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The Current Situation and the Outlook for Japan's Economy and the Conduct of Monetary Policy

Summary of a Speech Given by Miyako Suda, Member of the Policy Board, at a Meeting with Business Leaders in Miyazaki on March 27, 2008

June 6 ,2008
Bank of Japan

Contents

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I.  The Current Situation and the Outlook for Japan's Economy

A.  The Current Situation

Japan's economy has remained on a moderate but sustained path of expansion since early 2002 against the background of the expansion of overseas economies and the accommodative financial environment.  Despite the continuous decline in spending in the public sector, Japan's economy has succeeded in achieving solid growth with an average annual growth rate of around 2 percent for five years or so, supported by continued firmness in exports and a moderate but steady expansion of domestic private demand (Chart 1).  Recently, however, the pace of growth has been decelerating, mainly due to the coming into force of the revised Building Standard Law and the surge in materials prices.

Looking at recent economic developments in more detail, real exports have been on an upward trend, albeit with some fluctuations, rising by 5.2 percent in January 2008 compared with the average of the October-December quarter of 2007.  Continued weakness in exports to the United States has been offset by strong exports to Europe and emerging economies, particularly those of East Asia and the Middle East.  Regarding domestic demand, business fixed investment has also continued to trend upward, as corporate profits have remained high although they are leveling off.  Machinery orders, a leading indicator of machinery investment, have been more or less flat at high levels, albeit with some large fluctuations.  Private consumption has been firm in the favorable income environment: while sales at department stores and convenience stores have been more or less flat, sales of electrical appliances have been strong and sales in the food service industry and outlays for travel have remained firm.  Housing investment, after having dropped substantially due to the effects of the coming into force of the revised Building Standard Law, has remained at a low level, although signs of recovery have been observed recently (Chart 2).  Against the background of these developments in internal and external demand, industrial production continued to show high growth in the second half of 2007 but has been more or less flat since the beginning of the January-March quarter of 2008.  This seems to partly reflect a reaction to high levels of production of (1) electronic parts and devices in preparation for Christmas sales, following the completion of inventory adjustments, and (2) automobiles to make up for losses resulting from a strong earthquake in Niigata Prefecture in the summer of 2007.

As for developments in prices, the year-on-year rate of change in the consumer price index (CPI; excluding fresh food) has been rising since around the end of 2007 due to the increase in prices of petroleum products and food products.  Many firms previously absorbed higher materials prices by increasing productivity and restraining personnel costs such as bonus payments, but recently they have begun to pass on the rise to sales prices, mainly in the case of daily necessities, whose price elasticity is relatively low (Chart 3).

B.  Follow-Up to the Outlook for Japan's Economy

In the December 2007 issue of the Monthly Report of Recent Economic and Financial Developments (the Monthly Report), the Bank of Japan made a slight downward revision to its assessment of the state of Japan's economy, stating that "the pace of growth seems to be slowing mainly due to the drop in housing investment."  The Bank downgraded the assessment further in the March 2008 Monthly Report, using the expression "the pace of growth has been slowing."  During the period between these two releases, the Bank, at the interim assessment in January 2008, revised downward its economic projection presented in the October 2007 issue of the Outlook for Economic Activity and Prices (the Outlook Report), from "the rate of real GDP growth in fiscal 2007 and fiscal 2008 is likely to register around 2 percent on average, somewhat higher than the potential growth rate" to "the rate of real GDP growth in fiscal 2007 is likely to be slightly lower than the potential growth rate."  The Bank has made this series of downward revisions to its assessment in view of the following factors: the slower-than-expected recovery in housing investment; the increase in the number of firms, particularly small ones, that intend to absorb higher-than-expected rises in materials prices mainly by restraining wages; and the growing uncertainty about the outlook caused by turbulence in financial markets.

Developments in housing investment have generally been in line with my projection presented at the meeting in Mie in September 2007.  However, with regard to other downside risks that I highlighted at the time, such as greater financial market instability, decelerating U.S. economic growth, and a further surge in materials prices and a consequent deterioration in wages, corporate profits, and consumer and business sentiment, my impression is that they have materialized to an extent beyond my expectations.  I will now discuss these downside risks in more detail.

1.  The increased vulnerability of global financial markets

I will start off by examining economic and financial developments abroad, especially developments in U.S. financial markets -- the key factor in projecting the future course of Japan's economy -- with a brief overview of developments in securitization markets since summer 2007.  Against the background of a series of events such as reports of losses at hedge funds and downgrading of securitized products by major rating agencies, the so-called BNP Paribas shock on August 9, 2007 -- when three funds investing in asset-backed securities (ABSs) were suspended -- made it difficult for the market to reprice securitized products, such as those backed by subprime mortgage loans, and caused funding difficulties at financial institutions, leading to volatility in financial markets.  Financial markets started to gradually stabilize thereafter, supported by central banks' provision of ample liquidity and the Federal Reserve's policy rate cuts.  In fact, at the time of the meeting with business leaders in Mie held in September 2007, which I attended, there was positive news regarding the funding conditions of mortgage lenders and the financing of leveraged buyout (LBO) transactions, and also the fact that the decline in the amount outstanding of CP issued was coming to a halt.  Although developments in credit markets still required careful monitoring, in view of these developments as well as the strong risk appetite of investors, I had assumed that market functioning would eventually be restored once sufficient progress had been made on the repricing of securitized products such as those backed by subprime mortgage loans.

