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Recent Economic and Financial Developments in Japan
Summary of a speech given by Toshikatsu Fukuma, Member of the Policy Board, at a meeting with business leaders in Fukui on September 14, 2005
December 8, 2005
Bank of Japan
Contents
- I. Economic and Financial Developments
- II. The Bank's Conduct of Monetary Policy
- III. Conclusion
I. Economic and Financial Developments
A. Developments Overseas
1. Economic developments
I would like to begin first with the recent economic and financial picture, starting with developments overseas. There is economic expansion worldwide. Particularly noticeable is the rapid economic growth of China, a cornerstone of the so-called BRICs. International trade is growing every year supported by this worldwide economic expansion. Strong increases in energy sources and raw materials, such as crude oil, iron ore, and steel, and in machinery, are the main contributing factors. This indicates that demand for goods essential for the development of social infrastructure and natural resources, and for industrialization--such as steel, nonferrous metals, cement, machine tools, construction machinery, and plants--has been growing in many countries and regions, for example, India, the Middle East, Latin America, and central and eastern Europe as well as China.
2. Price developments
Commodity prices are surging both at home and abroad against the background of the worldwide economic expansion. Crude oil and other commodity prices are trading at record-high levels. Reflecting these high price levels upstream, producer prices down the line are also staying firm around the world.
Consumer prices are generally more stable around the world. This is largely due to the emergence of quantity suppliers of low-priced daily necessities including digital appliances, white goods, personal computers, cellular phones, and clothes in newly industrializing countries, China in particular. The rise of China is inflationary as far as upstream prices are concerned, but also tends to have a deflationary effect insofar as it contributes toward price stability downstream.
The entry of newly industrializing countries such as China into the global market has intensified international competition among firms. The fierce competition has made it difficult for the firms to pass on higher costs to end-product prices. Therefore, in order to maintain or expand profits, firms around the world are trying to make their way through globalization into regions enjoying economic growth, and also to contain and reduce their unit labor costs by increasing productivity through the use of IT or by restraining wages. As a result, there has been a slowdown in the rate of increase in unit labor costs around the world. It is such efforts as these that have made possible both economic expansion and price stability. There are, however, indications that unit labor costs may increase faster. Since the beginning of this year, consumer prices have been rising at a slightly quicker pace.
3. Immediate risk factors
a. Surges in energy and raw material prices
High crude oil prices are the center of attention around the world as an immediate risk factor to the world economy. In my speech in Yamanashi in February, I made the point that the impact of the economic growth of newly industrializing countries, such as China, on the global market economy may be compared, without exaggeration, "to an emergence of another globe." At that time, prices of energy and raw materials, particularly crude oil prices, were already heading upward, and their continuing rise can be attributed to increases in overall world demand outpacing supply capacity.
Expansion of supply capacity has been taking time. In some countries, development rights are not granted to foreign interests due to the rise of resource nationalism. Also, many firms are reluctant to take on the high risk and cost involved in resource development. This is because, despite the considerable amount of time and cost required from prospecting to commercial production, there is no guarantee that the current price level of a resource will be maintained into the future. Therefore, in order to realize economic growth in an environment of supply constraints, it is necessary to cut back on energy consumption, adopt alternative energies, and improve efficiency of resource and energy use through innovation in energy-saving technology.
The surge in energy and materials costs has resulted in an increase in the number of large projects facing cost overruns, a situation similar to that in the first oil crisis. If investment is withheld for reasons of unprofitability, the resulting supply constraint may exert downward pressure on the world economy as a whole, generating further inflationary pressure through bottlenecks created on the supply side.
b. The U.S. economy
As risk factors stemming from overseas, attention is being paid to developments in the U.S. and Chinese economies. In the case of the United States, the trend in housing prices and the impact of Hurricane Katrina are the main focus of attention. U.S. housing prices are continuing to rise due to increased availability of mortgages with significantly relaxed borrowing terms. It also appears that they are responsible, through the asset effect, for the firm trend in consumer spending. At present, those who regard the present situation as a bubble remain in the minority. The Federal Reserve Board, however, is taking a preemptive stance, with ten consecutive increases in the federal funds rate target and, more recently, repeated warnings against rising housing prices. It is well aware that a sudden fall in housing prices could cause serious problems for the U.S. economy as a whole. Memories are still fresh in the United States of the banking crisis triggered by the collapse in the real estate investment trust (REIT) market in the mid-1970s, and in the 1980s the savings and loan (S&L) crisis and the large amount of bad real estate loans that threatened the health of major financial institutions.
