Outlook for Economic Activity and Prices
(January 2020)
The Bank's View¹

January 21, 2020
Bank of Japan

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Summary

• Japan's economy is likely to continue on an expanding trend throughout the projection period -- that is, through fiscal 2021 -- as the impact of the slowdown in overseas economies on domestic demand is expected to be limited, although the effects of the slowdown are likely to remain for the time being. Although exports are projected to show some weakness for the time being, they are expected to be on a moderate increasing trend, with overseas economies growing moderately on the whole. Domestic demand also is likely to follow an uptrend, with a virtuous cycle from income to spending being maintained, mainly against the background of highly accommodative financial conditions and active government spending, although it has declined recently, due mainly to the effects of the consumption tax hike and natural disasters.
• The year-on-year rate of change in the consumer price index (CPI, all items less fresh food) is likely to increase gradually toward 2 percent, mainly on the back of the output gap remaining positive and medium- to long-term inflation expectations rising throughout the projection period, despite such effects as of the past decline in crude oil prices for the time being.
• Comparing the current projections with the previous ones, the projected growth rates are higher, mainly for fiscal 2020, reflecting the effects of the government's economic measures. The projected rates of increase in the CPI are more or less unchanged.
• With regard to the risk balance, risks to economic activity are skewed to the downside, particularly regarding developments in overseas economies. Risks to prices are skewed to the downside, mainly due to the downside risks to economic activity and uncertainties over developments in medium- to long-term inflation expectations. The momentum toward achieving the price stability target of 2 percent is maintained but is not yet sufficiently firm, and thus developments in prices continue to warrant careful attention.

I. Current Situation of Economic Activity and Prices in Japan

Japan's economy has been on a moderate expanding trend, with a virtuous cycle from income to spending operating, although exports, production, and business sentiment have shown some weakness, mainly affected by the slowdown in overseas economies and natural disasters. Overseas economies have been growing moderately on the whole, although slowdowns have continued to be observed. In this situation, exports have continued to show some weakness, and industrial production has declined recently, due partly to the effects of natural disasters. On the other hand, with corporate profits staying at high levels on the whole, business fixed investment has continued on an increasing trend. Private consumption has been increasing moderately, albeit with fluctuations due to such effects as of the consumption tax hike, against the background of steady improvement in the employment and income situation. Housing investment has been more or less flat, and public investment has increased moderately. Meanwhile, labor market conditions have remained tight. Financial conditions are highly accommodative. On the price front, the year-on-year rate of change in the CPI (all items less fresh food, and the same hereafter) is at around 0.5 percent. Inflation expectations have been more or less unchanged.

II. Baseline Scenario of the Outlook for Economic Activity and Prices in Japan

A. Baseline Scenario of the Outlook for Economic Activity

With regard to the outlook, Japan's economy is likely to continue on an expanding trend throughout the projection period -- that is, through fiscal 2021 -- as the impact of the slowdown in overseas economies on domestic demand is expected to be limited, although the effects of the slowdown are likely to remain for the time being.

In a situation where the growth pace of overseas economies will take some time to pick up, exports are projected to show some weakness for the time being. However, overseas economies are expected to grow moderately on the whole, with the growth rates rising on the back of the materialization of the effects of macroeconomic policies in each country as well as a pick-up in the manufacturing sector due mainly to the global cycle for IT-related goods shifting toward a phase of improvement. Under these circumstances, Japan's exports are projected to return to their moderate increasing trend.

Although domestic demand has declined recently, due mainly to the effects of the consumption tax hike and natural disasters, it is likely to follow an uptrend, with a virtuous cycle from income to spending being maintained in both the corporate and household sectors, mainly against the background of highly accommodative financial conditions and active government spending. Business fixed investment -- mainly investment related to urban redevelopment projects, labor-saving investment to address labor shortage, and research and development (R&D) investment for growth areas -- is likely to continue increasing moderately amid accommodative financial conditions, although the pace of increase is expected to decelerate temporarily, mainly for manufacturing, due to the effects of the slowdown in overseas economies, and such factors as an accumulation of capital stock are projected to exert downward pressure from a somewhat longer-term perspective. Private consumption is expected to follow a moderate increasing trend with such effects as of the consumption tax hike waning gradually and the employment and income situation continuing to improve. Meanwhile, government spending is expected to increase steadily through fiscal 2020 due to expansion in expenditure such as for disaster-related restoration and reconstruction as well as national resilience, both of which reflect the government's economic measures, in addition to Olympic Games-related demand; government spending thereafter is likely to remain at a relatively high level. Thus, the impact of the slowdown in overseas economies on domestic demand is expected to be limited.

