Home > About the Bank > Speeches and Statements > Speeches 1996–2010 > Speeches 2008 > Summary of a Speech Given by Tadao Noda, Member of the Policy Board, at a Meeting with Business Leaders in Gunma on March 12, 2008 (Recent Economic and Financial Developments and the Conduct of Monetary Policy)
Recent Economic and Financial Developments and the Conduct of Monetary Policy
Summary of a Speech Given by Tadao Noda, Member of the Policy Board, at a Meeting with Business Leaders in Gunma on March 12, 2008
May 13, 2008
Bank of Japan
Contents
I. Economic and Financial Developments
A. The Current State of and Outlook for Japan's Economy and Prices
Japan's economy is expanding moderately as a trend with the virtuous circle of growth in production, income, and spending remaining basically intact, although the pace of growth has been slowing mainly due to the drop in housing investment and the effects of high energy and materials prices. The economy is expected to continue expanding moderately, although the pace of growth is likely to slow for the time being.
Let me explain in more detail.
Exports to the United States have been relatively weak, but those to other economies have been increasing -- not only to the euro area and Asia, but also to oil-producing and other emerging economies. Exports are expected to continue to rise, as overseas economies are likely to expand although at a slower pace.
As for domestic private demand, business fixed investment has continued to trend upward and is expected to continue to do so, although the pace of increase is likely to slow gradually; behind this trend lie high corporate profits, which are likely to be maintained albeit with some sluggishness in growth. Meanwhile at small firms, due to the rise in materials prices, profits have been sluggish and sentiment has deteriorated, and the possibility that this will adversely affect their fixed investment requires careful monitoring.
Housing investment measured on a real GDP basis dropped substantially, affected by delays in the examination of applications for building approval after the revised Building Standard Law came into force. There have been some signs of recovery in housing investment as these delays have begun to be resolved; however, demand for condominiums has been weak due to the rise in real estate prices, so there remains the need for some caution concerning the pace and extent of the recovery in housing investment.
Private consumption has been firm and is likely to trend moderately upward, with aggregate employee income likely to continue to rise supported by increasing employee numbers, while wages per worker remain sluggish. However, some recent surveys suggest that consumer sentiment is rapidly becoming more cautious. This is mainly attributable to the rises in prices of daily necessities such as gasoline, kerosene, and food products amid the sluggish growth in wages. It is therefore necessary to watch closely developments in private consumption including the effect of the deterioration in consumer sentiment.
Given recent developments in demand at home and abroad, production is likely to be flat or to decline slightly in the short run, partly because of an anticipated dip in the production of automobiles and IT-related goods after their somewhat overly robust growth in the second half of 2007. Nevertheless, production is expected to increase in the longer run, given that inventories have been more or less in balance with shipments and adjustment pressure on inventories has therefore been low.
Turning to price developments, the three-month rate of change in the domestic corporate goods price index (CGPI) has been positive, and the CGPI is likely to continue increasing for the time being, mainly due to the continuing uptrend in international commodity prices. The year-on-year rate of change in the consumer price index (CPI) for all items excluding fresh food has bottomed out and recently rose to 0.8 percent. The surge observed in the past few months is mostly attributable to the rise in prices of petroleum products and food products.
However, the underlying trend in the year-on-year rate of change in the CPI has been slightly upward since around 2003, as evidenced by movements in its trimmed mean -- an index calculated by discarding a certain percentage of items from both ends of the price change distribution and thereby excluding the most extreme relative price movements. I believe that the fact that the output gap has remained positive for a considerable period has been underpinning price rises. In the short run, the CPI is likely to be significantly affected by swings in the prices of commodities such as crude oil, but in the longer run upward pressure on the underlying trend of the CPI is expected to increase gradually, not only because the output gap is likely to remain positive but also because an increasing number of retail firms, especially in food product and food service industries, have begun to pass on higher costs to final prices, although the pace and extent of this process remain uncertain.
I have discussed the current state of and outlook for Japan's economy and prices, but it should be noted that such an outlook is attended by risk factors affecting the likelihood of its materialization, and that these risks warrant attention. Among these, I believe that developments in Japan's exports -- the engine of production that drives the circle of growth in production, income, and spending -- as well as developments in global financial markets and overseas economies, both of which have a significant impact on exports, constitute important risk factors to Japan's economy that warrant particular attention.
