Home > Announcements > Speeches and Statements > Speeches 2007 > Summary of a Speech Given by Seiji Nakamura, Member of the Policy Board, at a Meeting with Business Leaders in Hiroshima on November 22, 2007 (Japan's Monetary Policy and Developments in Economic Activity and Prices)

Japan's Monetary Policy and Developments in Economic Activity and Prices

Summary of a Speech Given by Seiji Nakamura, Member of the Policy Board, at a Meeting with Business Leaders in Hiroshima on November 22, 2007

January 21, 2008
Bank of Japan


I. The Bank's Conduct of Monetary Policy

A. The Bank's Basic Thinking

The Bank of Japan Law stipulates that "currency and monetary control shall be aimed at, through the pursuit of price stability, contributing to the sound development of the national economy." The Bank pursues the appropriate conduct of monetary policy in accordance with this principle.

Our understanding of price stability is a state where various economic agents, including households and firms, can make decisions regarding economic activities such as consumption and investment without being concerned about the fluctuations in the general price level. Price stability is an indispensable prerequisite for achieving sustainable economic growth.

Japan's own history proves the importance of price stability. During the first oil crisis in the wake of the Arab-Israeli War of 1973, crude oil prices surged and the consumer price index (CPI) in Japan marked a year-on-year increase of 23 percent in 1974. The term "hyperinflation" was on everyone's lips, and my salary rose by about 30 percent. However, this did not really feel like an increase in income. Rather, I vividly remember this as a period when Japan's economy and consumer activity fell into a state of deep confusion. In the second half of the 1980s, during the bubble period, asset prices surged and economic activity was boosted temporarily. The bursting of the bubble eventually brought about heavy losses to Japan's economy, leading to a long period of stagnation. I believe that we have learned from these bitter experiences about the importance of "price stability."

Changes in monetary policy, in pursuit of price stability, take time to work their way through to actual economic activity. Moreover, swings in economic activity may actually be amplified if monetary policy attempts to absorb every short-term change in prices resulting from various shocks originating from, for example, financial markets, social and economic developments at home, or events abroad. Therefore, in making monetary policy decisions, the Bank strives to forecast developments in economic activity and prices from a sufficiently long-term viewpoint and to realize price stability over the medium to long term.

B. The Bank's Assessment of Economic Activity and Prices in the October 2007 Outlook for Economic Activity and Prices1 and the Conduct of Monetary Policy

In the most recent issue of the Outlook for Economic Activity and Prices, or the Outlook Report, released at the end of October 2007, the Bank's assessment was as follows. Japan's economy as a whole had been expanding moderately, although the pace of improvement in the household sector had remained slow relative to the strength in the corporate sector. From the second half of fiscal 2007 through fiscal 2008, the economy was likely to continue its sustained expansion, although there were uncertainties regarding overseas economies and global financial markets. A virtuous circle of growth in production, income, and spending was expected to remain in place. The rate of real GDP growth in fiscal 2007 and fiscal 2008 was likely to register around 2 percent on average, somewhat higher than the potential growth rate. The outlook rested on the assumption that the following underlying mechanisms of economic activity would operate. First, exports, which had contributed substantially to Japan's economic expansion, were likely to remain on the increase, reflecting continuing expansion of overseas economies. Second, strong corporate performance was expected to continue. Third, it was expected that the positive influence of the strength in the corporate sector would continue to feed through into the household sector slowly but steadily. And fourth, the extremely accommodative financial conditions were likely to continue to support private demand.

Regarding the future conduct of monetary policy, the Bank noted in the report that it would continue to adjust the level of interest rates gradually in accordance with improvements in the economic and price situation, while confirming that Japan's economy remained likely to follow a path of sustainable growth under price stability and assessing relevant risk factors.

At the Monetary Policy Meeting on November 12 and 13, 2007, the Bank decided, by a majority vote, to maintain, until the next meeting on December 19 and 20, 2007, the current guideline for money market operations to encourage the uncollateralized overnight call rate to remain at around 0.5 percent. This decision was based on the assessment that, although Japan's economy was expanding moderately as evident from economic indicators, developments in overseas economies and global financial markets continued to warrant attention.

