[Speech]Economic Activity, Prices, and Monetary Policy in JapanSpeech at a Meeting with Local Leaders in Okayama

TAMURA Naoki
Member of the Policy Board
September 12, 2024

I. Economic Activity and Prices

A. Economic Activity

I will begin my speech by talking about economic activity in Japan. The Bank of Japan assesses that the economy has recovered moderately on the whole, although some weakness has been seen in part. In terms of the median of the Policy Board members' forecasts -- as presented in the July 2024 Outlook for Economic Activity and Prices (Outlook Report) -- Japan's real GDP growth rate is expected to be at 0.6 percent for fiscal 2024, 1.0 percent for fiscal 2025, and 1.0 percent for fiscal 2026 (Chart 1). While the projected growth rate for fiscal 2024 appears to be low, this reflects the impact of the negative growth registered toward the end of fiscal 2023, partly due to the effects of a suspension of production and shipments at some automakers. That said, looking at the growth rates during the course of fiscal 2024 on a quarter-on-quarter basis suggests that Japan's economy is likely to achieve firm growth. Thereafter, the economy is projected to keep growing at a pace above its potential growth rate, as a virtuous cycle from income to spending gradually intensifies.

As background to what I just outlined, let me now explain developments in private consumption and business fixed investment in detail. First, private consumption as a whole has been resilient, although consumption of nondurable goods, such as food and clothes, has followed a decreasing trend in real terms after excluding price rises, amid households' defensive attitudes toward spending in reflection of high prices (Chart 2). As for these defensive attitudes, while some households have shifted toward less expensive products due to high prices, many of them appear to be selective in their consumption -- that is, they actively spend on products or services that meet their values and cut back other spending. Given that consumer behavior could have changed in response to the COVID-19 pandemic, I feel that the actual condition of private consumption may not be as weak as the statistics suggest. With respect to income, real wages have improved recently, although for some time nominal wage growth was not keeping up with inflation. Regarding the outlook, private consumption is projected to increase moderately, underpinned by an improvement in real wages. This is in view of the following: (1) the results of the annual spring labor-management wage negotiations this year revealed that the wage growth rate was significantly higher than the previous year, including among small and medium-sized firms and (2) anecdotal information from firms -- which was gathered through the Bank's Head Office and branches -- suggests that a wider range of firms have actually been raising wages, partly because they are feeling the need to retain and recruit human resources to address labor shortages (Chart 3). Moreover, the fact that a rapid and one-sided depreciation of the yen -- which had a negative impact on consumer sentiment -- has been corrected to a certain extent is expected to promote the moderate increase in private consumption.

Next, I will turn to business fixed investment. On the back of favorable corporate profits on the whole, business fixed investment has been on a moderate increasing trend; as for the business fixed investment plans in the June 2024 Tankan (Short-Term Economic Survey of Enterprises in Japan), the reported rate for fiscal 2024 indicates a relatively high increase compared with past June Tankan surveys (Chart 4). Under such circumstances, the remaining orders for machinery and construction have stayed on an increasing trend, as there have been some cases where firms postponed fixed investment in response to labor shortages. Regarding the outlook, although the amount of business fixed investment could be pushed down due to these postponements, such investment is likely to follow a long-term uptrend. This is due to firm demand for fixed investment, such as investment to address labor shortages and digital-related investment, as well as investments associated with the green transformation and with strengthening supply chains.

B. Price Developments

Turning to Japan's price developments, the year-on-year rate of increase in the consumer price index (CPI) for all items excluding fresh food has been lower than before, in the range of 2.5-3.0 percent recently; that for all items excluding fresh food and energy, for which prices fluctuate significantly, has been at around 2 percent (Chart 5). The contribution of goods prices to the rate of increase in the CPI has been declining due to the waning effects of a pass-through to consumer prices of cost increases led by the past rise in import prices. On the other hand, the CPI has been pushed up by increases in services prices resulting from the pass-through of higher personnel expenses to consumer prices.

