most firms seemed to "have reached the conclusion that raising wages, already high by international standards, any further is not a realistic option." In July 2006, it summarized the outcome of wage negotiations between labor and management in spring by stating that the majority of firms decided not to improve the general level of wages by means such as raising base wages and that the thinking had taken root that firms with a good performance would reward their employees through bonuses. In addition, a survey showed that more than 70 percent of large firms adopted a merit-based pay system by early 2005. Considering these factors, it seems that firms have established systems that reflect their stance of refraining as much as possible from raising regular payments, leading to an upward rigidity of regular payments. As for small firms, such systems are of no relevance and given that the pace of improvement in corporate profits has been moderate compared to that of large firms, overall there is not much room for increasing compensation for employees. I think the recent movements in regular payments reflect these developments.

With regard to bonuses, their growth is also relatively slow compared to that of corporate profits, as seen in the fact that the year-on-year rate of increase in special payments according to the Monthly Labour Survey was less than 2 percent for four consecutive bonus seasons from the winter of 2005 through the summer of 2006.

Faced with the retirement of baby boomers from fiscal 2007, firms are likely to remain eager to recruit employees, and therefore the tightening of labor market conditions is expected to continue for a while. If this situation persists for a long time, then at some point the supply of workers may be exhausted, leading to a clear increase in wages. In reality, however, the number of employees has been increasing by slightly over 1 percent from a year earlier, because many of the formerly self-employed have been moving into employment, many of the elderly have been continuing or returning to work, and the number of the unemployed has been decreasing. Therefore, for the time being, it is unlikely that a bottleneck in the supply of workers will form suddenly. I also think that the regional mismatch between the supply of and the demand for labor will be gradually alleviated to some extent as labor market conditions tighten further and some of the latent labor supply moves into the labor market.

The factors I have mentioned suggest that it may take longer time than expected for the tightening of labor market conditions to actually lead to a steady increase in wages.

Recently, there has been increasing media coverage of the issue of sluggish wages. Some reports say that a number of large firms will decide to effectively raise their wages. We need to watch developments in wages more carefully to assess whether the Bank's projection are realized, which state that "the increase in wages such as regular payments is expected to become clearer over time, given that labor market conditions are tightening steadily" and that "against this backdrop, private consumption is likely to continue increasing steadily."

C. The Possibility of a Further Acceleration of Business Fixed Investment

So far, I have talked about downside risks to Japan's economy. As the third factor influencing the future course of the economy, I will talk about an upside risk factor, namely, the risk of a further acceleration of business fixed investment.

Although firms have been stepping up their business fixed investment for the last few years, we think that so far an excessive build-up of capital stock cannot be observed in the economy overall. According to the GDP estimates, the quarter-on-quarter growth rate of business fixed investment has been declining gradually for three consecutive quarters.¹⁵ I think it is possible to say that these developments are generally in line with our projection in the Outlook Report that although firms are expected to generally maintain strong business fixed investment plans, the growth rate of business fixed investment is likely to decline as the economic expansion matures.

However, given the extremely accommodative financial conditions, firms may ease their cautious stance with respect to business management against the background of strong profits and may further accelerate investment. Recent survey results show that the purpose of firms' fixed investment has shifted from streamlining business and saving labor to expanding production and sales capacity. I do not think that firms will accelerate investment based on optimistic projections of future profitability and easily abandon their cautious stance of evaluating investment profitability carefully, which they have adopted in light of the past bitter experience of excessive build-up of capital stock. However, we cannot deny -- and therefore should take into account -- the possibility that a further acceleration of business fixed investment may lead to a temporary upswing in overall economic growth and an excessive build-up of capital stock, eventually resulting in adjustments.

I think we need to continue examining the relationship between possible changes in business sentiment on the one hand and firms' corporate performance and investment plans on the other by analyzing the incoming data, including the results of the Tankan to be released in December 2006.