  1. 1 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.

II. Japan's Economy and Prices: The Current Situation and Outlook

Next, let me discuss in a little more detail the recent economic and price situation in Japan.

For about four years, until March 2007, I managed a medium-sized firm that provides coastal shipping and passenger ferryboat services in Japan. To be honest, during this period, I did not have the impression that Japan's economy taken as a whole was expanding moderately. The price of fuel, which previously accounted for about 30 percent of business expenses, had almost doubled, while the increase in the amount of maritime transportation of goods and passengers had been sluggish, limiting the pass-through of higher fuel cost to shipping charges. Therefore, in order to keep the business going, we had to strengthen business performance, improve productivity, and reduce operating costs.

At the same time, however, it is also true that the current phase of economic expansion, which began in 2002, has lasted for nearly six years, exceeding the Izanagi boom (57 months during 1965-70), the longest economic expansion in Japan's postwar history. While exports to the United States have been somewhat weak, overall exports have continued to increase as the global economy has kept growing at an annual rate of around 5 percent, with the range of export destinations broadening. As for domestic private demand, the pace of improvement in the household sector has remained slow relative to the strength in the corporate sector. Overall developments in the economy, however, seem to have been generally in line with the Bank's projection for economic activity and prices.

Japan's real GDP growth rate for the July-September quarter of 2007 released on November 13 was 2.6 percent on an annualized quarter-on-quarter basis, reflecting the large contribution of external demand owing to the strong growth of East Asian economies. This suggests that domestic demand overall has been firm despite somewhat weak demand from the household sector.

A. Developments in the Corporate Sector

Let me now discuss economic developments in Japan, looking first at the corporate sector.

Exports have continued to increase against the background of the expansion of overseas economies. In the July-September quarter, real exports increased to all destinations from the previous quarter and, taken as a whole, rose by 6 percent. Real imports have also been on a gradual uptrend, assisted by the rise in domestic demand and production, despite downward pressure from the increase in import prices. Since the pace of increase in exports exceeded that in imports, the real trade balance (real exports minus real imports), increased substantially from the previous quarter by 15.8 percent in the July-September quarter, and the contribution of external demand to the real GDP growth rate was as high as 1.6 percentage points on an annualized basis. The increase in exports has been the driving force of the recent economic expansion, and I will discuss the background to this later on.

In this situation, corporate profits have been strong. Earnings reports of listed firms for the first half of fiscal 2007 suggest that many firms continue to post high profit growth. As of November 19, 2007, the current profits of firms listed on the Tokyo Stock Exchange (excluding those in the financial sector) for the first half of the fiscal year 2007 were up by 8.3 percent on a year-on-year basis, and the rate of increase for the whole of fiscal 2007 was expected to be 8.1 percent. Despite the favorable earnings results for the first half of the fiscal year, only a small number of listed firms seem to have revised upward their earnings forecasts for the whole year, and most firms seem to be maintaining a cautious stance regarding the future outlook, given concerns about adjustments in the U.S. economy and rises in the cost of, for example, materials. Furthermore, the recent rise in crude oil prices and the trend of yen appreciation in the exchange market may adversely affect future corporate profits of exporting firms. The pace of improvement in small firms' profits is slower than that of large firms, and it has been somewhat sluggish recently due mainly to effects from the rise in materials costs.

The Tankan, which is an abbreviation for Tanki Keizai Kansoku Chousa (Short-Term Economic Survey of Enterprises in Japan), is a nationwide quarterly survey on business sentiment among managers at approximately 10,000 firms around the country. According to the Tankan conducted in September 2007, although business sentiment among large firms -- both in the manufacturing and nonmanufacturing sectors -- seems to remain favorable, that of small firms seems to be deteriorating recently.