In terms of the median of the Policy Board members' forecasts, the CPI (all items less fresh food) is projected to continue to see a year-on-year rate of increase of around 2 percent -- specifically, 2.5 percent for fiscal 2024, 2.1 percent for fiscal 2025, and 1.9 percent for fiscal 2026 (Chart 6). Although there could be an upward or downward deviation in CPI figures, price developments have been on track to achieve the price stability target. The Bank therefore assesses that the likelihood of realizing this target has continued to rise.

Regarding the outlook for prices, I am concerned that risks are possibly becoming more skewed to the upside. The first risk concerns the impact of labor shortages. The June Tankan suggests that firms perceive labor shortages to be at substantially high levels (Chart 7). My impression is that such shortages have become supply-side constraints, thereby causing some industries to face short supply and excess demand. For example, the hotel industry inevitably has to limit occupancy rates while the taxi industry has been suffering from a shortage of drivers. Furthermore, some manufacturing firms have been unable to operate at full capacity due to labor shortages. Such a situation could cause prices to deviate upward from the baseline scenario. Second, firms could make further progress than anticipated in passing on increased personnel expenses to selling prices, in a situation where wage growth is expected to be higher than the previous year. That said, firms, especially small and medium-sized firms, have continued to report that it has been difficult to pass on their employees' higher wages to selling prices. Third, import prices, which had once settled down, have been on an uptrend again, partly because the yen has depreciated from the beginning of this year, despite being corrected to a certain extent recently. In terms of passing on higher import prices, the cost pass-through rate -- which shows the extent to which firms pass on cost increases to product prices -- has been on the rise in recent years. Thus, the uptrend in import prices could have a greater impact on the CPI than before.

II. Conduct of Monetary Policy

A. July 2024 Monetary Policy Meeting (MPM)

Now, I would like to turn to the Bank's conduct of monetary policy. The Bank conducts monetary policy with the aim of achieving the price stability target of 2 percent in a sustainable and stable manner. Since the changes in the monetary policy framework made in March 2024, it has regarded guiding the short-term interest rate as a primary policy tool. While the Bank intends to adjust the degree of monetary accommodation in response to an increase in the likelihood of achieving the price stability target, it decided at the July MPM to raise the target level of its short-term policy interest rate by 0.15 percentage points, to around 0.25 percent (Chart 8).

The Bank also decided on a plan for the reduction of its purchase amount of Japanese government bonds (JGBs) covering the period until March 2026, aimed at enhancing the predictability of its future JGB purchases and allowing long-term interest rates to be determined by the market (Chart 9). It should be noted, however, that the Bank has continued with JGB purchases to avoid bringing about discontinuous changes from the large-scale monetary easing conducted in the past, and not as an active monetary policy tool. Going into the details of the plan, the Bank intends to gradually reduce the amount of its monthly outright purchases of JGBs -- which amounted to about 6 trillion yen up until the July 2024 MPM -- to about 3 trillion yen over a period of around a year and a half. Moreover, with a view to allowing a certain degree of flexibility in the plan, the Bank's decisions included the following: (1) it would conduct an interim assessment of the plan in June 2025 and (2) in the case of a rapid rise in long-term interest rates, would make nimble responses by, for example, increasing the amount of JGB purchases regardless of the monthly schedule of such purchases.

While the amount outstanding of the Bank's JGB holdings stands close to 600 trillion yen, the amount in terms of the ratio to nominal GDP is larger by far relative to the United States and Europe (Chart 10). Since JGBs are redeemed at maturity, reducing the purchase amount so that it falls below the redemption amount would lower the amount outstanding of the Bank's JGB holdings. Reducing the purchase amount at the pace decided at the July MPM, however, will require considerable time for the Bank to normalize its balance sheet -- that is, to reduce the amount outstanding of its JGB holdings to a level where further reductions are no longer necessary. That said, it is appropriate for the Bank to set the pace of reduction at this level to proceed with the reduction without causing market disruption. The degree of JGB market functioning has stayed low, albeit having improved, and such side effects of the Bank's large amount of JGB holdings will likely remain for some time in the process of normalizing the balance sheet (Chart 11).