On this basis, although Japan's economy has grown at a slower pace than its potential recently, it is expected to see an acceleration in its growth pace thereafter.² Thus, on average, the economy is likely to continue growing at about the same pace as its potential or at a somewhat faster pace. Comparing the current projections with the previous ones, the projected growth rates are higher, mainly for fiscal 2020, reflecting the effects of the government's economic measures.

Looking at the financial conditions on which the above outlook is based, short- and long-term real interest rates are assumed to be in negative territory throughout the projection period as the Bank pursues "Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control."³ Financial institutions' active lending attitudes, as well as favorable conditions for corporate bond and CP issuance, are likely to be maintained and support firms' and households' activities from the financial side. Thus, financial conditions are likely to remain highly accommodative.

Meanwhile, the potential growth rate is expected to follow a moderate uptrend throughout the projection period against the backdrop of the following continuing developments: progress in implementation of the government's growth strategy, including regulatory and institutional reforms as well as measures to strengthen productivity, which are part of the economic measures; an increase in labor participation by women and seniors under such strategy; and firms' fixed investment and efforts toward improving productivity. In addition, as the natural rate of interest increases together with the rise in the growth potential of Japan's economy, monetary easing effects are likely to be enhanced.

B. Baseline Scenario of the Outlook for Prices

The year-on-year rate of change in the CPI has been positive but has continued to show relatively weak developments compared to the economic expansion and tight labor market conditions.

This is basically because firms' cautious wage- and price-setting stance, as well as households' cautiousness toward price rises, have not yet clearly changed in a situation where the mindset and behavior based on the assumption that wages and prices will not increase easily have been deeply entrenched. Firms' efforts to absorb upward pressure of costs by raising productivity, the technological progress in recent years, and the high wage elasticity of labor supply also are contributing factors. In addition, the continued lackluster developments in administered prices and housing rent are likely to have affected the sluggishness in prices. It has been taking time to resolve these factors that have been delaying price rises, and the situation likely has continued in which the responsiveness of prices to the output gap, as well as inflation expectations that are strongly affected by the adaptive formation mechanism, do not rise easily.

With regard to the outlook, the year-on-year rate of change in the CPI is likely to increase gradually toward 2 percent, mainly on the back of the output gap remaining positive and medium- to long-term inflation expectations rising throughout the projection period, despite such effects as of the past decline in crude oil prices for the time being. Comparing the current projections with the previous ones, the projected rates of increase in the CPI are more or less unchanged.⁴

The mechanism through which the year-on-year rate of change in the CPI increases gradually toward 2 percent can be explained by the following factors that determine general price inflation. First, although the output gap -- which shows the utilization of labor and capital -- recently seems to have narrowed within positive territory due to such effects as of the slowdown in overseas economies and the consumption tax hike, it is likely to widen moderately thereafter through the end of the projection period, as the economic growth rate is expected to exceed its potential somewhat. Under such circumstances, further price rises are likely to be observed widely as households' tolerance of price rises increases, mainly reflecting a rise in wage growth rates, and as firms' stance shifts toward further raising prices.

Second, medium- to long-term inflation expectations have remained more or less unchanged. As for the outlook, such expectations are likely to follow an increasing trend and gradually converge to 2 percent on the back of the following: (1) in terms of the adaptive component, a rise in the observed inflation rate is likely to push up inflation expectations, and (2) in terms of the forward-looking component, the Bank will pursue monetary easing through its strong commitment to achieving the price stability target, which will be effective in pushing up inflation expectations.⁵

Third, regarding import prices, the past decline in crude oil prices is likely to push down the CPI through the fall in energy prices for the time being. However, such downward pressure is projected to diminish gradually.

Meanwhile, the increase in labor participation by women and seniors, as well as firms' strengthening of efforts toward improving productivity, are expected to increase upward pressure on prices in the long term. Specifically, as the growth potential of the economy as a whole rises, reflecting such moves, firms' and households' spending behavior can be expected to become active.

III. Risks to Economic Activity and Prices

A. Risks to Economic Activity

The following four factors are upside and downside risks to the Bank's baseline scenario regarding the economy.

