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April 28, 2005
Bank of Japan
Japan's economy remains on a recovery trend, although recently the economy has been pausing temporarily due partly to adjustments in production and inventories in IT-related sectors in the second half of 2004. As a result, economic activity in fiscal 2004 seemed to have deviated slightly below the projected outlook reported in the Outlook for Economic Activity and Prices(the Outlook Report) released in October 2004.
Looking forward, Japan's economic recovery is likely to gradually gather momentum from the middle of 2005 as the effects of adjustments in IT-related sectors diminish, and growth in fiscal 2005 is expected slightly to exceed the economy's potential growth rate. This is generally in line with the outlook presented in the October Outlook Report. Although at present there is considerable uncertainty, in fiscal 2006 the economy is expected to follow a sustainable growth path, albeit at a moderate pace. This economic outlook rests on the following underlying assumptions: that overseas economies remain on an expansionary trend; that firms' profits remain at high levels as they continue their efforts on various fronts; that increased corporate profits spread to a wider range of sectors through various channels; and that firms' cautious business stance allows excesses in, for example, business fixed investment or inventory investment to be avoided.
Overseas economies, particularly the United States and East Asia, are likely to remain on an expansionary trend. Against this background and with the international division of the production process within the East Asian region continuing to develop, Japan's exports are expected to continue to increase. Since inventory adjustments in IT-related sectors are likely to be completed around the middle of 2005, industrial production is expected to return to its upward trend thereafter. With production and sales set to increase against the background of the development of new high value-added products and services as well as further streamlining efforts by firms, corporate profits, although already at high levels, are likely to continue to trend upward at a moderate pace, despite pressure from the rise in crude oil prices and other commodity prices. Although the pace of increase in business fixed investment is still contained compared with firms' cash flow, fixed investment is expected to follow an upward trend as adjustment pressure stemming from structural factors including excess capacity and debts eases. Household income is also likely to increase moderately reflecting improvement in supply and demand conditions in the labor market. In this situation, private consumption is expected to continue increasing moderately.
On the price front, as the output gap continues to narrow, domestic corporate goods prices have been increasing year on year since the beginning of 2004 reflecting the rise in commodity prices at home and abroad. The consumer price index (excluding fresh food, on a nationwide basis) has been declining slightly on a year-on-year basis partly due to the decline in rice prices and the reduction in electricity and telephone charges caused by intense competition accompanying deregulation. These developments in domestic corporate goods prices and consumer prices in fiscal 2004 were generally in line with the October outlook.
In fiscal 2005 and 2006, although domestic corporate goods prices will be sensitive to developments in commodity prices at home and abroad, they are likely to continue increasing, albeit at a slower pace than in the first half of 2004. In fiscal 2005, domestic corporate goods prices are likely to deviate above the projections given in the October outlook due mainly to the rise in crude oil prices. Consumer prices are unlikely to increase markedly since the rise in energy and materials prices is expected to be substantially offset by increases in corporate productivity. In fiscal 2005, developments in consumer prices are likely to deviate slightly below the projections in the October outlook. That is, consumer prices are likely to remain around zero percent on a year-on-year basis due partly to the fact that the effects of the decline in rice prices and the reduction in electricity and telephone charges are expected to remain for a while. In fiscal 2006, consumer prices are expected to increase on a year-on-year basis as the effects of these temporary factors fall off.
The following factors could cause economic activity to deviate either above or below the projections given in the above outlook.
The first factor is developments in energy and materials prices. Crude oil prices have risen again reflecting expectations of expanding global demand. Recently, crude oil prices have been recording historically high levels. There has also been some increase in the prices of various materials, particularly of steel plates and nonferrous metals. If energy and materials prices remain at high levels, the global economy may be adversely affected via declines in corporate profits and households' real purchasing power.
The second factor is developments in the U.S. and Chinese economies. In the outlook, the U.S. and East Asian economies, particularly the Chinese economy, are assumed to continue growing at around their current pace. Japan's exports could deviate from the projected outlook, either positively or negatively, depending on developments in these economies. Looking ahead, if, with energy prices rising and the output gap narrowing, inflationary pressures were to build in the U.S. economy, the subsequent changes in the monetary policy stance could trigger a U.S. and hence a global economic slowdown. If this situation materializes, attention should be paid to the risk of negative effects on the global economy, particularly on emerging economies, via capital flows and developments in financial markets. As for the Chinese economy, the government has made clear that it intends to contain the overheating of the economy and achieve a sustainable long-term economic expansion. The various structural problems remaining in the economy, however, mean that there is uncertainty about whether this can be achieved.
