Summary of a speech given by Tadao Noda, Member of the Policy Board, at a meeting with business leaders in Nara on July 26, 2007

September 28, 2007
Bank of Japan

Contents

1. Introduction
2. I. The Current State of and Outlook for Japan's Economy and Prices
   1. A. Current and Future Developments
   2. B. Key Factors in Projecting the Future Course of the Economy
3. II. The Future Conduct of Monetary Policy
   1. A. Financial Markets after the Policy Change in February 2007
   2. B. The Framework for the Conduct of Monetary Policy and the "Understanding of Medium- to Long-Term Price Stability"
   3. C. Policy Conduct in the Future
4. III. Challenges for Japan's Economy in the Longer Term: Population Aging and the Declining Birthrate
5. Closing Remarks

Introduction

Today, I would like to start by discussing the current state of Japan's economy and prices based on the Outlook for Economic Activity and Prices , or the Outlook Report, released in April 2007, and would also like to refer to the interim assessment made at the Monetary Policy Meeting (MPM) in July.  The Outlook Report, which is a semiannual report released every April and October after the decision at MPMs, makes public the Bank's outlook for economic activity and prices.  Every July and January, the Bank conducts an interim assessment of the outlook presented in the preceding Outlook Report.  The Outlook Report represents the majority view of the nine Policy Board members.  Today, I would like to discuss the current state of and outlook for Japan's economy based on the Outlook Report and talk about the Bank's future conduct of monetary policy and also my own views as one of the Policy Board members.

I. The Current State of and Outlook for Japan's Economy and Prices

A. Current and Future Developments

1. The current situation: Moderate economic expansion

First, let me briefly talk about recent developments in the economy and prices.

Our view is that Japan's economy is expanding moderately.  Exports have continued to increase against the background of a continuing expansion of economies overseas.  Domestic private demand continues to be solid, although the pace of improvement in the household sector has been somewhat slow relative to the strength of the corporate sector.  Japan's economy as a whole has evolved broadly in line with the basic scenario of the economic outlook presented in the April 2007 Outlook Report.¹

Japan's real GDP growth rate for the January-March quarter of 2007, released in June, was above 3 percent on an annualized quarter-on-quarter basis, marking continued high growth following the preceding October-December quarter, when the growth rate was above 5 percent.² Recent developments of demand components are as follows.  Net exports have continued their upward trend.  Private consumption has been firm along with the improving employment and income situation: after showing a temporary weakness in the July-September quarter last year due mainly to unfavorable weather conditions and consumers' reluctance to buy before the introduction of new products, consumption resumed its upward trend in the October-December quarter and continued to increase in the January-March quarter this year.  Business fixed investment, whose quarter-on-quarter growth slowed in the January-March quarter, seems to be increasing steadily against the background of high corporate profits and ample cash flows,³ as suggested by the June Tankan.⁴ Production as a whole has been on an increasing trend against the background of growth in domestic and external demand, despite some adjustments in production of IT-related goods and automobiles.

With regard to prices, domestic corporate goods prices have continued to increase, mainly due to the rise in international commodity prices, and corporate services prices have been rising gradually.  The year-on-year rate of change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) has recently been around 0 percent, mainly because the pace of increase in prices of petroleum products has slowed and prices of durable consumer goods have continued to fall.  The recent developments in the CPI are consistent with the basic scenario presented in the April Outlook Report, but prices of general services, such as housing rents and cellular phone charges, have been somewhat weaker than expected.

2. Outlook: Sustainable growth of the economy and the upward trend in prices

Turning to the outlook, we expect that Japan's economy is likely to continue its sustained expansion with a virtuous circle of production, income, and spending in place.  The majority view of the nine Policy Board members in the April Outlook Report is that real GDP was likely to register a growth rate of around 2 percent -- which is somewhat higher than the potential growth rate⁵ -- in both fiscal 2007 and fiscal 2008.⁶

Our basic thinking regarding the outlook for economic activity and prices has not changed much from the projection.  The outlook presented in the April Outlook Report rests on the following underlying assumptions and mechanisms.  First, exports are likely to remain on the increase, reflecting the continuing expansion of overseas economies.  Second, with corporate profits continuing to be high, business fixed investment is likely to keep rising, although it is likely that its rate of growth will fall gradually.  Third, it is expected that the positive influence of the strength in the corporate sector will continue to feed through into the household sector slowly but steadily via various channels such as increases in employee income and dividends.  And fourth, the extremely accommodative financial conditions are likely to continue to support private demand.