Against the background of continued expansion in domestic and external demand and high corporate profits, business fixed investment has continued to trend upward as seen in the fact that, for example, machinery orders increased in the July-September quarter for the first time in three quarters, by 2.5 percent from the previous quarter. However, since business fixed investment has continued to increase at a rapid pace for the last several years and the level of capital investment is already high, the pace of growth will likely decelerate gradually. According to business fixed investment plans indicated in the September Tankan, firms' active investment stance will continue in fiscal 2007, although the pace of increase in business fixed investment will slow somewhat relative to fiscal 2006 in both the manufacturing and nonmanufacturing sectors.

B. Developments in the Household Sector

The pace of improvement in the household sector has remained slow relative to the strength in the corporate sector, as I have mentioned earlier. Sales at department stores and supermarkets have been fluctuating significantly due to weather conditions, but private consumption on the whole has been firm. On a year-on-year basis, the number of new passenger-car registrations (excluding small cars with engine sizes of 660 cc or less) in October was up by 5.5 percent partly due to the introduction of new models, and sales in the food service industry and of electrical appliances in September were up by 6.4 percent and 15.1 percent, respectively, with the latter boosted by strong sales of digital appliances. Nevertheless, one matter of concern is that consumer sentiment has deteriorated slightly of late, as suggested, for example, by the most recently published Consumer Confidence Index, in response to price hikes for gasoline and daily necessities as well as several announcements of future price increases while wage growth has been sluggish, and to concerns about the future with regard to, for example, Japan's pension system.

As for housing investment in Japan, housing starts have been decreasing since July due to the effects of the revised Building Standard Law coming into force but are likely to recover as the effects wear off. However, the timing and degree of a recovery in housing starts are uncertain, and the negative impact on shipments of construction goods and the business performance of small firms in the construction industry would be cause for concern if the effects were to last for a prolonged period. In this situation, the Bank's projection for the year-on-year rate of change in real GDP for fiscal 2007 was revised downward with a forecast median of 1.8 percent, down 0.3 percentage point from the forecast made in April 2007. Moreover, given that household income has not increased noticeably, some industry experts are expressing concerns that there is some sluggishness in the underlying trend in housing demand affected by the rising prices of houses and condominiums for sale. Therefore, developments in housing investment warrant careful monitoring.

Looking at wages per worker, regular payments in September were down 0.4 percent on a year-on-year basis, indicating that the flow of income from the corporate sector to the household sector has been somewhat weaker than previously assumed. There are mainly three sources of downward pressure underlying the sluggishness in wages, namely firms' persistent labor cost restraints amid severe competition at home and abroad; fiscal consolidation, such as a reduction in salaries of local government employees; and demographic changes in the working population due to an increase in retirements of the well-paid baby-boomer generation and in recruitments of part-time workers. These factors restraining wages per worker seem to be particularly pronounced at small firms, due partly to sluggishness in their growth of profits reflecting the rise in materials prices. Against this background, it is unlikely that there will be a rapid change in the income situation, but upward pressure on wages is likely to intensify gradually as labor market conditions are likely to tighten further along with the continuing moderate expansion of Japan's economy.

Households' financial assets have been diversifying gradually and interest income from such assets, in addition to employee income, has been increasingly becoming an important source of overall household income. In this situation, the positive influence of high corporate profits is likely to affect the household sector through various channels such as increases in dividend payments and stock prices -- including those resulting from share buybacks -- and lead to a moderate increase in households' disposable income.

C. Developments in Prices

As for prices, the year-on-year rate of increase in the domestic corporate goods price index has generally been around 2 percent, which is higher than expected, mainly reflecting rises in international commodity prices. On the other hand, firms at the retail level have not been able to pass cost increases from higher material prices on to consumers to the extent that has been possible at the wholesale level due partly to fierce competition from low-priced imported goods brought about by the progress of economic globalization and deregulation. For this reason, the increase in the core CPI, which excludes fresh food, has been sluggish since February, with the rate of change hovering slightly below 0 percent.

One possible explanation for this sluggishness is that, as a result of the persistent decline in prices, consumers have come to judge more severely the value of services and goods provided and are decidedly reluctant to accept increases in prices. Many firms are therefore extremely cautious about raising prices, as they fear consumers' reaction.

