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Outlook and Risk Assessment of the Economy and Prices

(October 2001) *

  • As determined by the Policy Board at the Monetary Policy Meeting held on October 29, 2001.

October 29, 2001
Bank of Japan

Outlook for economic and price developments

  1. In assessing the outlook for economic and price developments in Japan for fiscal year of 2001 and 2002, it should be noted that greater uncertainty than usual exists. Such uncertainty includes the effects stemming from the terrorist attacks in the United States and subsequent developments on the global economy, the content and pace of forthcoming structural reform, and the fiscal reform.

    With this in mind, when we look at the outlook for the second half of fiscal 2001, it seems inevitable that Japan's economy will continue to experience severe adjustment as the effects of a sharp fall in exports and the associated significant decline in production will spread to domestic demand.

    In our standard scenario for fiscal 2002 which assumes the recovery of overseas economies in the first half, especially the United States, it is expected that exports will recover and, in turn, Japan's economy will stop deteriorating towards the second half. Even in this case, however, more time will be needed to see a clear recovery as overseas economies will recover only modestly and pressure from structural adjustment on various fronts will persist in Japan.

    Reflecting the above developments in the economy, prices will probably continue to decline gradually in fiscal 2001 and 2002 as demand-side factors are likely to exert more downward pressure together with continuing cost-cutting efforts on the supply side.

  2. The outlook for respective demand components is as follows.

    Currently available information indicates that public investment will probably decline further in fiscal 2002 following a fall in fiscal 2001. Exports are likely to drop significantly in fiscal 2001 against the background of prolonged adjustment in overseas economies, especially in the United States and East Asia. In fiscal 2002, exports could eventually resume growth if a gradual recovery is seen in overseas economies.

    In these circumstances, production is likely to remain on a declining trend towards the first half of fiscal 2002 as pressure for inventory adjustment will remain. Corporate profits will continue to deteriorate and capital spending is likely to continue declining, especially in IT-related areas. Against the background of adjustment in the corporate sector, it is expected that the employment and income environment of households will deteriorate and, consequently, private consumption will weaken gradually. Therefore, even if an export recovery brings a halt to the deterioration of the economy towards the second half of fiscal 2002, more time will be needed before seeing a recovery of domestic demand.

  3. Regarding financial developments, under the powerful monetary policy measures adopted by the Bank of Japan, extremely easy monetary conditions are likely to continue in financial markets. However, it is difficult to expect such monetary easing to lead to an increase in credit demand against the background of stagnant aggregate demand as described above as well as continuous efforts in the corporate sector to reduce excess debt. Financial institutions, in order to improve their financial condition, are expected to continue efforts to reprice lending rates so as to more accurately reflect the risks and returns associated with each borrower.

    In this situation, commercial bank lending is likely to remain weak. On the other hand, against the background of substantial demand for liquidity under the low interest rate environment as well as increased investments in Japanese government securities by financial institutions, the growth of money stock is expected to remain relatively high compared to the level of economic activity.

  4. Given the above demand prospects and despite a decline in the short-term growth rate of supply capacity of Japan's economy to some one percent-plus on a year-on-year basis, the output gap will probably widen towards fiscal 2002. Consequently, downward pressure on prices arising from weak demand is likely to continue. On the other hand, downward pressure will also continue from the supply side: namely, the import of low-priced goods, deregulation, and further rationalization of distribution systems.

    Reflecting the above factors, various price indexes are expected to continue to gradually decline. The year-on-year rate of change in both the domestic Wholesale Price Index and the Consumer Price Index (excluding perishables) will probably continue to be negative in fiscal 2001 and 2002.

    With such developments in the economy and prices, nominal income growth will probably continue to register a negative rate.

Risk assessment

  1. In the conduct of monetary policy, the above standard scenario is considered to be the most likely development with respect to the economy and prices. However, in assessing the standard scenario, both the upside and downside risk factors described below should be borne in mind more than ever given the significant uncertainty regarding the economy both at home and overseas.

    The first risk factor stems from developments in overseas economies, especially the United States, and also in IT-related areas.

    In the above standard scenario, the underlying assumptions are that overseas economies will pick up in the first half of fiscal 2002 and that the pace of recovery will be significantly modest. However, there is a risk that adjustment in overseas economies may become more widespread and deeper. This could happen if adjustment in IT-related areas is prolonged or if the impact of the terrorist attacks continues to affect business and consumer sentiment, production, and corporate and household expenditures. In this case, Japan's exports and production are likely to decline further. It should also be noted that such a delay in the recovery of Japan's economy could cause a delay in the global recovery.

    On the other hand, there is a possibility that, as a result of expansionary monetary and fiscal policy among others, the US economy, and, subsequently, overseas economies, will pick up relatively soon. If this scenario materializes, exports and production in Japan will strengthen in fiscal 2002 and thereafter.