However, the subprime mortgage problem became more serious, causing deterioration in financial institutions' balance sheets and shortages in their capital bases, and this was beyond my expectation.  Recently, financial institutions and hedge funds have been reducing their asset holdings extensively, and this has impaired the functioning of markets to a considerable extent.

How the subprime mortgage problem started to negatively affect balance sheets and capital bases of financial institutions can be summarized as follows.  The performance of underlying assets of securitized products continued to deteriorate as adjustments in the housing market, especially the decline in housing prices, proceeded faster than expected and delinquency and foreclosure rates rose while inventory ratios remained high and housing prices showed no sign of bottoming out.  As a result, spreads on subprime residential mortgage-backed securities (RMBSs) continued to widen, impeding the recovery of the functioning of markets for securitized products.  Despite the series of policy rate cuts by the Fed, there were intermittent reports of the emergence of losses at, and the closure of, hedge funds and structured investment vehicles (SIVs), and at the same time financial institutions started to face a deterioration in their balance sheets and capital base shortages due to heavy losses on securitized products such as collateralized debt obligations (CDOs) and the expansion of liabilities attributable to the provision of liquidity support to SIVs.  A widening of spreads came to be observed not only on securitized products backed by mortgage loans but also on those backed by consumer loans such as credit card and car loans, prompting financial institutions to tighten their lending standards on a wider range of loans.  This tightening led to a further deterioration in the market's views regarding future loan performance.  These developments seem to have evolved into a vicious circle in which the tightening of financial institutions' lending standards and deterioration in the underlying assets of various securitized products due to a economic slowdown trigger further downgrading of, and price declines in, securitized products and subsequently result in a further expansion of losses at financial institutions.  Under these circumstances, financial institutions' mark-to-market losses expanded every time they were announced, making market participants more concerned about counterparty risk and more suspicious about future developments in financial markets.

Meanwhile, the business performance of monoline insurers, or monolines for short, which guarantee various securities, deteriorated, and consequently there were rapidly mounting concerns over the possible downgrading of such monolines.  These concerns worsened the supply-demand balance for securitized products overall since a downgrading of monolines would be accompanied by a downgrading of securitized products backed by, for example, CDOs that had been rated AAA thanks to the guarantees provided by the monolines.  A large number of multilayered resecuritized products such as CDOs backed partly by residential loans were originated during the housing boom, obtained the highest rating thanks to the monolines' guarantees, and were sold to a wider range of investors including those that preferred low risks.  This is one reason why the downgrading of the monolines spurred the decline in the prices of securitized products.

In response to this situation, active countermeasures were taken: the Fed and other central banks of major economies provided the market with additional liquidity and the U.S. government launched large-scale fiscal stimulus measures, including tax relief.  However, the situation in the U.S. credit markets has worsened further since late February 2008 with concurrent events including (1) the failure of a major fund to meet margin calls; (2) reports of losses at U.S. government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac; (3) reports of further losses at major insurance companies; (4) the downgrading of regional financial institutions; and (5) the decline in prices of municipal bonds.  On top of these events and the ongoing process of deleveraging, encashment of investments by hedge funds occurred in preparation for withdrawals (Chart 4).  These events not only impaired the functioning of U.S. and other countries' credit markets but also destabilized asset markets more generally, including stock, bond, foreign exchange, and commodity markets.

In this regard, let us look in detail at developments in the Japanese bond market since the beginning of 2008.  Amid the rapid decline in the Nikkei 225 Stock Average, the demand-supply balance for Japanese government bonds (JGBs) remained generally favorable as market participants became more cautious regarding future developments in Japan's economy and investors, including financial institutions, reallocated funds from high-risk to low-risk assets before closing the books at the fiscal year-end.  Concurrently, the yield curve has been distorted since late February in a way that is difficult to explain from a theoretical perspective (Chart 4).  It has been dented in the medium-term horizon and has been showing an irregular shape, although the distortion has been somewhat corrected since late March.  Moreover, swap spreads in the super-long-term horizon temporarily sank deeply into negative territory (Chart 4).  As a background to these developments, it has been pointed out that hedge funds have rapidly unwound positions in the yen interest rate swap market.

The disruptions in global financial markets might not come to an end until market participants are to some extent satisfied with the reevaluated prices of risk assets and there is a deceleration in the pace of expansion in the amount of impaired assets -- or in other words, until the correction in the U.S. housing market, the cause of the disruptions, has started to show signs of bottoming out.  Therefore, developments in global financial markets should continue to be monitored carefully.

As I have explained, in a situation where the correction in the U.S. housing market has intensified further, the subprime mortgage problem has caused deterioration in balance sheets and capital base shortages at financial institutions, resulting in a considerable deterioration in business and consumer sentiment through the tightening of lending standards by financial institutions, the growing instability in and uncertainty of financial markets, and the rise in gasoline prices.  Recently, there have been some signs of deterioration in employment and consumption, leading market participants to revise downward their assessment of the outlook for U.S. economic growth day by day.