15Looking at the GDP estimates from the first quarter of 2006 onward, the growth rate of business fixed investment has been declining gradually. The quarter-on-quarter growth rates for the first, second, and third quarters were 3.7 percent, 3.5 percent, and 2.9 percent, respectively.

D. Uncertainty regarding the Relationship between Economic Activity and Prices

As the last factor influencing the future course of the economy, I will touch on the growing uncertainty regarding the outlook for prices.

As I mentioned earlier, the output gap in Japan's economy is positive, although only slightly so, and is likely to widen at a moderate pace. If this is the case, wages and prices will continue to face upward pressure with an accompanying increase in the expected rate of inflation. However, the actual developments in the CPI suggest that upward pressure on prices recently seems to have been extremely weak and the CPI is in fact only slightly higher than a year earlier. This implies that there is a possibility that prices may not increase noticeably even when the economy continues to expand steadily.

There are several factors that are responsible for the uncertainty regarding the sensitivity of prices to changes in the output gap. One of these is that, with the ongoing globalization of Japan's economy, low-priced products, mainly consumer goods, manufactured in China and other Asian countries have been flooding into Japan, and this has given Japan an economic structure in which supply constraints stemming from an increase in domestic demand are less severe. Therefore, there seems to be a growing tendency for the domestic supply and demand situation to be not necessarily reflected in price developments.

In addition, it is my view that the increase in imports of low-priced products due to globalization is facilitating competition between domestic and overseas products, and as a result, low labor costs overseas may be exerting downward pressure on labor costs in Japan. To put it another way in relation to price developments, unit labor costs are facing downward pressure. Although wages in the service sector, which are less affected by international competition, cannot be excluded from estimated unit labor costs, it is still evident that globalization has been acting as a restraint on wages. If wages remain sluggish for the domestic reasons that I pointed out earlier, this will also be a factor exerting downward pressure on unit labor costs.

As I said, the most likely scenario in the Bank's projection for prices indicated in the October Outlook Report is that unit labor costs stop declining and start increasing slightly. Taking into account the environment surrounding prices that I have just outlined, we need to bear in mind the risk that the point at which unit labor costs will start increasing may be later than projected.

Another factor affecting price developments is the impact from the change in the potential growth rate. There is a view in the market that the potential growth rate of Japan's economy has been increasing due to the fact that business fixed investment has been showing a double-digit increase for the past few years. We should note that an increase in the potential growth rate can generate downward pressure on prices from the supply side with improved productivity. On the other hand, it can also give rise to upward pressure on prices from the demand side via higher spending due to improved expectations regarding incomes and rates of return.

Developments in the prices of crude oil and other commodities also continue to warrant attention. Since it is difficult to project their future developments, I can only say that commodity prices may move considerably in either direction. Given that crude oil prices reached an all-time high in 2006, even if they remain flat, this would make a negative contribution to the inflation rate in 2007. Considering the magnitude of their impact on general prices, developments in commodity prices are a factor that should be taken into account in projecting the future course of prices.

In relation to crude oil prices, I would like to add a few words on the assessment of price developments.

When assessing prices, I focus not only on the level of price indices, but also on the underlying tendency of prices, in other words, the fundamental inflation pressure and its trend. When judging the underlying tendency of consumer prices, I pay attention especially to the core CPI, which is the headline CPI excluding fresh food, and also the CPI that further excludes items the price of which tends to fluctuate greatly -- such as petroleum products, including gasoline and kerosene -- and items the price of which is fluctuating temporarily due to institutional or other special factors. The reason is that price indices are basically lagging indicators and I think when using them as a basis for forward-looking monetary policy judgments, it is necessary to exclude short-term fluctuations.

Saying that, however, I certainly do not take lightly the importance of the headline CPI, which is closely in line with household and consumer perceptions.