It is too early at this stage to gauge the full effect of Hurricane Katrina as the extent of the damage and of measures to be taken is not clear. There is no doubt, however, that the hurricane has dealt a heavy blow to the supply side of the U.S. economy by causing havoc in the coastal area of the Gulf of Mexico, with its major energy infrastructure, and the port of New Orleans, one of the largest ports in the United States. In the short term at least, it is a factor that will depress the economy while putting upward pressure on prices. In the medium term, however, reconstruction demand, once in full swing, should bring the U.S. economy back on its growth path.
c. The Chinese economy
With regard to China, the value of the renminbi, one focus of attention, has recently been raised by 2 percent against the U.S. dollar. However, this amount of revaluation is regarded as inadequate to rectify China's trade imbalance, and therefore, interest continues to center on the next move of the Chinese authorities. China currently suffers from serious shortages of gasoline, electricity, and water, frequent labor disputes, and rising wages and salaries. In the meantime, foreign direct investment is continuing to decline on a year-on-year basis. Since the driving force of the Chinese economy has been foreign direct investment, it is in everybody's interest for China to improve its investment environment, particularly the social infrastructure. It is also necessary to watch trends in China's oil imports since the expansion in its oil demand has played an important part in boosting crude oil prices.
B. Developments in Japan
1. The current economic situation and outlook
Turning to Japan, the economy is continuing to recover with internal and external demand well in balance. As a result, the output gap is also continuing to narrow. As for the outlook, the current pace of recovery is expected to continue. As of September 2005, the current recovery became the third longest since the end of World War II, having lasted for 44 months from January 2002. The continuing recovery is being achieved through the innovative initiatives of private firms without stimulative fiscal measures, and there is, therefore, reason to believe that this recovery is steady and sustainable.
Regarding production, capacity operation rates continue to be high for firms in heavy manufacturing industries such as steel, automobiles, ships, machine tools, construction machinery, and plants. They reflect favorable sales of Japanese automobiles, which boast high fuel efficiency and environment-friendly technologies, construction of infrastructure as well as the progress of industrialization in newly industrializing countries, and a busy flow of goods due to the expansion of international trade.
a. Business fixed investment
Taking a look at trends by demand components, business fixed investment continues to move upward in a wide range of industries. Looking at firms by size, small and medium-sized firms are increasing their investment along with large ones. Fixed investment by manufacturers is expanding for a number of reasons. First, the disposal of production facilities is well underway following the introduction of current value accounting and impairment loss accounting and wide acceptance of the policy of "selection and concentration" of business lines. Second, the production facilities at an increasing number of firms were obsolete and needed replacement. Third, firms felt an increasing need to respond to calls for the protection of the environment. And fourth, the continuation of high-capacity operation rates in heavy industry due to the economic expansion at home and abroad has put production capacity under strain. With regard to nonmanufacturing industries, fixed investment is growing to meet the increased demand for services in the areas of medical and nursing care, welfare, and education and also for the maintenance and expansion of communications and distribution networks.
At present, business fixed investment consists mainly of repair and maintenance of existing facilities. On a closer look, however, investment to raise capacity is also beginning to increase. The total value of business fixed investment is still low relative to cash flow. This indicates that firms have learnt from the experience of the bursting of the bubble economy and, due to stronger corporate governance, are no longer making fixed investment simply for the sake of winning market share. They now take into account the trends in business fixed investment by nearby countries such as China, South Korea, and Taiwan, and are studying return on investment before making investment decisions. This gives all the more reason to believe that the present rise in business fixed investment is sustainable.
b. Private consumption
Private consumption, both of goods and services, remains steady. The business conditions of all sectors related to personal consumption are trending upward, with online shopping also increasing sharply. The market scale of online shopping is now almost comparable to that of department and convenience stores. Expenditure on services, including medical and nursing care, and social welfare, has continued to expand over a long period of time and its growth, accompanied by the rise in employment, is considered to have helped reduce the extent of business fluctuations.