In the October 2007 Outlook Report, the Bank expressed the following view with regard to the U.S. economy: "If 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 negative wealth effects, the credit tightening, and deterioration in business and consumer sentiment, and this may lead to further deceleration in growth of the U.S. economy."  Looking at the current situation, it could be said that many of these downside risks have materialized.

Given the current conditions in financial markets and the U.S. economy, it seems fair to say that recent economic growth has deviated below my projection as of September 2007, which then was more cautious than the average projection of market participants.

2.  The growing presence of emerging economies in the global economy

The recent slowdown in the U.S. economy is likely to adversely affect Japanese exports to some extent.  However, I do not think Japan will experience a significant decline in real exports, as the recent strength in exports to emerging economies can be counted on to continue offsetting the weakness in exports to the United States.  This assessment is based on the following underlying view regarding the structural changes in the global economy.

Global economic growth conceptually is growth in globally consolidated domestic demand, because from a global point of view the current account balances of economies cancel each other out.  Taking a look at the nature of domestic demand in each area, for example, in the Middle East, the recent construction boom is unlikely to be a temporary phenomenon brought about by the surge in crude oil prices, but rather seems to be based on medium- to long-term national strategic plans1 aiming to break away from the oil-based "monoculture."  The same kind of economic growth has been observed in Asian emerging economies, including China.  As long as strong growth continues in emerging economies led by domestic demand driven, for example, by investment in infrastructure, the global economy as a whole is likely to remain on a gradual uptrend even if a further slowdown in the U.S. economy curtails other countries' exports to the United States and/or increases financial market turbulence to an extent that it eventually adversely affects domestic demand in other countries.  To expand on this point, it appears very likely that the global economic structure is in a rebalancing process in which emerging economies are gaining a greater presence in the global economy (Chart 5).  This explains why Japanese exports have remained on an increasing trend as a whole despite the slowdown in the U.S. economy.  With such structural change in progress, demand has increased for primary commodities such as raw materials and foods, leading to a rise in their prices.  A rise in primary commodity prices, which causes an income transfer from importers to exporters, leads to a further increase in domestic demand in exporting countries, promoting structural change in the global economy.  The experience of the Japanese automobile industry suggests that the better an industry is able to adapt to structural change in the global economy, the smaller is the negative impact on its performance, because a decline in exports to the United States is offset by an increase in exports to emerging economies.  However, even though it is smaller than in the past, the share of the United States in the global economy is still significant (Chart 5).  In addition, it is difficult for Japan's economy to swiftly change its export structure, in which the United States is a major destination, in order to adjust to the global structural change.  Therefore, it seems inevitable that the slowdown in the U.S. economy will affect Japan's exports, but it is an open question how large the effect will be.

  1.  1  For example, the "Dubai Strategic Plan 2015" sets out specific goals for 2015, such as increasing real per capita GDP to 44,000 U.S. dollars in 2015 from 31,100 U.S. dollars in 2005; strengthening financial services, tourism, and education; and improving labor regulations and roads and transportation networks.

3.  The rise in primary commodity prices and its effects on small firms

The rise in primary commodity prices has been affecting small firms' profits and their sentiment.  Small firms' sentiment has been deteriorating markedly since the second half of 2007 due to their difficulty in passing on to sales the rise in materials prices, such as oil and food prices, in addition to the effects of the coming into force of the revised Building Standard Law.  The growing downward pressure on small firms' profits and the rapid deterioration in their sentiment are likely to have further restrained wages and contributed to a deceleration of growth in their fixed investment.  In fact, the Monthly Labour Survey suggests that while special payments including bonuses at establishments with 500 or more employees in the November 2007-January 2008 period rose by 1.1 percent year on year, those at establishments with 100 to 499 employees and with 30 to 99 employees declined by 7.9 percent and 4.3 percent, respectively.  The Financial Statements Statistics of Corporations by Industry, Quarterly showed a decline in fixed investment, particularly by small firms with relatively little capital.  These developments are likely to have caused the weakening of the virtuous circle of growth in production, income, and spending during the second half of 2007.

However, I still see the virtuous circle remaining intact.  The long-term trends in primary commodity prices must be in line with the economic fundamentals in emerging economies.  The current surge in primary commodity prices, as seen in the rise in crude oil prices above 100 U.S. dollars per barrel, is unlikely to last long, as the prices are partly pushed up by the speculative inflow of funds.  I expect that there will be some adjustment in primary commodity prices, and if this occurs, it will help the virtuous circle of growth in production, income, and spending to remain in place.

C.  The Outlook for Japan's Economy and Risk Factors

Based on the aforementioned thinking on economic and financial developments, I would now like to share my view on the outlook for Japan's economy.  At the interim assessment made in January 2008, the Bank revised downward the forecast for economic growth presented in the October 2007 Outlook Report, stating that the rate of real GDP growth in fiscal 2007 was likely to be slightly lower than the potential growth rate.  However, based on economic indicators released after the interim assessment, it now seems unlikely that the rate of real GDP growth in fiscal 2007 will turn out to be below the potential growth rate.  For fiscal 2008, it is my view at present that the rate of real GDP growth is likely to decline to around the potential growth rate.  This view is based on the fact that the greater-than-expected slowdown in U.S. economic growth will inevitably affect Japanese exports as a whole; in addition, there are the effects of the coming into force of the revised Building Standard Law and signs of a deceleration in growth in private consumption, while production has been more or less flat.