B. Developments in Global Financial Markets
Next, I would like to talk about developments in global financial markets and changes in the global financial environment.
Global financial markets have experienced disruptions stemming from the U.S. subprime mortgage problem, and some strains remain due to persisting concerns about downgrading of securitized products and possible further losses at financial institutions.1
Securitization markets, which triggered the subprime mortgage problem, are not yet functioning fully. Taking a broader look at the corporate financial scene, financial conditions have been tightening in the United States and Europe, as seen in the fact that credit spreads such as corporate bond spreads and credit default swap (CDS) premiums2 have widened further and financial institutions have tightened their lending standards. Moreover, large swings in stock and foreign exchange markets have been observed worldwide, and investors have continued to evince a strong degree of risk aversion.
The recent volatility in financial markets can be explained as follows: for a long time the global economic and financial environment has been benign, creating conditions under which risk evaluation by market participants became lax; this laxity has subsequently been undergoing reversal by the self-correcting forces of the market. I therefore believe that it will take some time for adjustments in the markets to be completed, and that during this process it is inevitable that losses will be experienced by some parties. Dealing with this situation will require that (1) financial institutions and institutional investors disclose the size of the losses they bear on their balance sheets; and (2) they repair their balance sheets, in other words, they restore and reinforce their capital base.3 Estimates of losses arising from subprime mortgage loan-related products have been released by some institutions, but it is still difficult to make an accurate forecast of total losses, as housing markets in the United States are still undergoing corrections. Furthermore, even though U.S. and European financial institutions have already recorded considerable losses and announced a series of capital reinforcement measures, financial markets have not yet regained stability and uncertainty about the outlook is still increasing, amid persisting concerns about possible further losses at financial institutions.
- There are also concerns about recent credit conditions at monoline insurers, which mainly guarantee the payment of principal and interest on municipal bonds and securitized products when an issuer defaults. Amid the recent decline in the prices of securitized products, they reported large losses from their insurance of securitized products, and some have had their credit ratings downgraded.
- A form of derivative transaction that transfers the credit risk associated with the underlying asset without directly transferring the asset itself. The related price in such a transaction is called the premium.
- The statement of the G-7 countries released on February 9, 2008 also stresses that "Financial institutions' recognition and full and prompt disclosure of their losses, based on appropriate valuation, accompanied, where necessary, by measures to reinforce their capital base, play an important role in reducing uncertainty, improving confidence, and restoring the normal functioning of the markets. We urge this process to continue."
C. Developments in Overseas Economies
Let me now discuss developments in overseas economies. The slowdown in the U.S. economy has become more evident since the October-December quarter of 2007. Housing investment has decreased substantially, and employment and production indicators have been somewhat weak. The pace of increase in private consumption has clearly slowed and has been more or less flat recently. According to the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices, financial institutions have been applying tighter lending standards not only on residential mortgage loans, but also on commercial real estate loans, consumer loans, and commercial and industrial loans, and this has been holding back the spending of households and firms.
Under these circumstances, since last September the Federal Reserve has lowered its target for the federal funds rate five times in succession, by a total of 225 basis points, while the U.S. government has decided to implement a fiscal stimulus package including tax cuts. Growth in the U.S. economy is expected to remain sluggish for the time being, but in the longer term it is likely to gradually accelerate to around its potential growth rate, reflecting the effects of these macroeconomic measures, provided that corrections in the housing market are near completion and tighter financial conditions begin to ease. Nevertheless, attention continues to be warranted by the risk that, if housing corrections and volatility in financial markets become larger than expected in terms of extent or duration, the U.S. economy may slow further than projected due to negative wealth effects, credit tightening, and deterioration in business and consumer sentiment.
European economies have continued to grow, although the pace of growth has been slowing moderately. Exports and private consumption have been somewhat weak, but business fixed investment has remained on an upward trend. However, the adverse effects of the volatility in global financial markets on financial conditions may pose a downside risk. Meanwhile, China and other emerging economies, as well as countries that produce natural resources, have continued to show high growth, increasingly playing the role of the engine for the global economy.