We also expect that prices will maintain their moderate upward trend.  Given the economic outlook I have outlined, the level of resource utilization, namely of production capacity and labor, is likely to rise further.  Although unit labor costs are currently still declining, they are likely to stop falling and start showing modest increases once wages start to rise noticeably.  In addition, it should be noted that the results of various surveys suggest that households have shifted up their inflation expectations again.⁷

Our view on price developments is that the year-on-year rate of change in the CPI is likely to be around 0 percent in the short run but will gradually rise in the longer run.  According to Policy Board members' forecasts of the year-on-year rate of increase in the CPI in the April Outlook Report, the rate of change is expected to rise at a very moderate pace from around 0 percent in fiscal 2006 to slightly above 0 percent in fiscal 2007 and then to around 0.5 percent in fiscal 2008.⁸

1. 1The forecasts of the majority of Policy Board members for fiscal 2007 in the April Outlook Report are as follows: the year-on-year rate of change in real GDP is expected to be in the range between 2.0 and 2.1 percent with a forecast median of 2.1 percent, and that in the CPI (excluding fresh food, on a nationwide basis) is expected to be in the range between 0.0 and 0.2 percent with a forecast median of 0.1 percent. Forecasts for fiscal 2008 are as follows: the year-on-year rate of change in real GDP is expected to be in the range between 2.0 and 2.3 percent with a forecast median of 2.1 percent, and that in the CPI is expected to be in the range between 0.4 and 0.6 percent with a forecast median of 0.5 percent.
2. 2More specifically, in the January-March quarter, Japan's real GDP grew by 0.8 percent on a quarter-on-quarter basis and 3.3 percent on an annualized quarter-on-quarter basis, respectively, compared to 1.3 percent and 5.4 percent, respectively, in the October-December quarter. This means that Japan's economy continued to grow at a fast pace, although somewhat slower. While business fixed investment did not contribute to the quarter-on-quarter growth in the January-March quarter, both private consumption and net exports contributed greatly, by 0.4 percentage point (0.6 percentage point in the previous quarter) and 0.5 percentage point, respectively.
3. 3The June Tankan shows that the growth rate of current profits of firms of all industries and sizes for fiscal 2007 is expected to be at around the same high level as in the previous year, when it was about 10 percent. The ratio of current profits to sales for fiscal 2007 is expected to be 4.16 percent, which is close to the record high of 4.26 percent registered in fiscal 2006. Business fixed investment of firms of all industries and sizes for fiscal 2007 is likely to be higher than in fiscal 2006, when it increased by nearly 10 percent.
4. 4The Tankan, which is an abbreviation for Tanki Keizai Kansoku Chousa (Short-Term Economic Survey of Enterprises in Japan), aims to provide an accurate picture of corporate activity in Japan, thereby contributing to the appropriate conduct of monetary policy. The Tankan is a nationwide business survey that covers overall corporate activity and is conducted on a quarterly basis (in March, June, September, and December). It consists of two parts: one is an opinion survey on firms' current and future business sentiment, and the other is a quantitative survey of firms' business activities and plans.
5. 5The Bank's estimate of Japan's current potential growth rate is around 1.5 percent or somewhat higher. Any estimate of the potential growth rate, however, is subject to a certain margin of error and varies over time depending on changes in the economic structure and the pace of technological innovation, and it may therefore be revised retroactively as new data become available.
6. 6See Footnote 1.
7. 7For example, according to the June 2007 issue of the Opinion Survey on the General Public's Views and Behavior, a public opinion poll conducted by the Bank, about 70 percent of respondents expect that prices will be higher a year later. With regard to the pace at which prices are projected to increase, the average is 4.5 percent, slightly higher than 3.0 percent in the previous survey conducted in March 2007. In the Cabinet Office's Consumer Confidence Survey conducted in June 2007, 66.6 percent of respondents answered that prices will "go up" in a year ahead, up 2.6 percentage points from the survey conducted in June 2006.
8. 8See Footnote 1.