Let me cite the example of a supermarket that decided to pass on cost increases to consumers amid the intensified competition among firms in the retail industry: the decision resulted in a decline in sales, even of items whose prices had not been raised, because the number of visiting customers had decreased, and the supermarket in the end had to reverse the price rise.

Another possible factor for the sluggishness in the core CPI is that the ongoing consolidation among electrical appliance retailers, supermarkets, and other retailers has strengthened their respective pricing power vis- -vis manufacturers.

As described, consumer prices have recently been sluggish and the year-on-year rate of change is likely to be around 0 percent in the short run, but in the longer run, the rate is expected gradually to rise. The rate of increase in the core CPI is projected to be around 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008. This projection is based on the Bank's outlook that more firms are likely to gradually pass on cost increases -- including those from the recent surge in crude oil and food prices as well as past rises in materials prices -- at the retail level in addition to the wholesale level in a situation where the utilization of resources, particularly labor, is likely to increase steadily, albeit gradually, because economic growth is expected to continue at a rate somewhat higher than the potential growth rate. The recent Opinion Survey on the General Public's View and Behavior conducted by the Bank also showed a slight increase in the proportion of respondents who expected that prices "will go up."

It has been suggested that the sluggishness in the CPI is at odds with consumer perceptions, given that the prices of some daily necessities purchased frequently have been on the rise. This disparity derives from the nature of consumer perceptions and the way the CPI is calculated. Consumer perceptions of the price level tend to be subjective, influenced by the prices of goods related closely to the everyday life of consumers, such as gasoline and food. But the CPI is calculated based on objective criteria, and items in the CPI basket include not only products that are purchased frequently but also those purchased less frequently. Moreover, the price of an item in the CPI basket is adjusted downward when the quality or performance of a product improves, even when the retail price remains unchanged. Taking the CPI in September as an example, the CPI declined by 0.2 percent from the previous year, and this decline is attributable to the year-on-year decrease of 15.7 percent in the prices of recreational durable goods, such as television sets and personal computers, which pushed down the general index by 0.14 percentage point. An assessment of price developments should be based on a comprehensive analysis of the economic and price situation, taking into account not only movements in price indicators, but also consumer perceptions of price developments.

III. Upside and Downside Risks to the Outlook for Economic Activity and Prices

A. Upside and Downside Risks to the Outlook for Economic Activity

The outlook for economic activity explained today is subject to upside and downside risks, such as those concerning developments in overseas economies, global financial markets, and housing investment in Japan. I would like to point out two risks that should be taken into consideration in projecting the future course of the economy.

1. Developments in overseas economies

The first risk concerns developments in overseas economies. In the United States, while indicators relating to private consumption and employment are on an uptrend, albeit with some deceleration in the pace of growth, housing investment continues to decline and indicators of consumer sentiment are deteriorating due to negative effects such as of the subprime mortgage problem. In this situation, downside risks to the U.S. economic outlook are increasing. If the correction in the housing market does not spread to other areas of the economy and the economic slowdown turns out to be limited, the global economy is likely to continue to expand, with the deceleration in U.S. economic growth being offset by high growth in emerging economies, partly because the contribution of U.S. economic growth to global economic growth has halved. However, if downside risks materialize, for example, the housing correction intensifies or the negative effects of the disruptions in financial markets become unexpectedly widespread, private consumption and business fixed investment may fall below expectations through credit tightening and deterioration in business and consumer sentiment, and this may lead to further deceleration in growth of the U.S. economy. If this turns out to be the case, growth in other parts of the world may be hampered and this could cause global economic growth to be weaker than expected. This could also affect Japan's economy.

