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April 28, 2004
Bank of Japan
Japan's economy has continued to recover at a moderate pace since the second half of 2003. The stimulus from exports has contributed to the rise in production and corporate profits. This, in turn, has generated an uptrend in business fixed investment. Household consumption has been somewhat firm. In fiscal 2004, the economy is expected to continue its recovery as momentum increases gradually. Economic activity in general is deviating above the"Standard Scenario" described in the"Outlook and Risk Assessment of the Economy and Prices" (October 2003).
Overseas economies, the U.S. and East Asian economies in particular, are expected to grow relatively fast. As a result, exports and production are likely to increase, and corporate profits will be on an uptrend thanks to cost reductions and the strengthening of the financial position. Although firms continue to cut their interest-bearing debts, the overall pace of debt reduction is likely to ease off. Under these circumstances, business fixed investment is expected to increase mainly in the manufacturing sector. While firms continue to restrain labor costs, the increases in production and corporate profits are expected to exert positive effects gradually on the household sector through changes in employment and income as well as in asset prices. As a result, household consumption is anticipated to recover at a moderate pace.
The year-on-year rate of change in domestic corporate goods prices in fiscal 2004 is likely to be slightly above zero percent, reflecting the increase in commodity prices at home and abroad as well as the improvement in domestic supply and demand conditions. Looking into the background of consumer price developments, the output gap, which affects the underlying trend of prices, is likely to narrow steadily with the economic recovery. However, such factors as the rise in medical costs and rice prices, which contributed to a temporary slowdown of the fall in consumer prices in fiscal 2003, will dissipate, and the impact of the rise in commodity prices on the prices of intermediate and finished products will be largely absorbed by higher productivity. Against such a background, consumer prices in fiscal 2004 are projected to be on a slight downtrend on a year-on-year basis.
The following factors could make the economy deviate either above or below the"Outlook for Fiscal 2004" (the Outlook).
The first factor is the developments in overseas economies. The economic outlook for the U.S. and Asia, China in particular, could make the global economy deviate either above or below the Outlook. Geopolitical risks as well as the twin deficits of the U.S. and its ramification in financial and foreign exchange markets could adversely affect not only the U.S. economy but also the global economy.
The second factor is the developments in domestic financial and foreign exchange markets. Markets reflect the developments in real economic activity in the medium to long term, but they may fluctuate due to various factors in the short run. The changes in stock prices, long-term interest rates and foreign exchange rates, depending on their extent and direction, could make the economy deviate either above or below the Outlook.
The third factor is the developments in domestic private demand. On one hand, if prospects for growth improve and the confidence in the corporate and household sectors rises, business fixed investment and household consumption could make the economy deviate above the Outlook. In this regard, the current lean level of inventory is considered to set the stage for production to expand quickly as final demand increases. On the other hand, if firms continue to restrain labor costs, the spillover effect of the recovery from the corporate sector to the household sector could delay, which is likely to make the economy deviate below the Outlook.
The fourth factor is the progress in the disposal of nonperforming loans (NPLs) and financial system developments. The outstanding amount of NPLs is declining, particularly at large banks, and the disposal of NPLs is making some progress at regional banks as well. Concerns over the financial system are subsiding partly due to the rise in stock prices, and this is evidenced in the recent reduction in demand for banknotes among the public. While concerns that the financial system problem could adversely affect corporate finance and economic activity are receding, it should be recognized that these concerns would make the economy deviate below the Outlook, if they materialize.
In order to put Japan's economy on a sustainable growth path and to extricate Japan from deflation, it is a prerequisite that private demand increases and prospects for long-term growth improve. In this regard, the initiatives of the private sector are as important as the efforts of the government and the Bank of Japan. Firms have been striving to increase profitability by redesigning their business strategy, reducing costs, and strengthening their financial position. Banks have been making progress in disposing of their NPLs. The government has been backing the initiatives of the private sector for economic revitalization by accelerating deregulation as well as implementing structural reforms in the areas of finance, tax system, and public expenditures. The Bank of Japan has been pursuing aggressive monetary easing.
With these initiatives, the economy has been gathering momentum. The year-on-year rate of decline in prices has been decelerating, as the output gap narrows steadily. If various economic agents persist in their initiatives and momentum for the recovery builds up further, the output gap will narrow, which leads to a higher possibility of overcoming deflation.
The Bank of Japan has been providing ample liquidity under the quantitative easing policy, and short-term interest rates have been at almost zero percent. Furthermore, the Bank has made a firm commitment to continuing the current policy until the year-on-year rate of change in consumer price index (excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis.
Such a framework of monetary easing has been giving strong support for economic activity of the private sector through the following channels. First, the provision of ample liquidity contributes to ensuring financial market stability and maintaining the accommodative environment for corporate finance. Second, the expectations about interest rates in the near future will be stable with the above-described commitment, and thus the returns on investment will rise as the economy recovers. The positive effect of this channel will be greater as the recovery accelerates and corporate profits increase.
The Bank of Japan aims at putting Japan's economy on a sustainable growth path and overcoming deflation by firmly maintaining the quantitative easing policy. Moreover, the Bank will continue to back the initiatives of market participants to improve credit markets, including loan trading and securitization markets. This is intended to make the credit intermediation in the market more diversified and efficient, and to strengthen the transmission mechanism of monetary easing.