III. The Future Conduct of Monetary Policy

A. Financial Markets after the Policy Change

Now I will briefly touch on developments in financial markets after the Bank brought the zero interest rate environment to an end and will then go on to explain the Bank's future conduct of monetary policy.

The Bank terminated its quantitative easing policy in March 2006 and raised the policy target rate -- the uncollateralized overnight call rate -- from "effectively zero percent" to "around 0.25 percent" in July. As a result, after more than five years during which transactions in the call money market earned hardly any interest, they now offer positive interest rates. Taking into account that the Bank's decision to bring the zero interest rate environment to an end might have a significant effect on financial conditions, the Bank paid close attention to developments in financial markets after the policy change. In particular, the Bank closely watched the money market, which had not been functioning well for some years since the introduction of the quantitative easing policy, and the behavior of participants in bond, equity, and foreign exchange markets. Overall, no major disruptions were observed and the rate rise seems to have been digested smoothly. Although there was an increase in interest rates in the call and repo markets immediately after the policy change, my understanding is that trading soon became smooth and the functioning of the money market is steadily being restored.

Developments in bond, equity, and foreign exchange markets also suggest that market participants calmly accepted the policy change. This reaction is because most market participants had expected the policy change and it was therefore already factored into market prices. The Bank's communication with market participants regarding the policy change went fairly smoothly, and I think one of the reasons for this is the Bank's new framework for the conduct of monetary policy. This new framework, introduced when the Bank terminated the quantitative easing policy in March, aims at ensuring the transparency of the Bank's policy conduct and appears to have been effective when the policy change was implemented.

B. The New Framework for the Conduct of Monetary Policy and Policy Conduct in the Future

Now that I have referred to the new framework for the conduct of monetary policy, I would like to briefly explain what it is.

Under this framework, the Bank decides monetary policy based on its assessment of economic activity and prices from "two perspectives" -- which I will explain later -- taking into account the "understanding of medium- to long-term price stability," that is, the rate of inflation that Policy Board members consider to be consistent with price stability from a medium- to long-term viewpoint.

We consider price stability as a state where various economic agents, including households and firms, can make decisions regarding economic activities such as consumption and investments without being concerned about the fluctuations in the general price level.¹⁶ Price stability is an indispensable prerequisite for achieving sustainable economic growth. In March 2006, the Bank made public that a year-on-year rate of increase in the CPI of approximately 0 to 2 percent was generally consistent with each Board member's understanding of medium- to long-term price stability.

The assessment of economic activity and prices from "two perspectives" basically means that the Bank examines whether the economy is on a path of sustainable growth under price stability from two angles when discussing the future conduct of monetary policy. The first perspective relates to the outlook that the Bank deems most likely for economic activity and prices in one to two years. The second perspective covers a longer time horizon and deals with the risks considered most relevant to the conduct of monetary policy taking account of the possible impact on economic activity and prices should risks materialize, however improbable they might be. Assessments from the "two perspectives" are made every time the Bank decides on monetary policy.

Having looked at how the Bank assesses economic activity and prices from the "two perspectives," I would like to now turn to our assessment of the current situation. From the first perspective, our assessment is that Japan's economy is likely to achieve sustainable growth under price stability, generally in line with the projection presented in the October Outlook Report. Needless to say, in making the projection we considered various risks -- both upside and downside risks to the outlook. At this point, however, I do not think there is elevated likelihood of such risks materializing that would warrant a change in our projection. In addition, the projection is made on the assumption that economic agents such as market participants are making various economic and financial decisions, taking account of the possibility of future rises in the policy interest rate. Therefore, if the Bank does not adjust the level of the policy interest rate even when developments in economic activity and prices are in line with the projection, the Bank will eventually be forced to make drastic monetary policy adjustments, which may result in large swings in economic activity and prices in the future and increase the possibility that Japan's economy fails to achieve sustained growth.