The strength in consumption comes on the back of improvement in employment and household income. Perception among firms of having excess labor has dissipated for the time being, and the effective ratio of job offers to applicants has recovered to its highest level in twelve years and nine months. Household income is increasing moderately. Other factors contributing to the rise in consumption include an increase in dividend payments; substantial capital gains from listings on stock exchanges of emerging companies, such as the Mothers section of the Tokyo Stock Exchange and the Hercules Market of the Osaka Securities Exchange; the incremental wealth effect from the strength in stock prices; and introduction of demand-creating new products through corporate endeavors in research and development, good examples being health foods, sales of which are booming, and white goods, which are continuing to show buoyant sales.
c. Exports
Exports are also recovering gradually. An interesting feature is the sharp increase in exports to the Middle East, Africa, and central and eastern Europe. As I mentioned earlier, this is due to the rise in exports to newly industrializing countries, which are building infrastructure and advancing industrialization. Orders received from overseas remain at high levels, thanks to the high quality and technology of Japanese products. As a result, exports are likely to continue to recover on a sustainable basis despite the fact that there are constraints on production capacity.
2. Corporate profits
a. Current trend
According to the Tankan (Short-Term Economic Survey of Enterprises in Japan) conducted in June, which surveyed about 10,000 companies throughout Japan, both manufacturers and nonmanufacturers expect their current profits for fiscal 2005 to increase for the fourth consecutive year. Data from the Financial Statements Statistics of Corporations by Industry for the April-June quarter released the other day confirmed that corporate profits are steadily increasing.
Corporate profits remain robust because firms have improved their profitability successfully by lowering their break-even point by means of eliminating excesses in three areas, that is, workforce, production capacity, and debt. The factors that have brought this about are the government's deregulatory reform, the efforts of the Industrial Revitalization Corporation of Japan to simultaneously revitalize the financial and business sectors, more effective corporate governance and internal control, the streamlining of laws relating to reorganization and revitalization of business and industry, and the shift to international accounting standards. Through a policy of "shrink to grow," the number of firms that have completed adjustment of balance sheets has been gradually on the increase for the past five years with the result that many firms are now in a position to take a forward-looking business stance. The profitability of Japanese firms now exceeds the level attained during the bubble years.
b. Innovation and globalization
Initially, Japanese firms' efforts to strengthen profitability centered on cost cutting. Specifically, they effectively applied IT to improve productivity, and extended outsourcing both at home and abroad. These unceasing rationalization efforts continue to this day. More recently, however, more positive means of increasing profits have been in evidence--innovation and globalization.
The domestic market for consumer goods is said to have reached the stage of maturity reflecting the progress of aging of the Japanese population coupled with the beginning of a decline in population. A growing number of firms, therefore, are intent on research and development in order to create a new demand and market for their new products, rather than wait for the market to come to them. Most firms that are highly competitive in the global arena and are enjoying a sustained profit increase are pondering their vision of themselves in five to ten years' time while concerned with increasing profits in the immediate future. They are free from complacency and are thinking ahead for further innovation.
As for globalization, Japanese firms' overseas sales as a proportion of total sales have recently been on an upward trend. According to a survey conducted by a newspaper company, the number of firms where the share of overseas sales accounts for 60 to 70 percent or even more of the total has also been increasing.
Globalization does not mean merely advancing into foreign markets. Taking a look at recent trends, all-purpose products with wide applications continue to be produced overseas in countries such as China, the factory of the world, but the production of "key devices" is increasingly being shifted back to Japan in order to protect know-how, sealed, as it were, in a black box. In order to maintain and enhance international competitiveness, Japanese firms are now constantly trying to build, both inside and outside of Japan, the development and production system best suited for the individual characteristics of products and a changing business environment. Looked at from this angle, I believe that Japanese firms' bid for globalization is gaining further momentum particularly through such efforts.
c. The birth of a new Japan
The long-standing tradition in Japan that values craftsmanship and the recent movement of overseas manufacturing back to Japan have both helped the manufacturing sector stay above 20 percent of gross domestic product (GDP) and to keep its relative balance with the service industry. Not a few Japanese manufacturers have continued to stay competitive with renewed efforts in research and development in areas from which their foreign counterparts have withdrawn. They are often rewarded with high profits. I believe that many of you among the audience can call to mind some very unique enterprises or ones that boast top or second place in terms of world market share, even if they are small or medium-scale in their size of operation.