I would like to briefly touch on the subprime mortgage problem, which has been exerting a substantial effect on global financial markets. Subprime mortgages are mortgages for individuals with a deficient credit history. The amount outstanding of subprime mortgages is approximately 1.3 trillion U.S. dollars, which is said to account for 13 to 15 percent of total mortgage loans extended in the United States. Given that resale of loan assets was easy due to securitization, mortgage lenders eased lending standards in the past few years and increased lending even to borrowers with insufficient repayment capabilities, factoring in future rises in house prices. However, due to the decline in house prices, or the deceleration in growth in house prices in some areas, an increasing number of borrowers intending to sell their houses or refinance their loans are experiencing difficulty in repaying principal and interest, and more borrowers are delaying mortgage payment on their homes with the rise in mortgage rates. Approximately 15 percent of mortgage loans extended in 2006 are over 60 days delinquent, and the number of mortgage loans extended in 2006 that are delinquent is about twice as large as the number of loans extended in 2005 that are delinquent, indicating that mortgage loans are increasingly becoming nonperforming. This situation is a result of mortgage loans that should not have been extended or taken out, and was thus inevitable. These loans are also sometimes called NINJA (No Income, No Job, and No Assets) loans.

With subprime mortgage loans increasingly becoming nonperforming, there are likely to be negative effects on the U.S. economy: there is a risk that an increase in the disposal of underlying collateral will prolong the correction in housing markets; and deterioration in corporate and consumer sentiment will place downward pressure on business fixed investment and private consumption.

In global financial markets, due to the reassessment of credit ratings of residential mortgage-backed securities (RMBS) with subprime mortgage loans as collateral, concerns increased about the prices of a wide range of securitized products and liquidity in financial markets, and in addition uncertainty increased about the earnings of U.S. and European financial institutions. Such negative effects spread to other credit products and stock markets. However, the effect of turbulence in global financial markets on Japanese money and credit markets has been limited so far.

As for the outlook, there is uncertainty about when the correction in the U.S. housing market will settle or when concerns about the price formation of securitized products in global financial markets will be dispelled, but the Bank will continue to closely monitor the effect of the subprime mortgage problem on the global economy and any spillover effects on Japan's economy.

2. Larger swings in financial and economic activity

Despite swings in global financial markets stemming from the U.S. subprime mortgage problem, real interest rates in Japan are likely to remain very low, as I mentioned earlier. In this regard, the second risk is that possible larger swings in financial and economic activity under continuing extremely accommodative financial conditions may cause economic activity to deviate either upward or downward from its expected path.

In this situation, if corporate managers' greater assertiveness should be based on optimistic assumptions regarding future financing costs, asset prices, and profits, the result could well be a misallocation of resources in the long run as agents become over-extended in financial markets or pour funds and other resources into inefficient economic activities. Such behavior may push up economic growth and asset prices in the short run, but lead to later downward adjustments and hamper the sustainability of economic growth. So far, such optimistic assumptions have not spread among corporate managers and the public given their past experience of the bursting of the bubble economy, but the possible materialization of this risk should be borne in mind as one of the risks to the outlook for economic activity.

B. Upside and Downside Risks to the Outlook for Prices

These upside and downside risks to the outlook for economic activity may affect prices should they materialize, but there are also upside and downside risks unique to price developments that could cause prices to deviate from the projection. For example, if, despite continued economic expansion, the factors restraining wage growth were to remain strong due to firms' cost reduction efforts to respond to intensified global competition, downward pressure on prices would be likely to persist.

As prices of crude oil-related products and daily necessities such as food have been rising worldwide, more Japanese firms may pass through cost increases into retail prices. And this, coupled with increases in inflation expectations, may cause prices to deviate upward from the projection. Also, if the U.S. economy returns earlier than expected to a rate of growth around its potential growth rate in a situation where the Chinese economy is overheating, this, along with further rises in the prices of international commodities, may lead to a rise in inflation pressures on the global economy, which is a concern shared among U.S. and European central banks. Particularly at present, robust demand reflecting strong growth of the global economy and geopolitical risks, among other factors, are causing crude oil and other international commodity prices to remain elevated, and the price situation may also be affected depending on future developments in these prices.