The third factor is developments in domestic private demand. The outlook is based on the assumption that firms' behavior is likely to remain cautious despite high corporate profits. In this situation, firms' spending, especially their business fixed investment, could deviate above the projected outlook if there is an increase in the economy's expected growth rate in the medium term, or if firms start to place less priority on reducing interest-bearing liabilities from their balance sheets. On the other hand, if firms' behavior becomes more cautious, this may constrain the growth of business fixed investment, employment, and wages.
As for price developments, there are factors that could cause deviations either above or below the projections of the outlook. If the factors, mentioned above, that cause economic activity to deviate were indeed to materialize, this would impact on prices. In addition, there are factors unique to prices that may cause either upward or downward deviation: a rise in crude oil and other commodity prices at home and abroad and the subsequent emergence of inflationary sentiment may cause upward deviation; meanwhile the intensification of competition among firms accompanying deregulation may cause downward deviation.
Looking back at the Japanese economy since the 1990s, the emergence of nonperforming loans (NPLs) due to the bursting of the bubble reduced firms' and financial institutions' risk-taking ability and placed constraints on positive economic activity. In addition to the NPL problem, the tardiness of individual sectors of the economy in adapting to economic globalization, advances in IT, and other various economic changes caused a gradual decline in the potential growth rate of the economy. Since the latter half of the 1990s, negative shocks to the economy triggered anxiety about financial system stability, and this in turn tended to amplify the negative impact on the economy.
During the past decade or so, firms have not only made progress in adjusting their excessive production capacity, holdings of labor, and debts but have also raised their ability to develop new products and services offering high value-added. The fruits of these efforts are becoming evident in corporate profitability. Financial institutions have been making progress in disposing of NPLs and restoring their financial soundness. Against this background, blanket deposit insurance was fully lifted in April 2005. The financial system is becoming more stable and the risk that financial system problems could affect economic activity seems to have receded significantly.
More than four years have passed since the Bank adopted the quantitative easing policy. The framework of the quantitative easing policy is based on two key elements. The first element is the Bank's provision of ample liquidity to the money market so that the outstanding balance of current accounts at the Bank substantially exceeds the amount of required reserves. The second is the Bank's commitment to continue with this ample provision of liquidity until the year-on-year rate of change in the consumer price index (excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis.
During the period of strong concerns about financial system stability, the Bank provided ample liquidity which met financial institutions' liquidity demand. This contributed greatly to stabilizing financial markets and maintaining an accommodative financial environment, thereby averting the risk of a contraction in economic activity caused by falling prices and decreases in corporate profits. At the same time, the commitment by the Bank caused market participants to expect interest rates to remain at zero for longer, and this in turn underpinned firms' profits and improved rates of return on investment by enabling firms to raise funds at low interest rates.
Anxiety about financial system stability has been subsiding. As a result, financial institutions are demanding less liquidity, as evidenced in undersubscription, where financial institutions' bids fall short of the Bank's offers, which has occurred frequently in the Bank's funds-supplying operations. Financial institutions have become more confident about raising funds under the quantitative easing framework, and an accommodative corporate financing environment has been maintained. The Bank's commitment to maintain the quantitative easing policy based on the consumer price index has allowed firms to continue to enjoy low funding costs even as the economy continues to recover. Positive effects on the economy, acting via interest rates, will strengthen as firms gradually become more confident about the economic outlook.
It is not certain whether or not there will be occasion to change the present framework of the quantitative easing policy during the projection period for this Outlook Report. However, assuming that the outlook's projections regarding economic activity and prices in fact materialize, it is likely that this possibility will gradually increase over the course of fiscal 2006. If upward pressure on prices continues to be to a large extent contained and the economy follows a sustainable and balanced growth path, this will likely give the Bank latitude in changing the policy framework and in conducting monetary policy thereafter.