Generally speaking, the rise of newly industrializing countries poses a threat to industrialized countries as it intensifies price competition, at the same time raising energy and materials costs. However, as I mentioned earlier, in the case of Japan, the rise of newly industrializing countries has led to an increase in its exports of products related to the construction of infrastructure, and the climb in energy and material prices has increased demand for Japanese automobiles and machinery that are superior in terms of energy saving. The rise of newly industrializing countries may be a threat, but it is also a factor beneficial to Japan's growth mechanism. There is no denying that Japan, surrounded by strong competitors such as China, South Korea, and Taiwan, finds itself in a region with the fiercest price competition in the world--a testing environment. However, persistent efforts in rationalization, innovation, and globalization are likely to result in higher international competitiveness of Japanese firms.
On top of these efforts, it is essential to strive to maintain high standards for both technology and manpower at the managerial level, the mainspring of Japanese competitiveness, if corporate profits are to be increased steadily. In addition, as business transcends national borders, firms need to adopt a system of global cash management in which the cash flows of consolidated overseas subsidiaries are concentrated and managed at the head office in Japan.
With regard to fostering skilled manpower, the increase of those among the young who avoid full-time regular jobs and those called "NEET" (not in employment, education, or training) has made it more difficult for firms to recruit workers with a level of knowledge and work motivation that satisfies their requirements. Faced with a certain decrease in population and progress in the aging of society, it is crucial that the mismatch in the labor market in respect of quality of available labor be resolved. With the job market currently taking a turn for the better, now is the time to implement measures to tackle this issue with renewed vigor.
To achieve this, it is necessary to rebuild the education and vocational training system to fit the new industrial structure, and develop personnel with a spirit of challenge, entrepreneurship, creativity, and social adaptability. Put another way, efforts need to be made to enhance the basic living skills of the younger generation. I have already mentioned the high value traditionally attached to craftsmanship in Japan. To reduce the impact that may result from "the year 2007 problem"--the mass retirement of baby boomers begins in 2007--there is a need to further improve the working environment for workers and technicians to maintain their morale and ensure that their technology and know-how are smoothly handed down.
As for global cash management, the recent string of corporate buyouts points to the need to increase corporate value by concentrating the entire cash flow under the control of the head office for its best-possible allocation to dividend payouts, share buybacks, repayment of bank debts, capital spending, launching new projects, or mergers and acquisitions. Such system of global cash management becomes particularly important with the advancement of globalization. To support and encourage such developments, I believe that a review of the overall tax system, including international tax agreements, may be in order.
3. Price developments
a. Domestic corporate goods prices
The year-on-year change in domestic corporate goods prices marked zero percent in January 2004, then steadily crept up to an increase of around 1.5 to 1.9 percent recently due to the rise in commodity prices both at home and abroad. Domestic corporate goods prices are very likely to remain on an upward trend given that a further increase in energy and raw materials prices is widely expected.
b. Consumer prices
The consumer price index (CPI), excluding fresh food, on a nationwide basis, has been declining slightly on a year-on-year basis due in part to special factors such as a reduction in telephone charges. As for the outlook, the CPI is likely to move into positive territory toward the end of 2005. In addition to the falling off of the effect of special factors, this is because of the improvement in the output gap which I mentioned earlier, and the surge in energy and raw materials costs, part of which will have to be passed on to the product prices.
Regarding the issue of changing the current framework of monetary policy and subsequent policy implementation, the Bank of Japan said in its Outlook for Economic Activity and Prices (the Outlook Report), released in April, that "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." With the environment for prices changing, whether upward pressure on prices will continue to be to a large extent containable will depend on energy and raw materials prices and also developments in unit labor costs which I touched upon earlier.
4. Financial developments
a. Extremely easy conditions in corporate financing
The financial environment is extremely accommodative and to an extent similar to conditions during the bubble era, with the diffusion index (DI) for the financial position of firms in the Tankan survey recovering to its highest level since the November 1990 survey.
The improvement can be attributed in the main to ample cash flow stemming from continued strength in corporate profits. In addition, there has been an upward trend in business-to-business credit, also a result of improvement in financial positions. Furthermore, the credit spread, the differential due to firms' differing levels of creditworthiness, has diminished substantially, with firms with relatively low credit ratings now able to procure funds at reduced rates. The lending attitude of financial institutions has also become more accommodative as they are ready to take risks. They are more able to take risks than previously as a result of progress in disposing of nonperforming loans (NPLs) and the consequent rise in their credit ratings. The year-on-year rate of growth in the amount outstanding of bank lending, which had been decreasing for a long time, is up slightly for the present over a year ago. Lending by regional banks is showing a gradual increase lately.