B. Key Factors in Projecting the Future Course of the Economy

Japan's economy is expanding steadily as I have outlined earlier, but there remain some upside and downside risks to the outlook for Japan's economy through fiscal 2008.  In what follows, I will briefly touch upon the key factors in projecting the future course of the economy.  Let me add, however, that I do not think that these risks are very likely to manifest themselves.

1. Overseas economies: Is the U.S. economy really firm?

As we have seen, so far the global economy has been firm on the whole.  Despite the ongoing adjustment in the housing market, it is still widely expected that the U.S. economy is headed for a soft landing.  Not only strong European and East Asian economies, but also resource-producing economies such as those in the Middle East and South America as well as Russia, are expected to contribute to global economic growth, offsetting the deceleration of the U.S. economy.  Overseas economies, taken as a whole, are thus expected to keep expanding with momentum being gained across a wide range of economies.⁹ Nevertheless, I am concerned about developments in the U.S. economy, since the United States carries the greatest weight in Japan's exports and has the most significant influence on the global economy.

The key factor for future developments in the U.S. economy is private consumption, which accounts for about 70 percent of GDP.  Although the pace of growth is decelerating due to the rise in gasoline prices, private consumption has been firm, underpinned by factors such as the robust employment situation and a rise in stock prices.  As for the outlook, however, consumption growth may decelerate further due to a decline in wealth effects resulting from the weakening U.S. housing market, which is unlikely to recover in the near future, and to a further rise in long-term interest rates.  In the housing market, recent data suggest that the market continues to be sluggish, and the subprime mortgage problem, that is, the increase in nonperforming mortgage loans with high interest rates, remains.  It is widely believed that the effects of these developments in the housing market on the overall economy and the financial system are likely to be limited, but the housing market continues to require careful monitoring as it may take longer than expected to recover.  Business fixed investment has finally started to show signs of recovery, but it is not as strong as before and therefore continues to require attention.

Furthermore, there remains the possibility that inflation expectations may strengthen, since high levels of resource utilization, namely in production capacity and labor, continue to be observed in the United States.  Looking at various price indices, the year-on-year rate of change in the core CPI and the personal consumption expenditures (PCE) deflator have been declining gradually.  However, as the unemployment rate remains low and unit labor costs remain high, inflation pressures from wages have yet to be contained.  In this situation, it seems that the Federal Reserve continues to be concerned about inflation.  In the course of adjustments in the U.S. economy in line with the soft-landing scenario, we must continue to keep in mind the risk that if markets start to think that the Fed is falling behind in containing inflation pressures, this may result in a further rise in long-term interest rates, which in turn may adversely affect the global economy, for instance through the reaction of financial markets.

2. Private consumption: Has private consumption really been recovering?

Next, I will talk about developments in private consumption in Japan.  We expect that, in the future course of economic expansion, the positive influence of the strength in the corporate sector will continue to feed through into the household sector slowly but steadily.  Private consumption has been recovering steadily from the weakness last summer.  In this context, some market participants seem to be expecting that, against the background of increases in employee income, private consumption will increase sharply and take the place of business fixed investment and net exports as the driver of economic growth.  In my opinion, however, private consumption is not likely to increase substantially but to follow the current extremely moderate upward trend.

As for recent developments in employment conditions, the number of employees has been increasing steadily at a rate around 1.5 percent from a year earlier, reflecting the strength in the corporate sector.  Given the declining trend in the working-age population, it seems inevitable that even if the labor force participation rate rises, continuing increases in the number of employees in the longer run will lead to a further tightening of labor market conditions.  Business surveys such as the Tankan suggest that firms are increasingly feeling a shortage of labor.  The unemployment rate has been on a declining trend, and the ratio of job offers to applicants has been exceeding 1.00.