Let me elaborate on my view of future developments in Japan's economy by looking at individual demand components.  Starting with exports, developments in the U.S. economy are key and, as I said earlier, the recent slowdown in the U.S. economy has been faster than expected and there have been growing uncertainties regarding the outlook for the U.S. economy due to the correction in the housing market and the malfunctioning of financial markets.  Therefore, it is reasonable to expect that the rate of U.S. real GDP growth in fiscal 2008, which in September 2007 I expected to be at around 2.0 percent, will fall to a level of around 1.5 percent.  However, taking into account the fact that emerging economies have not shown any significant changes in their growth trends and that they are likely to continue to be a driving force of the global economy, the uptrend in Japanese exports is expected to continue as a whole, although the pace of growth is likely to slow.

Moving on to private consumption, as the negative effects of the retirement of baby boomers and the reduction in the salaries of local government employees seem to have almost dissipated, regular payments have finally become higher than a year earlier and are likely to become one of the few supporting factors for private consumption.  Nevertheless, private consumption is unlikely to exhibit strong growth for the time being, since consumer sentiment has deteriorated due to the surge in prices of fuel oil and food products and to the financial market instability.  Let me note, however, that from a long-term perspective private consumption is likely to remain on a moderate increase in line with the developments in income conditions, for the following reasons.  First, as I mentioned earlier, I do not think prices of primary commodities such as crude oil and crops will diverge from economic fundamentals and continue to rise.  And second, an increasing number of firms are making it possible for their part-time employees to become full-time employees in order to comply with the revision of the so-called Part-Time Work Law and other laws and regulations and to let workers share their specialized skills with other employees.  Housing investment, which was previously declining, has finally started to show signs of recovery, and the pace of decline in housing investment is expected to moderate.  However, it may take some more time for housing investment to show a clear recovery given the sluggishness of sales of condominiums and the withdrawal of foreign funds from real estate funds.  As for business fixed investment, although recent developments in foreign exchange rates and stock prices are unlikely to continue to affect corporate profits significantly, business sentiment, just like consumer sentiment, might be negatively affected by the financial market instability, and this might cause fixed investment by firms, particularly small ones, to become sluggish.  Meanwhile, production, which has been more or less flat lately, is expected to increase again as inventories have been more or less in balance with shipments and domestic and external demand is likely to continue to be on a moderate uptrend.

Next, let me touch on the risk factors regarding the outlook for Japan's economy.  The Bank's projection is made for the purpose of conducting monetary policy, which is based on the understanding that it takes some time, perhaps six months or a year, before the effects of monetary policy appear.  If the Bank's economic projection appears optimistic, this may be because the Bank is not swayed too much by short-term developments and takes a forward-looking stance based on its projections of economic and price trends.  Needless to say, the Bank also monitors short-term developments when projecting the economy and prices.  By using all the data available at the time of projection and taking into account opinions of business leaders, the Bank carefully examines both upside and downside risks and makes every effort to accurately project the future path of Japan's economy.  Now, I will move on to the examination of risk factors based on such careful assessment of economic and price trends.

1.  Risks with regard to overseas economic and financial developments

As I explained earlier, U.S. financial markets continue to be unstable.  In this situation, uncertainty regarding the U.S. economy has increased and growth projections including those by market participants and the Fed show quite a wide dispersion.  My current projection of the economic growth rate for 2008 is similar to the average projection made by market participants, for the following reasons: U.S. exports are likely to remain on their expansionary trend, supported by the continuing global economic growth and the depreciation of the U.S. dollar; and the positive effects of the series of policy rate cuts by the Fed and the launch of large-scale fiscal stimulus measures, including tax relief, are likely to gradually materialize in the second half of 2008.  However, although many economic indicators have come in below market expectations, due to the financial market turbulence, some of the pessimism may be overdone and it also seems quite possible that there will be positive surprises.

If the U.S. economy were to weaken more than expected, there would be a significant impact on Japanese exports, including indirect exports that are shipped out to the United States via other areas such as Asia.  Moreover, the fallout of financial market instability and the decline in the prices of securitized products naturally are not confined to the United States.  In Japan, the Nikkei 225 Stock Average fell below 12,000 yen for the first time in two years and seven months on March 17, 2008, while the yen appreciated rapidly, temporarily being traded in the range of 95-96 yen to the dollar for the first time in twelve years and seven months.  In terms of the real effective exchange rate, this appreciation can be interpreted as merely a reversal of the depreciation of the yen since 2000, bringing it back to the level of 2006.  However, given the rapidity of the appreciation, it is likely that there has been a substantial psychological effect.  In particular, there are concerns that it may affect the profits and fixed investment plans of small firms, both of which have recently been somewhat weak, and therefore this is something I will keep an eye on when the upcoming April Tankan (Short-Term Economic Survey of Enterprises in Japan) is published.