The generally accepted view regarding the outlook for the global economy is that it is likely to continue to expand as a whole, albeit with a moderate slowing of the pace of growth. However, downside risks seem to be increasing due to deeper adjustments in the U.S. economy and global financial markets. As I mentioned earlier, developments in the global economy, particularly in the U.S. economy, could affect Japan's exports and production -- the source of Japan's virtuous circle of growth -- directly as well as indirectly via developments in financial markets. The impact on Japan's economy depends ultimately on the extent to which high growth in China and other emerging economies could offset the adverse effects of the slowdown in the U.S. economy. This line of argument, which relates to the so-called "decoupling" theory, will be discussed later in some detail. At any rate, developments in the global economy and in global financial markets as well as their effects on Japan's economy continue to warrant attention.
When projecting developments in the global economy, due consideration should be given to both upside and downside risks arising from the surge in energy and food prices. The current downside risk is that the following mechanism may operate: deterioration in the terms of trade caused by rises in such prices leads to an outflow of income from countries like Japan that import natural resources -- in other words, a decline in their purchasing power -- in favor of resource-rich countries; unable to completely recover the outflow of income by increasing exports of goods and services, economic growth in such countries therefore decelerates.
Needless to say, the current upside risk is the risk of inflation. In the United States and Europe, while the slowdown contributes to a gradual reduction of underlying inflationary pressures, the surge in international commodity prices, particularly crude oil prices, acts in the opposite direction. In China, despite the various tightening measures adopted by the public authorities, the economy continues to show robust growth, with some overheating observed mainly in fixed asset investment: the year-on-year rate of increase in the CPI for all items rose to the 8.0-9.0 percent level in February, partly reflecting the rise in food prices due to heavy snow.
As I have explained, there are both upside and downside risks to the global economy. To central banks worldwide, which must pay due attention to risks on both sides, the recent economic and financial circumstances present a particularly tough challenge.
II. Decoupling Theory
The decoupling theory has become popular among economists and market participants since last year, as the slowdown in the U.S. economy, the driving force of global economic growth, has grown evident. The theory runs as follows: robust global economic growth will continue as long as the high growth in emerging economies, particularly in China, offsets the adverse impact of the U.S. economic slowdown. Here is my view on the theory.
Economies around the world have been increasingly interrelated as globalization has progressed. An economic event in one country potentially affects others via two international channels, namely, trade and financial transactions.
Let us look first at the trade channel. It is true that developments in the U.S. economy have relatively less impact on the global economy now that global economic growth has undergone multipolarization driven by the expansion, mainly, of emerging economies. In terms of shares of overall exports,4 most countries and regions, including Japan, are now less dependent on exports to the United States, and are therefore less vulnerable to a fall in such exports caused by a further slowdown in the U.S. economy.
Nevertheless, the United States is still undeniably the world's largest importer. Further slowdown or stagnation in the U.S. economy will naturally exert a certain degree of downward pressure on world exports. In fact, with the slowdown in the U.S. economy, Japan's real exports to the United States decreased by 1.0 percent in 2007 from the previous year. Also in China, there has been a change in trends of exports to the United States, with year-on-year export growth falling rapidly. The export growth rate, which had stood at 20 percent or above until the January-March quarter of 2007, declined to 10.7 percent in the October-December quarter and to 5.3 percent in January 2008, before eventually plunging into negative territory: the preliminary figure for February is minus 5.3 percent. The impact on Japan's exports of falls in the exports of other East Asian countries including China to the United States requires monitoring, given the international division of the production process -- that is, the process by which Japan makes intermediate goods, or more specifically parts, that are exported to other East Asian countries, where they are assembled into final consumer goods and subsequently exported to the United States.
The second channel is that of global financial markets. Here, far from "decoupling," it is the "coupling" of stock market developments in the United States and emerging economies that is in progress. Disruptions in global financial markets stemming from the U.S. subprime mortgage problem are already greater than expected. If the U.S. economy slows down further and investors' capacity to take on market risk suffers a substantial fall, the flow of funds to emerging economies will narrow; thus, due attention needs to be paid to the risk of an adverse impact on overall growth in these economies.