  2. The second risk factor relates to financial market developments.

    In financial markets all over the world, stock price adjustment was being witnessed before the terrorist attacks in the United States impacted markets. Markets subsequently saw further falls in stock prices, widening credit spreads on corporate and emerging market bonds, and depreciation of the US dollar against major currencies. Furthermore, a decline in market liquidity was observed in some markets. Though stock prices and the exchange rate of the US dollar have almost recovered pre-attack levels, we cannot deny the possibility that global financial markets will remain unstable with investors becoming increasingly risk averse if markets believe global economic adjustment will be prolonged. In such an environment, global capital flows could be adversely affected, involving emerging markets. In Japan, since September, demand for liquidity from financial institutions has increased and the credit spreads of corporate bonds with low ratings have widened following the terrorist attacks and such a situation could continue.

    Given this situation, a further decline in domestic stock prices could have a negative impact on Japan's economy through a deterioration in business and consumer confidence as well as changes in the lending attitude of financial institutions. If the yen appreciates significantly reflecting increasing uncertainty regarding the US economy, it could have a negative impact on Japan's exports as well as corporate profits.

  3. The third risk factor is progress in dealing with non-performing loans and the effects.

    If we see further progress in dealing with the non-performing loan (NPL) problem and excess debt in the corporate sector, two sides of the same coin, it could result in an increase in corporate bankruptcies and unemployment in the short run. However, there is also a possibility that markets, both at home and abroad, might react positively to such progress, perceiving it as a positive move to strengthen the functions of the financial system. In that case, it could have a positive impact on the economy through various channels. In particular, if the financial intermediation function is restored, it would help make the Bank of Japan's powerful monetary policy measures already in place become more effective.

    If NPLs increase significantly against the background of prolonged economic adjustment and a decline in stock and land prices or if there is a delay in dealing with existing NPLs, it could impair the credibility of Japan's financial system and seriously hurt the economy.

  4. The fourth risk is the impact of structural and fiscal reform on the economy.

    For Japan's economy to return to a stable and sustainable growth path, it is indispensable to make progress in structural reform. In this regard, more concrete steps are being made in various areas as announced in"Reform Schedule" and"Advanced-Reform Program" by the government. In the short run, progress in structural reform could result in an increase in corporate bankruptcies and unemployment. However, the positive effects of structural reform could materialize earlier if the path to structural reform is clearly identified. For example, it could improve the credibility of Japan's economy and alleviate concern over the future held by the public, which may, in turn, encourage both the corporate and household sectors to spend more.

    Fiscal reform will also have a significant impact on prospects for the economy and prices. In the short run, the content and pace of fiscal reform are important for economic activity because fiscal expenditures directly affect total demand. In the long run, given the already high level of government debt, market confidence in fiscal discipline is crucial. The loss of such confidence could exert downward pressure on the economy by inviting a rise in long-term rates and the associated negative impact on the balance sheets of financial institutions. On the contrary, reform could have a positive impact on the economy if long-term prospects for the restructuring of public finances are clearly visible and the composition of fiscal expenditure is reviewed with a view to stimulating private demand.

Forecasts of the Majority of Policy Board Members

Table : Forecasts of the Majority of Policy Board Members (Y/y % change)
  Real GDP Domestic WPI CPI (excluding perishables)
Fiscal 2001 -1.2 to -0.9
(+0.3 to +0.8)
-1.2 to -1.0
(-0.9 to -0.6)
-1.1 to -1.0
(-0.8 to -0.4)
Fiscal 2002 -1.1 to +0.1 -1.3 to -0.9 -1.3 to -0.9
  • Note: The forecasts of Policy Board members are based on the assumption that there will be no change in monetary policy. Figures in parentheses are forecasts made in April.
    This time, given that uncertainty is greater than usual, each member made a forecast range with a maximum width of half a percentage point. In total, 18 figures were submitted by nine board members indicating the upper and lower limits of their forecasts. If a single figure instead of a range was submitted, it was double counted. Forecasts of the majority of Policy Board members are shown as a range, with the highest two and lowest two figures excluded.
    CPI forecasts made in April this year were with a base year of 1995 but this time the base year is 2000. Comparing year-on-year growth rates since the beginning of this year, those with a base of 2000 were approximately 0.3 percentage points lower than those with a base of 1995.
    The forecasts of all Policy Board members are as follows.
Table : Forecasts of the Majority of Policy Board Members (Y/y % change)
  Real GDP Domestic WPI CPI (excluding perishables)
Fiscal 2001 -1.6 to -0.6
(-0.1 to +1.0)
-1.5 to -0.9
(-1.5 to -0.5)
-1.3 to -0.9
(-1.0 to -0.3)
Fiscal 2002 -1.7 to +0.2 -1.9 to -0.5 -1.7 to -0.5
  • Note: Figures in parentheses are forecasts made in April 2001.