As for the second perspective, we think there are two risk factors with regard to the future course of economic activity and prices. One is the upside risk that stimulative effects of monetary policy are amplified and lead to an acceleration in corporate investment activity, which may eventually cause large swings in economic activity and prices in the future. The other is the downside risk factors that could lead to an economic slowdown -- such as a greater-than-expected deceleration in overseas economies -- materialize and as a result economic expansion and price rises stall.

In the October Outlook Report, based on the assessment of economic activity and prices from the "two perspectives" I have just described, the Policy Board members agreed with regard to the future course of monetary policy that the Bank would adjust the level of interest rates gradually in the light of developments in economic activity and prices, while maintaining for some time the accommodative financial conditions ensuing from very low interest rates. This is basically the same stance as indicated in the April Outlook Report.

As for the future conduct of monetary policy, I would like to continue to make my decisions at Monetary Policy Meetings based on the new framework and carefully assess economic activity and prices while also paying particular attention to the risks that I just talked about. If economic activity and prices develop in line with the projection in the Outlook Report, I think the Bank will gradually adjust the level of the policy interest rate in step with developments in economic activity and prices.

As we have seen, the Bank conducts monetary policy based on the new framework. The basic thinking behind this framework is to conduct monetary policy in a flexible and timely manner, not by simply watching current developments in economic activity and prices but rather by anticipating their future course to the extent possible, with due consideration to the time lag before the effects of monetary policy appear in the economy -- an approach that we often describe as "forward-looking." The Bank has explained the importance of this forward-looking approach to monetary policy at every opportunity, including when it terminated the quantitative easing policy and when it brought the zero interest rate environment to an end. Because this approach is not as clear-cut as the commitment to maintain the quantitative easing policy, it is more difficult to understand, but I think market participants seem to have become fairly familiar with it.

I would like to express my view about the market in relation to the Bank's conduct of monetary policy. I think the market is like a mirror. The market responds to individual economic indicators and, through the accumulation of responses and corrections in the light of new data, formulates prices that reflect its view of the future economy. The Bank's assessment of economic activity and prices and its thinking about monetary policy are undoubtedly one of the factors that to some extent affect market expectations. For us Policy Board members, how the Bank's view and thinking are reflected in the mirror -- the market -- is a key factor when considering the appropriate conduct of monetary policy, and therefore, we should always check and examine how the market sees the Bank's assessment and thinking, while taking into account the nature of the market.

16Please refer to "2. The Bank's Thinking on Price Stability" in "The Introduction of a New Framework for the Conduct of Monetary Policy" released by the Bank on March 9, 2006.

IV. Closing Remarks

According to the research at our Okayama Branch, the economy here in Okayama continues to recover, generally keeping pace with the developments in Japan's economy as a whole that I explained today, although trends vary by industry and firm size.

I pointed out that one of the key factors in projecting developments in Japan's economy is wages, whose rate of increase has so far been moderate, and discussed future developments in wages. As I mentioned earlier, firms in Japan are feeling a shortage of labor. It is worth noting that firms in Okayama are feeling a shortage of labor even more strongly than the average firm in Japan, as evidenced by the fact that the ratio of job offers to applicants is close to 1.4. Therefore, examining the developments in this region helps to foresee those in Japan's economy as a whole. In Okayama, despite the improvement in employment situation, regular payments are still sluggish. In relation to this point, I have heard that firms in the region continue to restrain costs due to intensified global competition even though they are feeling a shortage of labor, and that they are expanding their recruiting activities to a wider region to alleviate the mismatch between the supply of and the demand for labor in this region. While this explains why the increase in wages is only moderate, it also seems to imply that a further tightening of labor market conditions will eventually affect wages, although this may take time. In fact, there appear to be signs of wage increases in Okayama, an example of which is the rise in charges paid to temporary staffing agencies. Regional economic developments provide invaluable information when examining Japan's economy as a whole, and therefore I will continue to pay close attention to them.

The Bank of Japan

Recent Economic and Financial Developments in Japan and the Conduct of Monetary Policy

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