The NPL problem had an extremely large impact on corporate financing. This is evident in the lending attitude of financial institutions, which tightened visibly at the height of the NPL problem during the financial crisis of 1997-98, and also in 2002, when the government announced the Program for Financial Revival. During these periods, firms generally found it extremely difficult to procure external funds as evident from the financial position DI of the Tankan survey.
b. Shift from saving to investment
I mentioned that the risk-taking ability of financial institutions has improved. The same can be said of firms and households. The year 2003 was a turning point when both firms and households began to increase holdings of assets with greater risk. This shift from saving to investment has resulted from the long period of the zero interest rate environment and the recent rise in the expectation for overcoming deflation.
c. Stock and bond markets
Let us now look at capital markets. The stock market has been displaying further strength after the Nikkei 225 Stock Average broke through a resistance line at 12,000 yen. Foreign investors are the major force behind the buoyant market. They have not forgotten the pessimism that prevailed in the market a couple of years ago, but have since noted the improvement in the return on equity of Japanese firms, the continued increase in reported profits, and improvement in balance sheets in general. In addition, with the advance of the market, investment trusts and other domestic investors began to buy on market declines as they came to realize there was a risk in not holding stocks.
Long-term interest rates (the yield on the 10-year benchmark government bond) have shown small fluctuations, staying within the range previously established. This reflects the economic fundamentals, such as the gradual economic recovery and the stability of prices, government fiscal rehabilitation measures, and the stability of long-term interest rates in Europe and the United States.
II. The Bank's Conduct of Monetary Policy
Now, I will turn to the Bank's current monetary policy.
A. The Framework of the Quantitative Easing Policy
Let me begin with a brief explanation of the framework for the quantitative easing policy. The Bank introduced the current quantitative easing policy in March 2001, when there was growing anxiety that the economy might fall into a deflationary spiral. The policy framework of quantitative easing has been maintained with the Bank's firm commitment to provide ample liquidity to the money markets until the year-on-year rate of change in core consumer prices registers zero percent or higher on a sustainable basis. Under this framework, the uncollateralized overnight call rate, which was previously the main operating target for money market operations, will be generally maintained at around zero percent. Here, I would like to emphasize that the Bank provides the following two clear-cut conditions for terminating the quantitative easing policy. First, the Bank needs to make sure that not only the most recently published core CPI registers zero percent or above, but also that this tendency is confirmed over a period of a few months. Second, a majority of Policy Board members need to make forecasts that the core CPI will register above zero percent during the forecasting period of the Outlook Report. The Bank adds that there may be cases where it will judge it appropriate to continue with the policy even if these two conditions are fulfilled.
B. The Bank's Current Monetary Policy Stance
In providing ample liquidity to the market, the Bank has had the outstanding balance of financial institutions' non-interest-bearing current accounts at the Bank as its main operating target. Since January 2004, the Bank has been conducting market operations maintaining a target of around 30 to 35 trillion yen. From around fall 2004, however, undersubscription has occurred repeatedly in the Bank's funds-supplying operations. The term "undersubscription" refers to a situation where the aggregate bids of financial institutions fall short of the Bank's offers--in other words, the Bank cannot supply the amount of funds it initially intended. For example, since the October-December 2004 quarter, an increasing number of cases of undersubscription has been observed in outright purchase of bills, which is the Bank's main instrument for funds-supplying operations, and the bid-to-cover ratio has often gone below one. In this situation, the Bank took various measures to stimulate demand for its money market operations. Specifically, the Bank has been gradually increasing the duration of short-term funds-supplying operations. In addition, in May this year, the Bank decided to amend the proviso in the guideline for money market operations by adding a new sentence.