Japan's exports are also affected by prices of primary commodities.  Although the most likely scenario is that prices of primary commodities will develop in line with economic fundamentals, upward and downward risks in this regard also remain.  That is, if monetary policy were to be eased further in response to the slowdown in the U.S. economy, market participants might become more speculative with respect to a further depreciation of the dollar and higher natural resources prices, and this might push primary commodity prices far above levels consistent with economic fundamentals.  In this case, as there is a limit to the extent to which domestic demand can expand in primary commodity exporting countries, growth in globally consolidated domestic demand might slow further, leading to a deceleration in global economic growth.  As a consequence, it would be difficult to count on the strength in exports to emerging economies to offset the weakness in exports to the United States.  Meanwhile, if market participants' risk averseness were to increase further, adjustments of price excesses in primary commodities might occur due to a rapid outflow of risk capital that previously flowed into primary commodity markets, and this could cause commodity prices to drop below what economic fundamentals would warrant.  This could result in a substantial decline in domestic demand in primary commodity exporting countries, which could cause a decline in Japanese exports to emerging economies.  However, as the current expansion of domestic demand in emerging economies seems to be attributable to global structural changes, the long-term trends in primary commodity prices are likely to be in line with economic fundamentals and Japanese exports to emerging economies are likely to remain on an increasing trend.

2.  Inflation risks

In the United States, against the background that there remain inflationary pressures from the decline in the potential growth rate and continuing high wage growth, the Fed took various measures to provide liquidity, for example, by introducing the Term Auction Facility (TAF), and in addition lowered its target for the federal funds rate six times.  This series of policy actions aimed to prevent the materialization of systemic risks resulting from possible further losses and the deterioration in balance sheets at financial institutions, and to minimize the negative effects on the economy from financial market instability and a further tightening of lending standards with regard to providing loans.

At the same time, however, it seems that this series of monetary easing measures by the Fed has led to a monetary easing in countries with U.S. dollar-pegged currencies such as oil-producing economies and, eventually, to a global monetary easing.  This has given rise to the dilemma that, despite the slowdown in the U.S. economy, the upward trend in commodity prices has accelerated through the inflow of a large amount of funds into commodities and the decline in the dollar.  In addition, the core personal consumption expenditure (PCE) deflator and the core CPI -- the headline CPI excluding energy and food -- in the United States continue to rise at a pace slightly faster than the Fed's desired pace.  The Fed, when lowering its target for the federal funds rate, stated that it expected inflation to moderate soon, reflecting the economic slowdown, but it also clearly stated in the recently released Beige Book that downside risks to the economy and upward pressure on prices had both been increasing.  Recently, overall commodity prices have peaked out partly due to the profit-taking by hedge funds, and the break-even inflation rate has indicated a decline in inflation expectations.  However, it seems that the break-even inflation rate has been affected by changes in risk premiums.  Considering this and recently released results of the Reuters/University of Michigan Survey of Consumers, inflation expectations rather seem to be rising.  Thus, there is no doubt that currently prices are prone to rising higher than expected given that the global financial environment remains accommodative.

To a certain degree, there is also a risk of inflation in Japan.  Up to today, the year-on-year rate of change in the so-called core-core CPI, which excludes food and energy prices, has remained at around 0 percent, but if the rise in energy and food prices continues longer than expected, people's inflation expectations may gradually move upward and the core-core CPI may gradually rise further following the increase in the headline CPI.  Therefore, the risk of inflation should continue to be watched closely.

D.  The Bank's Monetary Policy for the Immediate Future

At the most recent Monetary Policy Meeting (MPM) of the Bank's Policy Board in March, members shared the view that Japan's economy was expected to continue expanding moderately, although the pace of growth was likely to slow for the time being.  This means that the Bank's thinking on monetary policy has remained unchanged.  It is natural to take into account the possibility of the Bank raising the policy rate, as the current financial environment as a whole is extremely accommodative although some developments remain a cause for concern, such as the financing of very small firms and firms with low credit ratings.  However, it is necessary to thoroughly examine both upside and downside risks without any preconceived ideas, since at this point I think it is highly possible that the rate of real GDP growth in fiscal 2008 may turn out to be weaker than expected and it is difficult to make accurate economic projections in the current situation of heightened instability in financial markets.  The Bank, while continuing to cooperate with other central banks, will do its utmost in examining and analyzing developments in markets and the economy and will make policy decisions appropriately while confirming that the Japanese economy remains likely to follow a path of sustainable growth under price stability in light of the "understanding of medium- to long-term price stability" (the "understanding").  In a situation where uncertainty regarding the economy is high, it is appropriate to take measures gradually in accordance with a careful examination of the economic situation.  At the same time, I will continuously consider whether the Bank should take flexible and timely policy action.2

  1.  2  My stance with regard to monetary policy is similar to that described in the paper by Kunio Okina, Takeshi Kimura, and Naoko Hara, "Defure he no Hoken wo Koryo shita Kin'yu Seisaku no Wakugumi (A Monetary Policy Framework That Insures against Deflation)," Bank of Japan Working Paper Series, 2008-J-6, Bank of Japan, 2008 (available only in Japanese).  This paper argues that, under circumstances of extreme uncertainty, a central bank should make clear its policy stance and work to gain credibility with market participants; that once the risk of deflation materializes to a certain extent, it will deviate from its normal policy rules and drastically lower interest rates (and will move back to its normal policy rules immediately when the risk of deflation abates); and that, moreover, it will not drastically lower the interest rate to a level impossible to realize on a real-time basis and will not commit to maintaining a low interest rate environment or setting a relatively high target inflation rate not credible with the markets.