The first is developments in overseas economies. Specifically, the following are considered as risks: the consequences of protectionist moves and their effects; developments in emerging and commodity-exporting economies such as China; developments in global demand for IT-related goods; developments in the United Kingdom's exit from the European Union (EU) and their effects; geopolitical risks; and developments in global financial markets under these circumstances. Downside risks concerning overseas economies seem to be still significant, although they have decreased somewhat compared to a while ago, and it also is necessary to pay close attention to their impact on firms' and households' sentiment in Japan.

The second risk is the effects of the consumption tax hike conducted in October 2019. Fluctuations in demand prior to and after the tax hike seem to have been constrained this time compared with those of the previous tax hike in April 2014, partly due to various measures implemented by the government. Although the impact of a decline in real income is expected to be smaller than that of the previous tax hike, it continues to warrant attention as it is likely to depend on consumer sentiment, the employment and income situation, and developments in prices.

Third, firms' and households' medium- to long-term growth expectations may be either raised or lowered depending on the following: efforts to address medium- to long-term issues such as the declining birthrate and aging population; developments in regulatory and institutional reforms, particularly in the labor market; innovation in the corporate sector; and the employment and income situation.

Fourth, in the event that confidence in fiscal sustainability in the medium to long term declines, the economy may deviate downward from the baseline scenario through increasing concerns regarding the future and the rises in long-term interest rates associated with them. On the other hand, there also is a possibility that the economy will deviate upward from the baseline scenario if confidence in the path toward fiscal consolidation strengthens and concerns regarding the future are alleviated.

B. Risks to Prices

As mentioned above, with regard to risks to economic activity, the downside risks concerning overseas economies in particular seem to be still significant. If these risks materialize, close attention should be paid to the possibility that prices also will be affected to some extent.

In addition, the specific factors that could exert upside and downside risks to prices are as follows. The first is developments in firms' and households' medium- to long-term inflation expectations. Although inflation expectations are likely to follow an increasing trend, there is a risk that a rise in such expectations will be delayed through the adaptive formation mechanism if it takes longer than projected for firms' stance to shift toward further raising wages and prices and actual inflation consequently remains relatively sluggish.

The second factor is the responsiveness of prices to the output gap. If firms' efforts to absorb upward pressure of costs by raising productivity continue for a long time, or competition among firms intensifies further, due partly to the technological progress in recent years and changes in the distribution system, downward pressure on prices stemming from these factors may last longer than expected. In addition, the lackluster developments in administered prices and housing rent also may continue to constrain the rise in CPI inflation for a long period.

Third, developments in foreign exchange rates and international commodity prices going forward, as well as the extent to which such developments will spread to import prices and domestic prices, may lead prices to deviate either upward or downward from the baseline scenario.

IV. Conduct of Monetary Policy

In the context of the price stability target, the Bank assesses the aforementioned economic and price situation from two perspectives and then outlines its thinking on the future conduct of monetary policy.⁶

The first perspective involves an examination of the baseline scenario for the outlook. The year-on-year rate of change in the CPI is likely to increase gradually toward 2 percent. Although it is necessary to carefully examine the risks to economic activity and prices, the momentum toward achieving the price stability target of 2 percent appears to be maintained. This is because (1) firms' stance is expected to gradually shift toward further raising wages and prices with the output gap remaining positive, and (2) medium- to long-term inflation expectations have been more or less unchanged and are projected to rise gradually as further price rises come to be observed widely.

The second perspective involves an examination of the risks considered most relevant to the conduct of monetary policy. With regard to the outlook for economic activity, risks are skewed to the downside, particularly regarding developments in overseas economies. Regarding the outlook for prices, risks are skewed to the downside, mainly due to the downside risks to economic activity and uncertainties over developments in medium- to long-term inflation expectations. Although there has been no further increase in the possibility that the momentum toward achieving the price stability target will be lost, it is necessary to continue to pay close attention to the possibility. Examining financial imbalances from a longer-term perspective, there is no sign so far of excessively bullish expectations in asset markets or in the activities of financial institutions. However, prolonged downward pressure on financial institutions' profits, with the low interest rate environment and severe competition among financial institutions continuing, could create risks of a gradual pullback in financial intermediation and of destabilizing the financial system. Although these risks are judged as not significant at this point, mainly because financial institutions have sufficient capital bases, it is necessary to pay close attention to future developments.