IV. The Background to the Increase in Japanese Exports

The increase in exports has contributed greatly to the current economic expansion, which started in early 2002. I will now talk about some of the features of this export performance.2

  1. 2 For details, refer to "Recent Developments of Japan's External Trade and Corporate Behavior," BOJ Reports & Research Papers, Research and Statistics Department, Bank of Japan, October 2007.

A. Expansion of the Global Economy

The global economy has been registering high annual rates of growth of about 5 percent since 2004. According to the International Monetary Fund's World Economic Outlook, global growth in 2008 is forecast to slow somewhat but maintain high growth of slightly below 5 percent. By region, over the past few years, China and other emerging economies have been growing rapidly, increasing their presence in the global economy. In contrast, the percentage share of U.S. economic growth in global economic growth has declined from an average of 20 percent during the period from around 1980 to around 2000 to an average of 10 percent since 2002.

Since 1980, the global trade volume has increased fivefold, outpacing by far the threefold growth in global real GDP during the same period. Furthermore, the global population has risen about 1.5-fold to 6.6 billion, from 4.4 billion in 1980. It is expected to further increase at an annual rate of more than 1 percent for some years to come. Therefore, global trade is likely to continue to expand.

During this period, Japan took advantage of the expansion in global trade, and as a result, the ratio of net exports to GDP has approximately doubled in less than 30 years.

These developments are underlined by the expansion in the volume transported by container ships and bulk ships. Particularly since 2002, the year after China's accession to the World Trade Organization, the volume of maritime transportation has been robust, and freight rates have been rising due to tight market conditions. Shipping firms are investing in new vessels to meet global transportation demand expected to grow at an average annual rate of more than 5 percent during the next few years. In Japan, the shipbuilding industry is also buoyant with shipbuilding berths said to be almost full for the next four years.

B. Diversification of Japanese Exports in Terms of Destinations and Types of Goods

The destinations of Japanese exports have diversified. A breakdown of exports by destination shows that the share of the United States, which accounted for more than 30 percent until 2001, has declined year after year, while that of China and other regions has increased.

Exported goods have also become more diversified and better balanced, with the share of IT-related goods declining to about 20 percent from over 30 percent, while that of automobile-related products and capital goods has increased.

C. Measures Taken by Japanese Firms to Meet Global Demand

During the current economic expansion, the global economy has grown at about 5 percent per year while Japanese exports, at a rate of about 10 percent, have increased at twice that pace. Thus, Japan has been able to secure a stable share of the growing global demand through diversification in terms of both destinations and types of goods.

At the same time, the overseas production ratio of Japanese firms, especially those in the assembly industries, has been increasing, and they have expanded both domestic and overseas production to complement each other to meet brisk overseas demand.

D. Construction of a Global Supply System

While boosting overseas production, exporting firms in the past few years have been constructing large-scale production bases in Japan, as seen by Sharp Corporation's Kameyama Plant or Toshiba Corporation's Yokkaichi operations. Thus, Japan's exporting firms have been lowering costs through overseas production, while at the same time trying to maintain high domestic operating rates and strengthen the competitiveness of production at home by concentrating high-tech operations and increasing efficiency. In other words, in order to meet the growth in global demand, Japanese firms are attempting to establish an optimized global production network.

E. Improvement in the Balance of Trade in Services and of Income

The surplus of trade in goods, which used to account for a large share of the current account surplus, has been more or less unchanged in recent years: while the real trade balance has increased, the nominal trade balance has been affected by the rise in the prices of crude oil and other imported goods. On the other hand, the deficit in the balance of trade in services has been decreasing moderately, and the surplus in the balance of income has expanded, slightly exceeding the surplus of trade in goods, and these developments have greatly contributed to the increase in the current account surplus.

A breakdown of the balance of trade in services shows an increase in income from royalties and license fees received from foreign firms as well as Japanese overseas subsidiaries, and growth in profits from exports via overseas subsidiaries. The surplus in the balance of income has risen basically due to the increase in external net assets: specifically, net income on debt and direct investment income has increased. In view of these developments, the improvements in the balance of trade in services and of income to a substantial extent are attributable to the increases in profits of Japanese business operations overseas.