Nonetheless, growth in wages has been sluggish.  The statistics indicate that the year-on-year rate of change in nominal wages per worker has been negative since December 2006.  We expect that in due time the steady tightening of labor market conditions will eventually lead to a clear rise in wages, such as regular payments, against the background of the lengthening of the economic expansion.  However, up to now, increases in employee income overall have manifested themselves primarily in increases in the number of employees.

The main reason for the sluggish growth in wages seems to be the strong labor cost restraint by firms.  In the context of the globalization of Japan's economy and with a view to maintaining their competitive edge, firms have been extremely cautious about raising wages, which are already high by international standards.  Although the decline in the labor share of income has been leveling off, there are also no signs of increases in the labor share of income; this is particularly the case in the manufacturing sector, which is subject to global competition.  Other possible reasons for the sluggish growth in wages include the following: the change in the age structure of the workforce, that is, the increase in the number of younger workers receiving relatively low wages who are replacing retired baby-boomers; the increase in the number of workers with shorter working hours such as reemployed workers and part-time workers; and a reduction in the salaries of local government employees.

If, given the aging of the population and the decline in the birthrate, the tightening of labor market conditions continues for a while, then at some point the supply of workers should be exhausted, leading to a clear increase in wages.  In reality, however, the increased demand for labor has been met through a diversification of labor supply, including, for example, the move into employment by the formerly self-employed, the continuation of or return to work by the elderly, an increase in the female labor force participation rate, and a decrease in unemployment.  Therefore, for the time being, it is unlikely that a bottleneck in the supply of workers will form suddenly.  As I mentioned earlier, firms, especially manufacturers -- the main engine of the current economic expansion -- are likely to remain cautious about wage raises, which would increase in their fixed costs, as they are sensitive to global competition.  Therefore, it seems appropriate to be conservative in forecasting private consumption and assume that it is likely to increase only moderately, at a rate more or less equivalent to the rate of growth in household income, namely, the sum of employee income -- the product of the number of employees, which continues to increase, and the nominal wage per worker, which is sluggish -- and property income such as dividends.

3. Price situation: Will the CPI start increasing in the near future?

We expect that prices will basically continue to increase at a marginal pace.  The June Tankan indicated that firms continued to judge production capacity and labor to be the tightest since the bubble era.  In line with this, the utilization of resources such as production capacity and labor has been rising steadily.  According to our estimation, the output gap of the economy, or the GDP gap, which is one of the gauges of the level of pressure on prices from resource utilization, has recently been marginally positive, although there may be a certain margin of error.  In other words, aggregate demand has exceeded aggregate supply, indicating a situation in which prices tend to rise as the economy continues to expand.  We also expect the positive output gap to widen gradually over time, as the economy is likely to expand at a rate slightly higher than the potential growth rate.  If this is the case, wages and prices will basically continue to face upward pressure, with an accompanying increase in the expected rate of inflation.

However, the year-on-year rate of change in the CPI has been at around 0 percent, and it cannot be denied that there is an inconsistency between the developments in the CPI and the economic situation, or the output gap.  In other words, the CPI has not started to increase noticeably despite the fact that the economy has continued to expand steadily, and therefore, the outlook for the CPI is becoming increasingly uncertain.

There are several factors that are responsible for the uncertainty regarding the sensitivity of the CPI to changes in the output gap.  One of these is that, with the ongoing globalization of Japan's economy, firms are facing greater competition from low-priced products, mainly consumer goods, manufactured in China and other Asian countries.  Therefore, there seems to be a growing tendency for the domestic supply and demand situation to be not necessarily reflected in price developments.  Another factor is, as I said earlier, that Japanese firms have been cautious about raising domestic labor costs in view of maintaining their competitiveness, and this has been restraining upward pressure on unit labor costs.  In addition, deregulation has also increased competition among firms, pushing down prices of some products.

When looking at price indicators to assess the price situation, I focus on the underlying tendency of prices, in other words, the fundamental inflation pressure and its trend.  When judging the trend of the CPI, I examine various CPI data comprehensively.  Those data include not only the headline CPI and the core CPI, which is the headline CPI excluding fresh food, but also the following: the CPI that further excludes items whose price tends to fluctuate greatly -- such as petroleum products, including gasoline and kerosene -- and items whose price is fluctuating temporarily due to institutional or other special factors; the trimmed mean of the CPI, which excludes the highest rises and declines in prices of items by a certain percentage;¹⁰ and the difference in the number of items showing a rise and a decline in their prices.  I think it is important to examine these data and understand the trend of price indices in order to make a forward-looking monetary policy judgment.