II.  The Surge in Crude Oil Prices and Monetary Policy

A careful examination of how the surge in primary commodity prices affects the economy and prices is now indispensable to forecast economic developments.  As I explained earlier, if primary commodity prices rise excessively, this will on the one hand have negative effects on the global economy and, on the other, exert upward pressure on inflation.  In fact, in most economies and regions, projections for growth in 2008 have been revised downward, while those for inflation have been revised upward, including the revision of projections for growth and prices for the United States at the January Federal Open Market Committee (FOMC) meeting.  A central bank conducts monetary policy generally by taking into account both inflation and economic growth, but when these are moving in opposite directions away from the central bank's policy goal, the conduct of monetary policy becomes extremely complicated.  I will now discuss how monetary policy should be conducted in such a situation.

A.  Should the Bank Respond to the Headline or the Core CPI?

The Bank conducts monetary policy with the aim of realizing sustainable growth through the pursuit of price stability.  Therefore, when primary commodity prices are changing greatly, the issue arises as to which price index the Bank should focus on in assessing price trends.  Currently, the Ministry of Internal Affairs and Communications releases three types of CPI measures: the headline CPI, the core CPI -- the headline CPI excluding fresh food -- and the so-called core-core CPI -- the headline CPI excluding food and energy.  Reflecting the recent rise in energy and food prices, developments in these three measures have significantly differed from one another.  For example, comparing their respective year-on-year rates of change for January 2008, while the headline CPI increased by 0.7 percent and the core CPI increased by 0.8 percent, the core-core CPI remained essentially unchanged, with a marginal decline of 0.1 percent.

The headline CPI, which covers all goods and services consumed by households, should be the basic indicator for evaluating the level of inflation perceived by the public.  Based on this thinking, in March 2006, when the Bank introduced the "understanding," it announced that it would refer to the headline CPI as its principal indicator in assessing price trends.  Many central banks adopting an inflation target also focus on headline measures of inflation.  However, when it comes to deciding on monetary policy, it seems more appropriate to focus on the core CPI rather than the headline CPI, as highly volatile components such as fresh food tend to fluctuate widely reflecting weather conditions.  The reason why the Bank referred to the year-on-year rate of change in the core CPI when deciding the termination of the quantitative easing policy was that focusing on headline CPI would have required the Bank to respond strongly to any temporary fluctuations.  In this context, in a simulation study Governor Frederic Mishkin of the Fed examined which measure -- headline or core inflation -- monetary policy should respond to in order to keep down the unemployment rate in case of a shock to oil prices, and concluded that it should focus on stabilizing core inflation.3

In Japan, the spread between core and headline CPI inflation has not been biased toward both directions, and from a relatively long-term perspective it seems that the core CPI has not diverged substantially from the headline CPI.  On the other hand, however, the core-core CPI has at times diverged substantially from the headline CPI (Chart 6).  This becomes an issue when the divergence between the core CPI and the headline CPI is persistent.  In fact, quite a persistent divergence lasting a few years can be observed between the core-core CPI and the headline CPI in Japan and the core CPI and the headline CPI in the United States (Chart 7).  In a situation such as the present one, where the prices of daily necessities such as gasoline and food are rising persistently, adoption of policies that focus on the core CPI makes it more likely that the central bank will face criticisms that it is adopting an inappropriate monetary policy.  The Fed's decision to release FOMC participants' projections not only of core CPI inflation but also of headline CPI inflation appears to be a response to this kind of criticism.4

Assuming that consumption demand for energy and food from emerging economies will remain strong, I think primary commodity prices will keep rising as a trend.  Therefore, monitoring inflation measures that exclude energy and food in following price trends might lead to an underestimation of inflation.  At the same time, however, the risk of considerable adjustments in commodity prices in the short run is not negligible given that the speculative inflow of funds into the primary commodity market is likely to be only a temporary phenomenon.  In the end, the best course for the Bank is to conduct monetary policy based on a comprehensive assessment of the underlying trend of inflation through the unbiased monitoring of both inflation measures that include and exclude energy and food prices.

  1.  3  For details, refer to the speech by Frederic S. Mishkin, "Does Stabilizing Inflation Contribute to Stabilizing Economic Activity?" at East Carolina University's Beta Gamma Sigma Distinguished Lecture Series in Greenville, North Carolina on February 25, 2008.  See also Rajeev Dhawan and Karsten Jeske, "Taylor Rules with Headline Inflation: A Bad Idea," Working Paper Series, 2007-14, Federal Reserve Bank of Atlanta, 2007.
  2.  4  For details, refer to the speech by Frederic S. Mishkin, "Headline versus Core Inflation in the Conduct of Monetary Policy" at the Business Cycles, International Transmission and Macroeconomic Policies Conference in Montreal on October 20, 2007.  See also "Comments on Stylized Facts of Globalization and World Inflation," remarks made by Richard W. Fisher at the International Symposium of the Banque de France on Globalisation, Inflation and Monetary Policy in Paris on March 7, 2008.