In short, in my opinion complete decoupling between the U.S. economy and emerging economies is an impossibility. Indeed, the idea of decoupling itself is a misnomer: rather than binary relationship that the name implies -- with economies either "coupled" or "decoupled" -- the reality is more a matter of degree, with the degree of decoupling reflecting the extent of interdependence.5
- 4Exports to the United States as a proportion of each country or region's overall exports decreased in 2007 compared with 2002: (1) from 28.5 percent to 20.1 percent in Japan; (2) from 27.8 percent to 21.1 percent in the euro area; and (3) from 21.5 percent to 19.1 percent in China.
- 5European Central Bank (ECB) President Jean-Claude Trichet gave a speech on February 25, 2008 titled "The growing importance of the Asia-Pacific region," in which he remarked the following: "We are in a universe of interdependence. If one economy slows down, it has an influence on all other economies. Since we are all interdependent, the key question is how, and to what extent, a possible slowing down in some mature economies might be partially offset by stronger growth in other regions, notably in emerging Asia."
III. Conduct of Monetary Policy
A. The Framework for the Conduct of Monetary Policy
Lastly, I would like to explain the Bank of Japan's conduct of monetary policy. The Bank assesses the economic and price situation from the "two perspectives" and then outlines its thinking on the future conduct of monetary policy, taking account of the "understanding of medium- to long-term price stability," that is, the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term.6
The first perspective relates to the outlook for economic activity and prices over the next two fiscal years that the Bank deems the most likely and assesses whether this is consistent with sustained growth under price stability.
The second perspective extends the time horizon and assesses the risks considered most relevant to the conduct of monetary policy, taking account of the cost incurred should risks materialize, even though the probability of such materialization may be low.
The Bank's basic thinking has been that (1) given the extremely accommodative financial conditions, the level of interest rates is to be raised if Japan's economy is to follow a path of sustainable growth under price stability; and (2) the pace of increase in interest rates should be determined in accordance with improvements in the economic and price situation without any predetermined view. Based on this thinking, in every Monetary Policy Meeting the Bank has carefully assessed, under the "two perspectives," the future paths of the economy and prices and the levels of uncertainty associated with its projections, as well as both upside and downside risks, and has made its policy decisions accordingly.
- 6The "understanding of medium- to long-term price stability" reviewed in April 2007, expressed in terms of the year-on-year rate of change in the CPI, takes the form of a range approximately between 0 and 2 percent, with most Policy Board members' median figures falling on one side or the other of 1 percent.
B. The Bank's Thinking about the Conduct of Monetary Policy
As I explained earlier in some detail, current developments in economic activity and prices in Japan can be summarized as follows: although the economy has been expanding moderately, the pace of growth is slowing somewhat due to negative factors such as the substantial rise in materials prices, the sharp drop in housing investment, and heightened uncertainty regarding global economic developments; meanwhile, the export-driven virtuous circle of growth in production, income, and spending has begun to flash a few warning lights, but there is no clear evidence to suggest that it will come to a complete stop. I therefore believe that the Bank's existing baseline scenario, namely, that Japan's economy is likely to continue to expand moderately, remains apposite, as does its basic thinking regarding the conduct of monetary policy.
The reasons for maintaining the baseline scenario can be outlined as follows -- there is a degree of overlap here with some of the points made earlier. First, the virtuous circle has been operating steadily, as exports, which are directly affected by developments in overseas economies, have continued to increase, and it is expected that production, though more or less flat in the short run, will increase thereafter. Second, firms as a whole have increased their capacity to absorb stresses and shocks, as they no longer face pressure to adjust their previous three excesses, namely, excess capacity, excess employees, and excess debt. And third, not only has the financial system been stable -- witness the relatively limited negative impact of the U.S. subprime mortgage problem and the consequent volatility in global financial markets on Japanese financial institutions compared with their U.S. and European counterparts -- but the extremely accommodative financial conditions are also continuing to successfully support private demand, as evidenced by the positive lending attitudes of financial institutions as a whole, credit market conditions that continue to be favorable, and short-term interest rates that remain low.
However, it is important to recognize various risks to the outlook for economic activity and prices and the underlying assumptions on which the outlook rests, including some major risks that I mentioned earlier. For this reason, the Bank will continue to pay close attention to economic indicators and other relevant information and will carefully assess the likelihoods of materialization of the Bank's projections and their associated risks, thereby making the policy decisions most appropriate for promoting sustainable economic growth under price stability.