As for the conduct of monetary policy, the Bank will continue with "QQE with Yield Curve Control," aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner. It will continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds 2 percent and stays above the target in a stable manner. As for the policy rates, the Bank expects short- and long-term interest rates to remain at their present or lower levels as long as it is necessary to pay close attention to the possibility that the momentum toward achieving the price stability target will be lost. It will examine the risks considered most relevant to the conduct of monetary policy and make policy adjustments as appropriate, taking account of developments in economic activity and prices as well as financial conditions, with a view to maintaining the momentum toward achieving the price stability target. In particular, in a situation where downside risks to economic activity and prices, mainly regarding developments in overseas economies, are significant, the Bank will not hesitate to take additional easing measures if there is a greater possibility that the momentum toward achieving the price stability target will be lost.

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1. The text of "The Bank's View" -- the outlook for economic activity and prices as well as the Bank's thinking on the conduct of monetary policy, both of which are based on individual Policy Board members' views -- was decided by the Policy Board at the Monetary Policy Meeting held on January 20 and 21, 2020. Return to text
2. Under a specific methodology, Japan's potential growth rate is estimated to be in the range of 0.5-1.0 percent recently. However, the estimate of the potential growth rate varies depending on the methodologies employed and could be revised as the sample period becomes longer over time. Thus, it should be regarded as being subject to a considerable margin of error. Return to text
3. Individual Policy Board members make their forecasts taking into account the effects of past policy decisions and with reference to views incorporated in financial markets regarding future policy. Return to text
4. Taking into account the actual CPI figures for October and November 2019, the effect of the October 2019 consumption tax hike on the year-on-year rate of change in the CPI (all items less fresh food) for October 2019 onward is estimated to be 1.0 percentage point; the effects for fiscal 2019 and 2020 are estimated to be 0.5 percentage point for each fiscal year. In addition, based on a specific assumption, the effects of policies concerning the provision of free education on the year-on-year rates of change in the CPI (all items less fresh food) for fiscal 2019 and 2020 are estimated to be around minus 0.3 percentage point and around minus 0.4 percentage point, respectively. Return to text
5. Medium- to long-term inflation expectations can be regarded as consisting of two components: a forward-looking component, in which inflation expectations converge to the price stability target set by the central bank, and a backward-looking, or adaptive, component that reflects the observed inflation rate. For details, see the Bank's Comprehensive Assessment: Developments in Economic Activity and Prices as well as Policy Effects since the Introduction of Quantitative and Qualitative Monetary Easing (QQE) released in September 2016. Return to text
6. As for the examination from two perspectives in the context of the price stability target, see the Bank's statement released on January 22, 2013, entitled "The 'Price Stability Target' under the Framework for the Conduct of Monetary Policy." Return to text

Appendix

Forecasts of the Majority of Policy Board Members

Notes:

1. Figures in brackets indicate the medians of the Policy Board members' forecasts (point estimates).
2. The forecasts of the majority of the Policy Board members are constructed as follows: each Policy Board member's forecast takes the form of a point estimate -- namely, the figure to which he or she attaches the highest probability of realization. These forecasts are then shown as a range, with the highest figure and the lowest figure excluded. The range does not indicate the forecast errors.
3. Individual Policy Board members make their forecasts taking into account the effects of past policy decisions and with reference to views incorporated in financial markets regarding future policy.
4. With regard to policies concerning the provision of free education, it is assumed that measures such as free higher education will be introduced in April 2020. Taking into account the actual CPI figures for October and November 2019, the direct effects of the October 2019 consumption tax hike on the CPI for fiscal 2019 and 2020 are estimated to be 0.5 percentage point for each fiscal year. In addition, based on a specific assumption, the direct effects of policies concerning the provision of free education on the CPI for fiscal 2019 and 2020 are estimated to be around minus 0.3 percentage point and around minus 0.4 percentage point, respectively.

Policy Board Members' Forecasts and Risk Assessments

(1) Real GDP

(2) CPI (All Items Less Fresh Food)

Notes:

1. Solid lines show actual figures, while dotted lines show the medians of the Policy Board members' forecasts (point estimates).
2. The locations of , , and in the charts indicate the figures for each Policy Board member's forecasts to which he or she attaches the highest probability. The risk balance assessed by each Policy Board member is shown by the following shapes: indicates that a member assesses "upside and downside risks as being generally balanced," indicates that a member assesses "risks are skewed to the upside," and indicates that a member assesses "risks are skewed to the downside."
3. The CPI figures for fiscal 2014 and 2015 exclude the direct effects of the consumption tax hike in April 2014.