Outlook and Risk Assessment of the Economy and Prices
(April 2002) *
- As determined by the Policy Board at the Monetary Policy Meeting held on April 30, 2002.
April 30, 2002
Bank of Japan
Outlook for economic and price developments
During fiscal 2001, Japan's economy continued to deteriorate. Yet the pace of deterioration had somewhat moderated towards the fiscal year-end against the background of a recovery in overseas economies.
On the outlook for economic developments in Japan for fiscal 2002 and early fiscal 2003, an increase in exports and progress in inventory adjustment are expected to induce a recovery in production. This will lead to an improvement in corporate profits and capital spending, particularly in the manufacturing sector.
At the same time, against the backdrop of intensifying global competition and a heavy debt burden, the corporate sector continues to pursue enhanced efficiency through restructuring. Thus, persistent pressure on employment and wages will remain. Therefore, it is expected to take a significant period before the exports and production recovery in the manufacturing sector spreads to the economy as a whole, including the non-manufacturing sector, small firms, and households. Overall, Japan's economy is expected to stop deteriorating towards the latter half of fiscal 2002 but an anticipated autonomous recovery is not likely to gain much momentum.
Prices are likely to stay on a gradual declining trend given downward pressure from both the demand and supply sides.
The outlook for respective demand components is as follows.
Currently available information indicates that public investment will probably decline further in fiscal 2002. Exports are expected to continue increasing mainly reflecting a recovery in overseas economies, especially in the United States and East Asia.
Regarding domestic private demand, it can be assumed that the production recovery will improve capacity utilization and corporate profits, especially in the manufacturing sector, and capital spending will stop falling or start to gradually recover in the latter half of fiscal 2002. On the other hand, private consumption is likely to remain relatively weak throughout fiscal 2002 as pressure for adjustment continues with respect to employment and wages. Overall, although domestic private demand will gradually gain firmness, it will continue to be difficult to expect a strong and autonomous turnaround.
Regarding financial developments, under aggressive liquidity provision by the Bank of Japan, extremely easy monetary conditions are likely to continue in the financial market. In addition, the recovery of corporate profits could also work to ease the financial position of firms. However, a severe financing environment is likely to continue for those with a lower credit rating as commercial banks and investors will remain cautious in taking credit risks.
On the other hand, loan demand is likely to remain stagnant as the corporate sector will continue to reduce debt. Commercial bank lending is expected to decline further reflecting these demand- and supply-side factors. Nevertheless, it is likely that money stock growth will remain relatively high in comparison with the rate of economic growth. This is because extremely low interest rates induce the shift of funds from various financial instruments to demand deposits and financial institutions increase their investment in Japanese government securities.
On the price front, given the aforementioned demand prospects, the output gap is expected to widen as the short-term growth rate of supply capacity of Japan's economy seems to have declined to some one percent-plus on a year-on-year basis. The output gap is not necessarily a sole determinant of prices as evidenced by the fact that the rate of decline in the Consumer Price Index changed little in the past year despite a widening output gap. Still, it is likely that the large output gap will exert persistent downward pressure on prices. Service prices may also be pressured as they are sensitive to weak wage developments. On the other hand, the yen's depreciation since last autumn and rising global commodity prices are likely to exert upward pressure on prices. In the meantime, imports of low-priced goods, technological advances, and deregulation are likely to remain structural forces pushing prices down.
Reflecting these factors, various price indexes are expected to continue to gradually decline. It is anticipated that the year-on-year rate of change in both the domestic Wholesale Price Index and Consumer Price Index (excluding fresh food) will remain negative in fiscal 2002. Yet the rate of decline in the domestic Wholesale Price Index is likely to narrow somewhat reflecting the progress of inventory adjustments and higher global commodity prices.
With such developments in the economy and prices, it is likely that nominal income growth will continue to register a negative rate.
Risk assessment
The above 'standard scenario' with respect to the economy and prices entails both upside and downside risks. Major risk factors, which will be regularly assessed in monetary policy deliberations, are as follows.
The first is the uncertainty regarding the strength of domestic private demand such as private consumption and capital spending.
The standard scenario assumes that capital spending will gradually begin to respond to a recovery in production and corporate profits. However, the strength of plant and equipment spending depends on the extent of improvement in capacity utilization and corporate profits, prospects for the recovery of demand, and comparative benefits of domestic investment vis-à-vis overseas investment. The standard scenario for private consumption also carries significant uncertainty as it assumes that consumer sentiment will not noticeably deteriorate despite persistent pressure on employment and wages.
Given the above standard scenario, we should be alert for the uncertainty with respect to the possible strength and pace of an autonomous recovery in private demand.
The second is the strength and sustainability of recovery in overseas economies.
Under the standard scenario, which does not assume a strong and autonomous turnaround of domestic demand, the economy's return to a solid recovery path in the initial phase depends largely on developments in overseas economies and exports.
