Outlook for Economic Activity and Prices (October 2006)

October 31, 2006
Bank of Japan

[The Bank's View]1
(Outlook for Economic Activity and Prices)
Japan's economy is expanding moderately. Economic activity has been generally in line with the projection in the April 2006 Outlook for Economic Activity and Prices (hereafter the Outlook Report), although so far developments in the corporate sector have been somewhat stronger than projected while those in the household sector have been somewhat weaker.

From the second half of fiscal 2006 through fiscal 2007, the economy is likely to experience a sustained period of expansion with domestic and external demand increasing and the positive influence of the strength in the corporate sector feeding through into the household sector. As the economic expansion lengthens and matures, the growth rate is likely to slow gradually from around 2.5 percent for fiscal 2006 to around 2 percent for fiscal 2007, approaching the potential growth rate.

The outlook rests on the following underlying assumptions and mechanisms. First, exports are likely to remain on the increase, reflecting the continuing expansion of overseas economies. Although the pace of expansion in the U.S. economy has been decelerating recently, overseas economies as a whole are likely to keep expanding across a broader range of regions. Second, strong corporate performance is likely to continue. Corporate profits are expected to remain high and the ratio of firms' profits to sales is likely to remain at a high level. Business fixed investment is likely to continue increasing, partly because firms are factoring increasing overseas demand into their investment decisions given the ongoing progress of globalization. Through fiscal 2007, however, the growth rate of business fixed investment is expected to decline, in view of the capital stock cycle, since firms are still displaying a strong tendency to evaluate investment profitability strictly. Third, it is likely that the positive influence of the strength in the corporate sector will continue to feed through into the household sector via channels such as increases in household income and dividends. The number of employees is likely to continue to rise steadily. The rate of increase in wages has so far been moderate due partly to persistent labor cost restraint by firms, but the increase is expected to become clearer over time, given that labor market conditions are tightening steadily. Against this backdrop, private consumption is likely to continue increasing steadily. And fourth, the extremely accommodative financial conditions are likely to continue to support private demand. Lending by private banks is on the rise, and short-term interest rates have been very low relative to the state of economic activity and prices.

Given this economic outlook, the environment surrounding prices is likely to change gradually. First, a higher level of resource utilization, namely in production capacity and labor, is being observed. The output gap is positive and is likely to widen at a moderate pace going forward. Second, although unit labor costs (labor costs per unit of output) continue to decline, they are expected to stop declining and start increasing slightly in line with the deceleration in productivity growth and clearer increases in wages resulting from the prolonged economic expansion. And third, results of various surveys show that firms and households are shifting up their inflation expectations for both the short term and the medium to long term.

Looking at various indices for inflation, the domestic corporate goods price index (CGPI) in the first half of fiscal 2006 exceeded the April projection, mainly reflecting rises in international commodity prices. While the prices of crude oil and other commodities and foreign exchange rates will influence the CGPI significantly, it is likely to continue its upward trend.

The movement of the consumer price index (CPI; excluding fresh food, on a nationwide basis) has been generally in line with the April projection: year-on-year changes have been on a positive trend. The year-on-year rate of increase in the CPI is likely to gradually rise from the 0.0-0.5 percent range in fiscal 2006 to around 0.5 percent in fiscal 2007.2

(Positive and Negative Deviations)
The outlook described above is the most likely projection based on the underlying assumptions and mechanisms mentioned earlier. It should be noted that there exist the following upside and downside risks to the outlook.

The first risk concerns the growth path of the global economy. The U.S. economy is likely to realize a soft landing and to move toward sustainable growth. However, if a greater-than-expected downward adjustment in housing prices occurs, it may lead to lower growth rates via, for example, a deceleration of growth in private consumption. In addition, higher resource utilization, namely in production capacity and labor, coupled with, for example, the impact of past rises in crude oil prices may lead to higher inflation expectations. In such a case, there may be adverse effects not only on the U.S. but also on the global economy operating, for instance, through the reactions of financial markets. In China, the economy continues to expand strongly, and there is a possibility that this growth will accelerate during the projection period, influenced by developments in fixed asset investments and exports. Global economic developments may also be influenced by international commodity prices, such as crude oil prices, depending on their future movements. These developments in economies abroad may cause Japanese exports and production to deviate either upward or downward from their expected trajectory. Japanese business fixed investment may also be affected, as firms are factoring expanding external demand into their investment plans.

If the pace of the expansion of overseas economies decelerates unexpectedly, inventory adjustments may occur, for example, in IT-related goods where the pace of increase in supply has been rapid. Even in such a case, however, high corporate profitability as well as the fact that Japanese firms have on the whole completed adjusting excesses in employment and production capacity may act as a cushion minimizing the impact on the overall economy.