1.  The difficulty of making projections for economic growth and inflation

Projections for economic growth and inflation depend greatly on the assumptions regarding developments in crude oil prices.  While the assumptions should be highly probable ones, in practice it is difficult to accurately predict developments in crude oil prices even for a relatively short period of one to two years ahead because of the many special factors involved, such as speculative inflows of funds, geopolitical risks, and weather conditions.  In the United States, several FOMC members, including Chairman Ben S. Bernanke in his Congressional testimony, pointing to the role of energy prices, have suggested that inflation would moderate along with a slowdown in economic growth.  As Vice Chairman Donald Kohn noted, this projection appears to be based on the assumption that energy and other commodity prices will level off, as suggested by the futures markets.5  However, recently the rate of inflation has diverged from projections and members of the FOMC have increasingly referred to the upside risks to inflation.6  Moreover, as President Richard Fisher of the Federal Reserve Bank of Dallas noted, the persistent increase in commodity prices has made it difficult to accurately forecast the inflation rate.7

  1.  5  See Vice Chairman Donald L. Kohn, "The U.S. Economy and Monetary Policy," speech at the University of North Carolina at Wilmington, North Carolina on February 26, 2008.
  2.  6  See President and CEO Janet L. Yellen of the Federal Reserve Bank of San Francisco, "Prospects for the Economy in 2008," speech to the Chartered Financial Analysts of Hawaii on February 7, 2008; and Vice Chairman Donald L. Kohn, "Implications of Globalization for the Conduct of Monetary Policy," speech at the International Symposium of the Banque de France in Paris on March 7, 2008.
  3.  7  See Footnote 4 for more information about his speech.

B.  The Inflation-Perception Gap of the Public

Another issue I would like to point out is the gap between the public's perception of the rate of inflation and the underlying inflation rate analyzed by policymakers.  The public's perception of inflation tends to be strongly influenced by changes in the prices of daily necessities rather than overall consumer prices.  Prices of frequently purchased products, such as energy and food products, have indeed been rising considerably, and as a result the public is worried about inflation, as evidenced by the results of surveys conducted by the Bank and by the Cabinet Office (Chart 3).

In relation to daily life, housing costs also greatly affect the public's perception of inflation.  In the United Kingdom, because the CPI does not fully reflect housing costs, the public does not seem convinced that inflation is well anchored, even though the CPI, the indicator targeted by monetary policy, is within the target range.  Governor Mervyn King of the Bank of England (BOE), at the February Inflation Report press conference, expressed his sympathy with the view that one of the reasons why the public seemed to be more worried about inflation was the expanding gap between developments in the CPI -- the target for the BOE's monetary policy -- and other indicators that better reflect increases in the cost of living and were thus regarded as more relevant to the public's living standards, such as the retail price index (RPI) or the retail price index excluding mortgage interest payments (RPIX).  In fact, although CPI inflation virtually has fallen within the target range, the public recently has been less satisfied than before with the BOE's performance in containing inflation because the overall RPIX is still high (Chart 8).  Similarly, in the Middle East, in view of the surge in rents, the public seems to regard inflation as considerably higher than the rate statistics show.  A surge in the prices of daily necessities that raises public perceptions of inflation above general price inflation inevitably worsens consumer sentiment.

So what should be done to narrow the gap between the rate of inflation perceived by the public and the rate statistics show?  In Japan, the rate of inflation expected by the public has been higher than the actual rate of inflation since 2006.  An analysis by the Bank's staff shows that the greater the number of households that are interested in, and have trust in, the Bank, the lower the expected inflation rate is.8 In other words, to stabilize the rate of inflation expected by households at a low level, the Bank should win greater interest and trust from households as regards its monetary policy.  To this end, the Bank's communication with the public plays a key role, and we should continue to clearly explain our thinking behind the conduct of monetary policy.

  1.  8  For details, see Koichiro Kamada, "Kakei no Bukkamito'oshi no Kahokochokusei: Seikatsu Ishiki ni kansuru Anketochosa wo Mochiita Bunseki (Downward Rigidity of Households' Price Forecasts: Analysis of the Results of the Opinion Survey on the General Public's Views and Behavior)," Bank of Japan Working Paper Series, 2008-J-8, Bank of Japan, 2008 (available only in Japanese).

C.  Response to High Crude Oil Prices

Let us look at policy actions that central banks could take in response to a rise in crude oil prices.  High crude oil prices are likely to cause a trade-off between higher inflation and lower economic growth.  Policymakers are faced with a difficult choice as to which of the two -- higher inflation or lower economic growth -- they should focus on in their response, because the type of policy action necessary to deal with the two differs.  Central banks that define a target or reference inflation rate, such as the BOE and the European Central Bank (ECB), are most likely to take policy action aimed at lowering the inflation rate.  In fact, BOE Deputy Governor Rachel Lomax expressed the view in her speech that if higher inflation expectations persist, the BOE would need to allow some slack in the economy in order to bring inflation back down to the target range.9

The extent of this trade-off depends on the following factors: whether the rises in crude oil prices are driven either by strong global demand or by supply shocks; how much of the outflow of income due to high crude oil prices flows back into the country; and how long crude oil prices remain high.  Therefore, before deciding what action to take, policymakers should carefully examine the various factors underlying the rise in crude oil prices.10