Developments in the global economy -- with which, as mentioned earlier, the current low-inflation environment in Japan is closely connected -- are also a factor affecting longer-term price developments in Japan.  If emerging economies such as China and India continue to expand rapidly and thus the global output gap continues to tighten for a long period of time, stronger-than-expected inflation pressure may arise on a global basis.  In such a case, Japan's economy will also be subject to inflation pressures, and therefore we should bear this in mind.

For the same reason, developments in the prices of crude oil and other commodities also continue to warrant attention.  It is difficult to project their future developments, but considering the magnitude of their impact on general prices, developments in commodity prices are a factor that continues to need to be taken into account in projecting the future course of prices.

4. Financial environment: Are Japanese firms too optimistic about future prospects?

Now I would like to talk about the environment for corporate finance.  Japan's current economic circumstances are such as potentially to encourage assertive financial and economic activity, with the financial positions of both firms and financial institutions improving and real interest rates remaining very low.  Firms may ease their cautious stance with respect to business management against the background of strong profits and may further accelerate investment.  I do not think that firms will accelerate investment based on overly optimistic projections of future profitability and easily abandon their cautious stance of evaluating investment profitability carefully, which they have adopted in light of the bitter experience in the recent past of an excessive buildup of capital stock.  However, if firms, with the aim of strengthening their growth strategies, have become more assertive in their financial and economic activity based on optimistic assumptions regarding future profitability, such as favorable assumptions concerning the expected growth rate, financing costs, foreign exchange rates, and asset prices, including stock prices and land prices, they may become overextended in financial markets or pour funds and other resources into inefficient economic activities, and the result could well be a misallocation of resources in the long run.  Such behavior may lead to a temporary upswing in overall economic growth and cause later downward adjustments and hamper the sustainability of economic growth.

Particularly in the current recovery phase, firms have, for a long period of time, enjoyed economic and financial conditions more favorable than they had expected: (1) financial markets, including capital and foreign exchange markets, have generally been on steady trends that are comfortable for firms; (2) the economic expansion has been sustained for the longest time ever; and (3) accommodative financial conditions have continued for a considerable time.  I am concerned that these favorable conditions may cause firms to have an overly optimistic view regarding future prospects and as a result (1) discourage firms' efforts to be innovative to enhance productivity and (2) reduce resilience against significant shocks to financial markets or the economy.  I think this potential risk should continue to warrant close attention, although economic data, including the June Tankan, have not so far shown any signs that an increasing number of firms are becoming overly optimistic about future prospects.

1. 9According to the World Economic Outlook released by the International Monetary Fund (IMF) in April 2007, the global economy is projected to continue growing at a high rate of 4.9 percent in both 2007 and 2008, unchanged from the forecast made in September 2006.
2. 10Specifically, the trimmed mean of the CPI is calculated as follows. First, items comprising the CPI are put in order of the rates of change in their prices. Then, some items with the largest and smallest rates of change are excluded until items of a certain weight in the CPI basket (e.g., 10 percent) are excluded. Finally, the weighted average of the remaining items is calculated.

II. The Future Conduct of Monetary Policy

A. Financial Markets after the Policy Change in February 2007

Now I will briefly touch on developments in financial markets after the policy change in February this year and will then go on to explain the Bank's future conduct of monetary policy.

The Bank terminated its quantitative easing policy in March 2006 and brought the zero interest rate environment to an end in July of the same year.  Then, in February 2007, it raised the policy target rate -- the uncollateralized overnight call rate -- from "around 0.25 percent" to "around 0.5 percent."  As the series of policy changes following the prolonged period of quantitative easing and the zero interest rate environment could have had a significant effect on financial conditions, the Bank paid close attention to developments in financial markets after these policy changes.  Overall, no major disruptions were observed and the policy changes seem to have been digested smoothly.