Let me explain more about this amendment of the proviso. The added sentence says that the Bank will allow the balance of current accounts to fall short of the target in cases when liquidity demand is judged to be exceptionally weak. This decision reflects the Bank's intention to facilitate smooth implementation of the quantitative easing policy by enabling the Bank to give due consideration to the functioning of the market mechanism. The Bank wants as far as possible to avoid undermining the market mechanism, and this has been the precondition in conducting policy to maintain the current target range including the enhancement of its money market operations. When financial institutions' liquidity demand is declining substantially and the Bank judges that a market operation to keep the outstanding balance of current accounts within the target range might undermine the market mechanism, the Bank will not conduct it. In such cases, amendment of the proviso allows the Bank to accept the balance of current accounts falling short of the target range.
Let me elaborate on what the Bank means by saying that it will as far as possible not undermine the market mechanism in conducting the quantitative easing policy. The Bank has been paying close attention to avoid hindering the functioning of the market mechanism through its policy. This is because the Bank cannot gain market information necessary for formulating policy measures if the market mechanism does not function properly, and that would make it difficult for the Bank to implement policy measures smoothly and flexibly. Today, financial institutions have started financing autonomously in the market as evident from an increase in call transactions, and the situation has completely changed from the time when there was serious concern about financial system stability and the market mechanism had stopped functioning. It is the Bank's responsibility to further encourage the market initiative in restoring the proper functioning of the market.
C. Lowering the Target Range for the Outstanding Balance of Current Accounts at the Bank
In the current financial situation where consumer prices have been declining slightly on a year-on-year basis, I think it is essential to maintain the framework of the quantitative easing policy and continue providing ample liquidity to the market, to keep the uncollateralized overnight call rate stable at around zero percent. Let me add that all nine members of the Policy Board share this view.
Since this April, however, there have been various opinions among the members regarding the target for the outstanding balance of current accounts at the Bank. The majority of members have been proposing that the Bank continue the current money market operations with the target range for the outstanding balance of current accounts at the Bank from around 30 to 35 trillion yen. At the Monetary Policy Meeting (MPM) held in August, two members, including myself, opposed this. Both of us advocated a lowering of the target range. Although my ideas have already been released in the minutes of the meeting, I would like to take this opportunity to explain the main points of my proposal.
1. Decline in financial institutions' precautionary demand for funds
Ever since the first MPM held after the full removal of the government's blanket deposit insurance in April 2005, I have been reiterating that the Bank should lower the target range for the outstanding balance of current accounts at the Bank from around 30 to 35 trillion yen to around 27 to 32 trillion yen. Let me briefly explain why I have been proposing this. Financial institutions' precautionary demand for funds has been decreasing recently, due to a further decline in their anxiety about the financial system stability. In this situation, any excess funds held in the Bank's current accounts should be reduced. If the Bank fails to pay due consideration to changes in the financial system and maintains the same target range, I think negative effects of the quantitative easing policy will outweigh its positive effects. And I believe that the Bank can support Japan's economy from the financial side even in cases where it lowers the target balance--by underpinning sustainable economic growth, and preventing the recurrence of deflation--as long as the uncollateralized overnight call rate stays at around zero percent under the framework of the quantitative easing policy.
As I mentioned earlier, the Bank has been observing frequent undersubscription in its market operations since fall 2004, reflecting the decrease in financial institutions' precautionary demand for funds. Financial institutions' non-interest-bearing current accounts at the Bank had been kept well above the required level of reserves because they judged it necessary to secure a sufficient amount of cash when there was serious concern about financial system stability, so that they could withdraw whenever necessary in order to avoid liquidity risk materializing.
More recently, concerns about financial system stability have finally subsided. Substantial progress in disposing of Japanese banks' NPLs and the resultant upgrading in their ratings contributed to this change in the financial environment, which is evident from foreign banks' expansion of credit lines to Japanese banks; the fall in the "Japan premium"; and an increase in interbank transactions. With this change in the financial environment, financial institutions have had less need to deposit precautionary liquidity in their current accounts at the Bank. This explains why undersubscription in the Bank's market operations has been occurring more frequently.
2. Increase in demand for funds-supplying operations based on the change in interest rate prospects
I would like to comment on the most recent situation regarding the outstanding balance of current accounts, which has generally been maintained within the target range. Undersubscription has been decreasing in the Bank's funds-supplying operations, especially those with long-term maturities. Moreover, there has been a surplus of funds kept in current accounts due to seasonal factors. I sense that there has been a growing tendency among financial institutions to secure their funds while bid rates are still at low levels, because money market rates have been on the rise and the interest rate differential between bid rates and money market rates is spreading. The rise in money market rates indicates a change in interest rate prospects in the market reflecting an improved perception of the future outlook for the economy based on recent positive developments in prices and the economy. The change in interest rate prospects is evident from the steepening of the forward rate curve of money market rates.