Such an examination is not easy, however, and the expected inflation rate may be the key to deciding what policy action to take.  Let us consider the case where the expected inflation rate does not rise despite higher materials prices: firms are unable to pass higher costs on to sales prices, and thus general prices do not rise noticeably.  In this case, the negative effect on economic growth from the deterioration in the terms of trade would be large, calling for an accommodative monetary policy.  In Japan, the prevalent view is that higher prices of primary commodities such as crude oil and food will negatively affect corporate profits and private consumption, and this view seems to assume implicitly that inflation expectations will be restrained.  Recently, however, households' inflation expectations have been rising due to the ongoing surge in resource prices and the rises in the prices of daily necessities.  Under these circumstances, increasing costs may be passed on further to sales prices and this may eventually lead to a rise in general prices with higher nominal wages.  In this case, and also when materials prices are expected to continue rising, a tighter monetary policy is called for.

Inflation rates have recently exceeded their target levels in quite a few countries, but if central banks were to neglect this given that economies are slowing and downside risks are growing, they would stand in danger of losing their credibility.  Yet, tightening monetary policy to lower the inflation rate to the target level amid a slowing of the economy is quite a challenge for a central bank, even when it does not have a specific target for economic growth to achieve.

  1.  9  See Deputy Governor Rachel Lomax, "The State of the Economy," speech to the Institute of Economic Affairs 25th Anniversary Conference on February 26, 2008.
  2. 10 For details, see Sylvain Leduc and Keith Sill, "A Quantitative Analysis of Oil-Price Shocks, Systematic Monetary Policy, and Economic Downturns," Journal of Monetary Economics, 51 (4), 2004, pp. 781-808.

D.  Stable Inflation Expectations and Central Bank Credibility

The view has recently been expressed by FOMC members that stable inflation expectations are essential to the conduct of monetary policy.11  In its press release on March 18, 2008, the FOMC remarked, "Inflation has been elevated, and some indicators of inflation expectations have risen" and "Still, uncertainty about the inflation outlook has increased."  If a vicious circle starts to operate in which higher inflation expectations lead to higher wage increases and this eventually leads to even higher inflation expectations, quite a strong tightening of monetary policy would become necessary to compensate.  Chairman Bernanke bore this in mind when he said in his speech on January 10, 2008 that "any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability."12  Looking at Japan's own experience, the inflation rate did not rise as high, and economic growth did not fall as much, during the second oil crisis as during the first one, and one hypothesis put forward to explain this is that the Bank's policy conduct based on the determination not to repeat the mistakes made during the first oil crisis gained it the reputation of an inflation fighter and contributed to a stabilization of people's inflation expectations.13

One critical precondition for the easing of monetary policy to be effective is that inflation expectations are anchored.  Otherwise, lowering the policy interest rate in a situation where inflation expectations are high may lead to higher, rather than lower, long-term interest rates, thereby depriving monetary policy of one of its key transmission channels for stimulating the economy.14  If a monetary easing increases inflation expectations substantially, the outcome may be sustained inflation and a deeper recession.  To avoid this result, central banks should always pay due attention to inflationary risks and strive to keep the public's inflation expectations stable in order to gain and maintain credibility.15  From a long-term perspective, this also applies to Japan, although the current inflation rate is not as high as in other countries.

  1. 11 For details, see the Minutes of the FOMC meetings on December 11, 2007 and on January 29-30, 2008, and also Chairman Bernanke's Congressional testimony on February 27, 2008.
  2. 12 See Chairman Ben S. Bernanke, "Financial Markets, the Economic Outlook, and Monetary Policy," speech at the Women in Housing and Finance and Exchequer Club Joint Luncheon in Washington, D.C. on January 10, 2008.
  3. 13 For details, see Kumiharu Shigehara, ed. Price Stabilization in the 1990s: Domestic and International Policy Requirements, Macmillan Press, 1993.
  4. 14 See Footnote 4 for details of the speech by Governor Frederic S. Mishkin.
  5. 15 For details, see Allan H. Meltzer, "That '70s Show," The Wall Street Journal, February 28, 2008.

III.  Closing Remarks

Teiichiro Morinaga, the 23rd Governor of the Bank and a leading figure in making the Bank more open to the public, was born in the city of Kobayashi in Miyazaki Prefecture.  Morinaga, who served as Governor at the beginning of the second oil crisis, made many well-known statements -- including "The door to the Governor's office is always open" -- all of which are useful in the conduct of monetary policy today.  The following, for instance, are his words from a press conference in April 1979, a year after the Iranian Revolution: "The current state of Japan's economy is not exactly characterized by inflation, but we must nevertheless work together to avoid such an economic situation so as not to increase people's inflation expectations" and "While either-or arguments limit solutions to 'economic growth' or 'price stability,' I believe the two ultimately are two sides of the same coin from the perspective that price stability leads to maintaining sustainable growth in the long run."

This stance continues to be held by the Bank today.  Our mission is to encourage sustainable economic growth under price stability, and only by accomplishing that do we as the central bank of Japan deserve the trust of the public.