In the money market, although call and repo rates increased immediately before the fiscal year-end in March 2007, this was a temporary phenomenon and the functioning of the money market showed a steady recovery as evidenced by stable increases in trading volume.

Developments in bond, equity, and foreign exchange markets also suggest that market participants calmly accepted the policy changes, reflecting the fact that most market participants had expected the policy changes, which therefore had already been factored into market prices.  There were sharp declines in global asset prices twice: stock prices fell in February and bond prices in June.  However, both times, prices rebounded and regained stability thereafter.  Meanwhile, in foreign exchange markets, the real effective exchange rate has fallen to levels as low as those before the Plaza Accord in 1985.  What worries me about these market developments is that market participants have grown accustomed to such adjustments in the markets and may have become overly optimistic, believing that there will not be a collapse in the markets, and thus have accumulated extremely large positions.

B. The Framework for the Conduct of Monetary Policy and the "Understanding of Medium- to Long-Term Price Stability"

In March 2006, the Bank made public its basic thinking behind monetary policy decisions at MPMs in the "New Framework for the Conduct of Monetary Policy" with the aim of ensuring the transparency of monetary policy.

Under this framework, the Bank decides monetary policy based on its assessment of economic activity and prices from "two perspectives" -- which I will explain later -- taking into account the "understanding of medium- to long-term price stability" (hereafter "understanding"), that is, the rate of inflation that Policy Board members consider to be consistent with price stability from a medium- to long-term viewpoint.

We consider price stability as a state where various economic agents, including households and firms, can make decisions regarding economic activities such as consumption and investments without being concerned about the fluctuations in the general price level.  Price stability is an indispensable prerequisite for achieving sustainable economic growth.  The "understanding" is reviewed annually, and the first review was conducted in April this year.  As was the case a year earlier, it was agreed that the "understanding," expressed in terms of the year-on-year rate of change in the CPI, takes the form of a range approximately between 0 and 2 percent, with most Policy Board members' median figures falling on one side or the other of 1 percent.¹¹

I will now explain the "two perspectives," from which the Bank assesses economic activity and prices.  The first perspective relates to the outlook for economic activity and prices in one to two years that the Bank deems the most likely and assesses whether this is consistent with sustained growth under price stability.  The second perspective covers a longer time horizon and deals with the risks considered most relevant to the conduct of monetary policy taking account of the possible impact on economic activity and prices should risks materialize, however improbable they might be.  Assessments from the "two perspectives" are made every time the Bank decides on monetary policy.

1. 11For details, please refer to the Box titled "Review of the 'Understanding of Medium- to Long-Term Price Stability'" in the Outlook for Economic Activity and Prices released by the Bank on April 27, 2007.

C. Policy Conduct in the Future

Having looked at how the Bank assesses economic activity and prices from the "two perspectives," I would now like to turn to our assessment of the current situation.  From the first perspective, our assessment is that Japan's economy is likely to achieve sustainable growth under price stability generally in line with the projection presented in the April Outlook Report.  Needless to say, in making the projection we considered various risks -- both on the upside and on the downside.  At this point, however, I do not think there is an elevated likelihood of such risks materializing that would warrant a change in our projection.  In addition, the projection is made on the assumption that economic agents such as market participants and firms are making various economic and financial decisions taking account of the possibility of future changes in the policy interest rate.  Therefore, in order to ensure that economic activity and prices remain in line with the projection, the Bank will need to adjust the level of the policy interest rate.  Otherwise, it will eventually be forced to make drastic monetary policy adjustments, which may result in large swings in economic activity and prices in the future and increase the possibility that Japan's economy fails to achieve sustained growth.

As for the second perspective, as mentioned earlier, we think there are both upside and down side risks to the future course of economic activity and prices.  The upside risk is that, with the improved prospects for economic activity and prices, the stimulative effect of monetary policy may be further amplified and lead to the medium- to long-term risk of larger swings and an inefficient allocation of resources as firms and financial institutions overextend themselves based on an overly optimistic view of future prospects.  The downside risk is that if risk factors that could lead to an economic slowdown such as a deceleration in overseas economies materialize, the improvement in the economic situation and price rises may stall. 