3. Negative effects of maintaining the target range
In short, maintaining the target range for the outstanding balance of current accounts at the Bank is not as difficult as before. However, with the economy continuing to recover and the CPI likely to move into positive territory, I think that there are two major negative effects of maintaining the target range at a level which is significantly higher than the amount of reserves required of financial institutions. First, in a situation where bid rates in the Bank's market operations have been kept low by the Bank's provision of a massive amount of funds to the market, the rise in money market rates on term instruments supported by the improvement of fundamentals will further widen the interest rate differential between bid rates and money market rates. Second, maintaining the target range could increase interest rate risk in the future. Indeed, the Bank has been providing a huge amount of funds to the market, and the monetary base, which consists of the outstanding balance of current accounts at the Bank and that of banknotes issued, has been at an unprecedentedly high level relative to the size of economic activity.
a. The importance of continuing communication with market participants during the process of restoring the proper functioning of the market
With regard to the interest rate differential between bid rates and money market rates, it is important for the Bank to continue communication with market participants in order to create an environment in which interest rates are formed more naturally through the proper functioning of the market. The Outlook Report released in April 2005 indicated that the possibility of a change from the current framework of the quantitative easing policy will gradually increase over the course of fiscal 2006, and therefore, the maturities of funds-supplying operations needed to be as short as possible. But under the current framework, the target range of around 30 to 35 trillion yen has been kept, and thus, the balance of current accounts is restored as soon as possible whenever it falls short of the target. For this reason, I think that amendment of the proviso has only limited effectiveness as a means of preventing the extension of the maturity of its funds-supplying operations. This is the first reason why I have proposed that the Bank should lower the target range.
b. Reducing interest rate risk in the future
Ten years have passed since the Bank lowered the official discount rate from 1.0 percent to 0.5 percent. I think that maintaining the current target range for the outstanding balance of current accounts at the Bank could cause excessive risk taking based on unrealistic expectations that the current extremely accommodative conditions will continue for a very long time. This could in turn increase interest rate risk in the future. The Bank should reduce these risks to ensure the smooth conduct of monetary policy while maintaining the stability of financial markets.
D. Conducting Monetary Policy at a Gradual Pace, Not in a Rush
Policy Board members will discuss the future conduct of money policy based on a careful examination of the economic and financial situation at each MPM. I would like to stress that, as I said at the MPM in May, it is important to conduct monetary policy at a gradual pace, not in a rush. This is because market participants at home and abroad must have accumulated large positions during the long period of the zero interest rate policy, assuming that interest rates will remain at zero percent for some time longer. As I mentioned earlier, quoting the Outlook Report, the possibility of a change from the current framework of the quantitative easing policy will gradually increase over the course of fiscal 2006. In the actual process of changing the framework of the quantitative easing policy to an interest rate policy, we must go at a gradual pace, not in a rush. Keeping the current policy framework regardless of changes in the financial environment is a risk, but I believe that a radical policy shift is also risky.
III. Conclusion
I think it is appropriate to continue monetary easing for the time being in order to establish a more solid foundation for sustainable economic growth without inflation, as long as fiscal consolidation, which has become the nation's primary concern, proceeds steadily and fiscal discipline is maintained. Maintaining financial market discipline is a precondition for achieving this. Excessive monetary easing unsuitable for the economic and financial situation could increase interest rate risk in the future, which could eventually cause us to fail to establish the foundation for sustainable economic growth without inflation.
For all these reasons, I think it is appropriate for the Bank to maintain the quantitative easing policy framework to anchor the uncollateralized overnight call rate near zero, while reducing the quantity of funds it provides to the market. I believe that such a double-edged stance best suits the current economic and financial situation. Given the continuing historic high in crude oil prices, it is challenging for the Bank to conduct an easy monetary policy. To support the Bank's pursuit of such a narrow path, I shall strive to be courageous and knowledgeable. At the same time, I believe that communication with the public such as through this meeting is critically important for me to make an accurate analysis of the economy and prices, which is a basis of monetary policymaking.