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Outlook for Economic Activity and Prices

(October 2004)

October 29, 2004
Bank of Japan

[The Bank's View]1

Outlook for Economic Activity and Prices

Japan's economy continues to recover. As exports and production continue to be on an uptrend, albeit at a slightly slower pace, corporate profits are increasing, and this has led to an increase in business fixed investment. Household consumption continues to hold up well reflecting the improvement in the employment situation and consumer sentiment. Thus, economic activity is deviating above the"Outlook for Fiscal 2004" described in the Outlook for Economic Activity and Prices released in April 2004. Developments in domestic corporate goods prices are deviating above the"Outlook for Fiscal 2004," while those in consumer prices are generally in line with it.

Looking forward, Japan's economy is expected to continue recovering and gradually move to a sustainable growth path. Though overseas economies are expected to grow at a somewhat slower pace due to the rise in crude oil prices and inventory adjustment in IT-related goods, they are likely to continue expanding. Under such circumstances, Japan's exports are likely to continue increasing, albeit at a slower pace. The ongoing inventory adjustment in IT-related goods is expected to be small. Production in the materials industry is at high levels reflecting the increase in demand. Thus, industrial production is expected to continue an uptrend given the low levels of inventory in the manufacturing industry as a whole. Profits of firms both large and small in a wide range of industries are likely to continue increasing as firms have reduced costs and strengthened their financial position. Moreover, structural adjustment pressure stemming from excess capacity and debt has been easing. Against this background, business fixed investment is expected to continue increasing. While firms are expected to continue restraining labor costs, household income is likely to start increasing gradually since corporate profits are increasing and the extent of excess labor perceived by firms is continuing to ease. Household consumption is expected to continue increasing gradually.

Domestic corporate goods prices are likely to continue rising in fiscal 2004 reflecting higher crude oil prices and the tightening of supply-demand conditions for materials. In fiscal 2005, the pace of the rise is likely to become moderate if crude oil prices do not rise significantly. Meanwhile, consumer prices are unlikely to rise for the time being due partly to the increase in productivity and the restraint on labor costs by firms, though the output gap is continuing to narrow in line with the economic recovery. The year-on-year change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) is likely to continue declining slightly due partly to the fall in rice prices year on year in the second half of fiscal 2004. In fiscal 2005, the CPI is expected to increase slightly on a year-on-year basis reflecting continued improvement in the output gap. It should be noted that the forecasts for prices are subject to some uncertainty as future developments in prices may be influenced by changes in various factors, such as crude oil prices, productivity, and labor costs.

Positive and Negative Deviations

The following factors could make the economy deviate either above or below the Outlook for Economic Activity and Prices through fiscal 2005 (the Outlook).

The first factor is the developments in overseas economies. There is a possibility that the U.S. and East Asian economies, particularly the Chinese economy, could make the global economy deviate below the Outlook, and reduce Japan's exports. A further rise in crude oil prices, which are already at high levels, could cause the global economy, especially oil importing economies, to deviate below the Outlook through a decline in corporate profits and in households' real purchasing power. Since demand for IT-related goods tends to be volatile, adjustment in both production and inventory may become severe if final demand declines more than anticipated.

The second factor is the developments in domestic private demand. Greater-than-expected fluctuations in crude oil prices and global demand for IT-related goods could influence not only Japan's exports through the change in overseas economies as described earlier but also business fixed investment and other domestic private demand. If firms continue to restrain labor costs persistently, delayed improvement in household income could cause household consumption to deviate below the Outlook. On the other hand, if bullish sentiment about the economic outlook becomes widespread among firms and households against the background of the increase in productivity and progress in structural adjustments, business fixed investment and household consumption may deviate above the Outlook.

The third factor is the developments in domestic financial and foreign exchange markets. While financial markets reflect the developments in economic activity and prices in the medium to long term, they may fluctuate due to various factors in the short term. Depending on the extent and direction of market developments, the economy could deviate either above or below the Outlook.

The fourth factor is the nonperforming loan (NPL) problem and financial system developments. Considerable progress has been made in the resolution of the NPL problem, and concerns over financial system stability have been subsiding. Though financial system problems warrant continued monitoring given the upcoming removal of blanket deposit insurance in April 2005, concerns that they could affect economic activity through corporate finance are receding.

Conduct of Monetary Policy

Currently, firms have been striving to increase profitability by articulating their business strategy, reducing costs, and strengthening their financial positions. Their efforts have been bearing fruits. Financial institutions have been making progress in disposing of their NPLs. The government on its part has been backing the private sector efforts toward revitalization through deregulation and reforms in the areas of financial infrastructure, tax system, and public expenditure. The Bank of Japan has been continuing with aggressive monetary easing. If various economic agents continue their efforts and the economic recovery gathers further momentum, there will be a stronger possibility of achieving sustainable growth and overcoming deflation.

In such circumstances, the Bank is firmly committed to continue with the quantitative easing policy until the year-on-year rate of change in the CPI (excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. The positive effect of the commitment through interest rates on the economy will strengthen as corporate profits increase along with the economic recovery.

Under the current Outlook, it is not certain whether or not the occasion will arise during fiscal 2005 to change the present monetary policy framework of using the current account balances at the Bank as the main operating target. The way the central bank conducts monetary policy depends on future developments in economic activity and prices. If higher productivity and other factors continue to contain to a large extent upward pressure on prices as the economy follows a sustainable and balanced growth path, this will likely give the Bank latitude in conducting monetary policy.

The Bank will take appropriate measures in a flexible manner in response to changes in economic and financial developments, while endeavoring to offer a lucid explanation about the assessment of economic activity and prices as well as the thinking behind the conduct of monetary policy. The Bank will continue to enhance its communication with market participants so that they will be better able to judge and predict the future conduct of monetary policy.

  1. The text of"The Bank's View" was decided by the Policy Board at the Monetary Policy Meeting held on October 29, 2004
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  1. 2Forecasts 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.
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