In the April Outlook Report, based on the assessment of economic activity and prices from the "two perspectives" I have just described, the Policy Board members agreed with regard to the future course of monetary policy that "while confirming that the Japanese economy remains likely to follow a path of sustainable growth under price stability in light of the 'understanding' and assessing relevant risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation."

As for the future conduct of monetary policy, I will continue to make my decisions at MPMs based on this framework, carefully assessing economic activity and prices while also paying particular attention to the risks that I just talked about.

In making policy decisions, it is important that we can have confidence in our forecast of future developments in economic activity and prices.  This is because we need to conduct monetary policy in a flexible and timely manner, not only assessing current developments in economic activity and prices but also anticipating their future course to the greatest extent possible, with due consideration to the time lag before the effects of monetary policy appear in the economy -- an approach that we often describe as "forward-looking."  Forecasting future developments always entails a certain degree of uncertainty.  Therefore, at each MPM we, the Policy Board members, carefully examine all available information from the viewpoint of whether it allows us to be confident in our forecast so as to make an appropriate decision.  A Policy Board member will vote to leave the current policy unchanged if he or she believes that further examination is needed, but will vote for a change in policy if he or she is convinced that a particular scenario is highly likely to materialize.  All nine Policy Board members go through this type of decision-making process and put forward and discuss their views at each MPM.  I also assess various economic indicators and relevant information available until the very last minute before an MPM and put my ideas, including my projection of the economy, into shape.  Therefore, we do not, and cannot, have preconceptions about the future conduct of monetary policy at this point.

III. Challenges for Japan's Economy in the Longer Term: Population Aging and the Declining Birthrate

I have discussed the current situation of and the outlook for Japan's economy as well as the Bank's conduct of monetary policy.  I would now like to change the topic and turn to population aging and the declining birthrate, one of the structural problems Japan has to deal with in the longer term. 

Japan's economy has finally emerged from a period that is often referred to as the "lost decade" -- when the economy experienced a prolonged period of sluggishness following the collapse of the bubble in the early 1990s -- and has now returned to a stable growth path.  However, from a longer-term perspective, Japan's economy is facing new challenges in the form of a decreasing working-age population due to population aging and a declining birthrate.  Therefore, in order to achieve stable and sustainable growth, Japan must seek to continuously improve labor productivity -- output or value added per worker -- in an environment where firms are facing severe global competition.¹²

According to a recent study by the Japan Productivity Center for Socio-Economic Development,¹³ Japan's labor productivity in 2004 was in the 19th place among the 30 member countries of the Organisation for Economic Co-operation and Development (OECD), and was the lowest among the Group of Seven (G-7) countries.  Moreover, if we consider that Japan's labor productivity in the manufacturing sector is third among OECD countries and second only to the United States among the G-7, it becomes clear that labor productivity in Japan's nonmanufacturing sector is relatively low.  For example, comparing labor productivity in the nonmanufacturing sector in Japan and the United States, that in Japan only reaches about 60 percent of that in the United States -- the highest in the world -- and, in wholesaling and retailing, transportation, and restaurants and accommodation businesses, Japan's productivity is only about half of the U.S. level.

In Japan, a large increase in labor productivity has been observed in the manufacturing sector in recent years, and an equivalent increase can be seen in some nonmanufacturing industries such as finance and real estate, as well as information and communications.  However, in services, wholesaling and retailing, restaurants, and construction, labor productivity has basically remained unchanged.¹⁴

As in other major economies, the share of services, in a broad sense, in Japan's economy has been increasing.  For example, the share of value added of the tertiary sector in nominal GDP is over 70 percent.  Also, as mentioned earlier, while employment in the manufacturing sector has been decreasing due to the increase in productivity and other factors, that in the nonmanufacturing sector, particularly in the services industries, has been increasing.  From a macroeconomic point of view, if this trend in the allocation of labor resources -- a decrease in the allocation to the manufacturing sector, whose productivity is relatively high, and an increase in the allocation to the nonmanufacturing sector, whose productivity is relatively low -- continues, it will be even more difficult for Japan's economy to realize sustainable growth amid a declining population unless productivity in the nonmanufacturing sector increases.