The second risk is a further acceleration of business fixed investment. Although firms, mainly manufacturers, have been stepping up their business fixed investment, an excessive build-up of capital stock has not so far been observed in the economy overall. However, given the extremely accommodative financial conditions, firms may further accelerate investment based on optimistic projections of future profitability, such as favorable expectations regarding the growth rate, financing costs, and foreign exchange rates. Such acceleration may push up overall growth in the short run, but may lead in turn to an excessive build-up of capital stock that could precipitate an economic slowdown. Developments in asset prices, such as a more widely observed upturn in land prices, particularly those in major cities, may also increase private demand.

Turning to the outlook for the inflation rate, attention needs to be paid to factors that may cause the rate to deviate either upward or downward from the projection. The first factor is uncertainty regarding the sensitivity of prices to changes in the output gap. Wages and prices may face upward pressure if the output gap remains positive and continues to widen at a moderate pace with an accompanying increase in the expected rate of inflation. On the other hand, if productivity keeps rising and wage increases lag behind in spite of the prolonged economic expansion, there may be no upward shift in the inflation rate. The second factor is developments in the prices of crude oil and other commodities. There are substantial uncertainties in this regard which could cause prices to move in either direction. The third factor is the impact from the change in the potential growth rate. The potential growth rate of the Japanese economy seems to have been increasing in recent years. An increase in the potential growth rate generates downward pressure on prices from the supply side, whereas it may give rise to upward pressure on prices from the demand side via higher spending due to improved expectations regarding income and rates of return.

(Conduct of Monetary Policy)
In line with the new framework for the conduct of monetary policy released on March 9, 2006, the Bank assesses economic activity and prices from two perspectives, taking account of the "understanding of medium- to long-term price stability," and outlines its view on the future course of monetary policy.

The Bank first assesses the outlook that it deems most likely for economic activity and prices through fiscal 2007 with reference to the view of market participants regarding the future course of the policy interest rate -- a view that is incorporated in market interest rates. According to this perspective (the first perspective), Japan's economy is likely to continue expanding with domestic and external demand increasing. The year-on-year rate of increase in the CPI (excluding fresh food, on a nationwide basis) is expected to rise gradually through fiscal 2007, as the level of excess demand in the economy (the positive output gap) is increasing at a moderate pace and downward pressure from declining unit labor costs is weakening. In sum, Japan's economy is likely to achieve sustainable growth under price stability.

Next the Bank assesses the risks considered most relevant to conducting monetary policy, looking over a longer time horizon and taking account of the cost incurred should risks materialize, however improbable they might be. From this perspective (the second perspective), it can be seen that, with corporate profitability high and prices on a positive trend, the stimulative effect of monetary policy on economic activity and prices may be amplified. For instance, if the expectation takes hold that interest rates will remain low for a long time regardless of economic activity and prices, there is a risk in the medium to long term of larger economic swings, resulting in large fluctuations in the rate of inflation, channeled, for example, via financial and corporate investment activities. Meanwhile, there is also the downside risk that economic expansion and rising prices may stall. However, even in such a case, the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity seems small, since the Japanese financial system has regained stability and the economy has now cast off its excesses in production capacity, employment, and debt.

With regard to the future course of monetary policy, as a result of the assessment of economic activity and prices from the two perspectives described above, the Bank will adjust the level of interest rates gradually in the light of developments in economic activity and prices, while maintaining the accommodative financial conditions ensuing from very low interest rates for some time.

1 The text of "The Bank's View" was decided by the Policy Board at the Monetary Policy Meeting held on October 31, 2006.

2 This outlook for inflation is based on the 2005-base CPI. In August 2006, the CPI was rebased from a 2000 base to a 2005 base, and year-on-year figures back as far as January 2006 were revised retroactively. This rebasing caused the year-on-year rate of increase in the CPI from January 2006 to July to decline by around 0.5 percentage point on average. However, the difference between the 2000-base CPI and the 2005-base CPI is expected to decrease in the future, as most of the effects stemming from changing the calculation methods for, for instance, mobile telephone charges, will disappear after the first year. Given this, the basic view on the CPI in the current projection remains the same as that in the April projection, which was based on the 2000-base CPI.

3 Forecasts of the majority of Policy Board members are the figures to which the individual members attach the highest probability. They are shown as a range, with the highest and lowest figures excluded. It should be noted that the range does not indicate the forecast errors.

4 The forecasts of all Policy Board members are as follows.