In this regard, although the outlook for overseas economies has significantly improved compared to last year, there is still a possibility that recovery will remain relatively slow. While inventory adjustment in IT-related goods has almost been completed, the momentum of recovery in final demand remains uncertain. The US economy has been supported by firmer-than-expected private consumption but its sustainability is uncertain given the low personal saving rate, the high level of household debt, and existing pressure to adjust capital stock in the corporate sector. Due attention is required for the global economic implications of developments in oil prices, geopolitics, and instability of some emerging economies. In addition, given many uncertainties regarding the global economy, careful monitoring is also warranted with respect to international capital flows and their effects.
The third is developments in dealing with non-performing loans.
Aiming at restoring their strength and credibility in the market, financial institutions are making further efforts to deal with the non-performing loan (NPL) problem as well as to enhance profitability by securing sufficient lending margins. These efforts are part of structural reform of the economy and industry and can be regarded as facilitating the more efficient allocation of resources and funds. Although such moves may constrain bank lending in the short run, they are unlikely to cause difficulty for creditworthy firms. The aforementioned standard scenario assumes that such a financial environment will be broadly maintained even if the lending attitude of financial institutions becomes somewhat more sensitive to credit risks.
However, if there is a further delay in dealing with NPLs or a significant amount of new NPLs emerge, public confidence in Japan's financial system could be impaired. In this case, it could hurt economic activity through the weakening of the financial intermediary function. In particular, the termination of the blanket guarantee of bank liabilities in April, with the exception of demand deposits, has increased uncertainty regarding the shift of funds among financial institutions and thus the impact on financial markets requires due attention.
To complement the intermediary function of financial institutions, the role of capital markets is crucial. Against the background of the successive bankruptcy of large firms since autumn, investors continue to be cautious in taking credit risks. Credit spreads remain on a plateau in the CP and corporate bond markets, especially for those with low credit ratings, and difficulty continues for new issuance. Investors becoming even more risk averse might adversely affect economic activity.
The fourth risk factor, closely related to the third, is developments in key asset prices such as stock and land prices and long-term interest rates.
Stock prices in Japan have recovered somewhat after hitting a post-bubble low in early February, partly reflecting expectations for a recovery of economic activity and corporate profits. More recently, however, the market has shown no clear trend as the performance of non-manufacturers' shares has been unstable. In the meantime, land prices continue to decline as a whole although price developments differ depending on area and usage. Long-term interest rates have been broadly stable but carry potential instability given the level of government debt outstanding, which is among the highest in major countries.
Financial institutions remain vulnerable to market swings with a large amount of stocks still remaining on their balance sheets despite their efforts to reduce them. Land price developments also affect the collateral value of existing loans. In addition, in view of a decline in lending, financial institutions are inclined to earn profits through securities investment, in particular Japanese government securities. A larger JGB portfolio at some institutions has made them more vulnerable to a rise in long-term interest rates if not accompanied by economic recovery.
Therefore, if a significant decline in stock and land prices or a rise in long-term interest rates occurs, it could have a negative impact on economic activity by affecting the performance of financial institutions and their financial intermediary function. It could also erode the confidence of households and firms. On the other hand, should the asset prices rise significantly, reflecting, for example, the progress of structural reform, it could strongly support economic recovery through a reversal of the process described above.
The fifth is the uncertainty associated with the progress of structural reform and its effects.
In the short run, progress in the structural reform of the economy and industry, including the disposal of NPLs by financial institutions, could depress economic activity through an increase in corporate bankruptcies and unemployment. In the long run, however, structural reform will induce the consolidation and revival of firms and stimulate corporate activity in promising areas, thereby contributing to productivity growth. In addition, once the path to structural reform is clearly identified and confidence in Japan's economy is restored in both domestic and overseas markets, there could be a positive impact on economic activity even in the short run through positive asset price developments.
Fiscal reform could have both positive and negative effects on economic activity. A decline in fiscal expenditures would have a negative impact on economic activity. On the other hand, fiscal reform could work positively if Government outlays and taxation are seriously reviewed with a view to stimulating private demand or to ensure public confidence in fiscal discipline.
Forecasts of the Majority of Policy Board Members
| Real GDP | Domestic WPI | CPI (excluding fresh food) | |
|---|---|---|---|
| Fiscal 2002 | -0.5 to +0.1 (-1.1 to +0.1) |
-1.0 to -0.5 (-1.3 to -0.9) |
-1.0 to -0.8 (-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 October 2001.
Forecasts of the majority of Policy Board members are shown as a range with the highest and lowest figures excluded. The forecasts of all Policy Board members are as follows.
Forecasts of All Policy Board Members
| Real GDP | Domestic WPI | CPI (excluding fresh food) | |
|---|---|---|---|
| Fiscal 2002 | -0.5 to +0.2 (-1.7 to +0.2) |
-1.0 to -0.3 (-1.9 to -0.5) |
-1.1 to -0.5 (-1.7 to -0.5) |
- Note: Figures in parentheses are forecasts made in October 2001.
Figures for fiscal 2001 are as follows: (1) The year-on-year growth rate of real GDP is estimated to be -1.5 percent on the assumption that the level of GDP for January-March 2001 is unchanged from the previous quarter.
(2) The year-on-year rate of increase in the domestic WPI is -1.1 percent.
(3) The year-on-year rate of increase in the CPI (excluding fresh food) is -0.8 percent.