Therefore, enhancing Japan's overall labor productivity would require an increase in the productivity of the nonmanufacturing sector, especially in the area of services, wholesaling and retailing, and restaurants.  There are various ways in which such an increase can be achieved.¹⁵ One example is investment in IT capital and its network integration.  In the United States, which is a successful example, the accumulation of IT capital is continuing, interfirm networks for the exchange of information through IT are being created, and firms understand and actively incorporate IT in their management.  This, coupled with more flexible business management, has led to the emergence of various new methods that increase productivity, including "supply chain management," a technique to manage inventories; the outsourcing of business operations; and "offshoring," that is, the outsourcing of business operations to firms abroad where labor costs are relatively low.  Besides the application of IT, there are other important ways to improve productivity.  These include, for instance, technical innovation that responds to changing times, and further deregulation, which introduces market mechanisms and is a prerequisite for production resources to shift from low-productivity industries or firms to high-productivity industries or firms. 

The government has been discussing measures to improve productivity,¹⁶ but clearly it is the efforts of individual firms, especially of firms' management, that are indispensable for achieving this goal.  I believe that the recovery of Japan's economy from a long period of stagnation is truly the result of firms' efforts.  I also believe that the main driving force in enhancing the productivity of Japan's economy will be the strong determination of and actions by the private sector, and therefore firms' ceaseless efforts will remain essential.  Although the Bank cannot directly enhance the productivity of the economy, it will support such efforts by firms' management through the appropriate conduct of monetary policy with the aim of achieving sustainable growth of Japan's economy. 

1. 12The growth rate of the economy can be expressed as the sum of (1) the growth rate of labor productivity and (2) the growth rate of the number of persons employed. This relationship shows that, in order to achieve higher economic growth without changing the number of persons employed, growth in labor productivity is necessary. If the labor share of income is kept constant, the growth rate of labor productivity equals the growth rate of wages, and this relationship shows that growth in productivity will result in higher wages.
2. 13For details, see the 2006 International Comparison of Labor Productivity released by the Japan Productivity Center for Socio-Economic Development in December 2006.
3. 14Reasons for the difference in productivity between the manufacturing and the nonmanufacturing sector include that manufacturers, especially exporters, have been exposed to global competition, and that active IT investment by manufacturers has helped to lower the costs associated with production and inventory management.
4. 15For details, see T. Miyagawa, "Seisansei no Keizaigaku -- Wareware no Rikai wa Doko made Susunda ka (The Economics of Productivity -- How Far Has Our Understanding Come?)," Bank of Japan Working Paper Series, No. 06-J-06, March 2006, available only in Japanese.
5. 16For details, see "Direction and Strategy for the Japanese Economy" and "Economic and Fiscal Reform 2007" released by the government in January 2007 and June 2007, respectively.

Closing Remarks

I would like to end my speech by talking about the economic situation of Nara Prefecture briefly.

Our view is that Nara's economy as a whole has been recovering moderately, but unfortunately with a weaker momentum than in larger cities such as Osaka.

Nara's local industries, such as forestry, lumber and wood products, and textiles, have a high reputation.  However, the business conditions of these industries seem to be quite severe because they are exposed to greater competition from lower-priced imported goods and because of the increase in prices of oil and other raw materials.  Furthermore, I have been told that small firms face weak business conditions, particularly in the construction business because of the decrease in public spending and in retailing due to severe competition from large retailers.

However, in recent months, some signs of a moderate recovery have been observed, particularly in the manufacturing sector, in areas such as electrical machinery, automobiles, and general machinery, due to steady demand supported by an increase in exports and in business fixed investment.  Moreover, firms in these industries seem to be increasing investment in order to renew and expand their equipment and facilities.

In the household sector, private consumption seems to have been firm recently due to a moderate improvement in the employment and income situation.  Housing investment also seems to be on an increasing trend on the whole.

As I have mentioned above, our view is that, on the whole, the economy of Nara has been recovering moderately, although trends vary by firm size, industry, and area.

I sincerely hope that Nara's economy, based on its rich history and culture as well as new technical bases, will develop further with fresh vigor thanks to the ambitious entrepreneurship of firms' management.