In my view, the Bank's future policy conduct will be crucial to normalizing large-scale monetary easing, and there is still a long way to go. Moreover, I have come to recognize once again the need for the Bank to carefully examine the balance between the positive effects and costs of quantitative monetary easing -- should the situation require reconsideration of such a policy measure in the future -- as well as the steps toward an exit I discussed earlier.

B. Conduct of Monetary Policy over the Projection Period

Let me return to the guiding of the short-term interest rate as a primary policy tool.

Underlying CPI inflation is expected to increase gradually; in the second half of the projection period presented in the July Outlook Report -- which covers the period through fiscal 2026 -- it is likely to be at a level that is generally consistent with the price stability target. If this outlook is realized, I think it will be necessary for the Bank to raise the short-term policy interest rate to a level that is neutral to economic activity and prices -- i.e., the nominal neutral interest rate -- by the second half of the projection period that runs through fiscal 2026. The reason is that, if the short-term interest rate stays below the level that is neutral to economic activity and prices, this will push up inflation higher than necessary.

Conceptually, the neutral interest rate is the sum of the natural rate of interest -- which is the real interest rate level that is neutral to economic activity and prices -- and the expected rate of inflation. That said, the natural rate of interest is not directly observable, and estimates of it vary widely depending on the estimation method employed (Chart 12). The real interest rate -- calculated as the nominal interest rate minus the expected rate of inflation -- has been clearly negative, falling below all estimates of the natural rate of interest. This implies that the current short-term interest rate level provides accommodative financial conditions; in other words, it is at a level that will push up economic activity and prices.

My sense is that the neutral interest rate would be at least around 1 percent. Therefore, I think it is necessary for the Bank to raise the short-term interest rate to at least that level by the second half of the projection period that runs through fiscal 2026 to contain upside risks to prices and achieve the price stability target in a sustainable and stable manner.

However, how economic agents in Japan, which has long experienced a state without meaningful interest rates, react to interest rates is an issue that warrants careful attention without any preconceptions. Thus, bearing in mind that the short-term interest rate should be at the 1 percent level by the second half of the projection period that runs through fiscal 2026, I think the Bank needs to gradually raise this rate in response to the increase in the likelihood of achieving the price stability target. While doing so, it also needs to determine the appropriate level of the short-term interest rate by paying attention to how the economy and prices respond to the rate hikes.

Stock prices in Japan and foreign exchange rates saw large fluctuations at the beginning of August. While this was likely due to a depreciation of the U.S. dollar and a fall in stock prices on a global scale, triggered by concerns over a slowdown in the U.S. economy reflecting weak economic indicators, some have associated the fluctuations with the Bank's monetary policy. Some have argued that the policy revision made at the end of July was a step taken too early, while some have argued it was a step too late. Taking a brief look back on monetary policy, since April, the Bank has been consistent with its intention that, if the outlook for economic activity and prices is realized, it will adjust the degree of monetary accommodation. However, I believe it is important for the Bank to take stock -- even if only in retrospect -- of whether this intention was adequately conveyed to the market and whether there was a more appropriate way for the Bank to respond to market reactions, and thereby continuously seek to improve its communication with the market. I also think the Bank needs to continue to keep a close watch on developments in financial and capital markets and their impact on economic activity and prices.

The market currently expects the pace of short-term interest rate hikes to be moderate (Chart 13). Of course, the pace of the Bank's rate hikes could only be at this level depending on developments in economic activity and prices. If the Bank does raise the short-term interest rate at this pace, however, the rate will likely not reach the neutral interest rate by the second half of the projection period. In addition, the possibility that this could further heighten upside risks to prices, which are of concern, or result in the Bank having to conduct rapid interest rate hikes at a later stage, cannot be ruled out. To avoid such risks, I think the Bank needs to raise the policy interest rate in a timely and gradual manner, while giving due consideration to developments in financial markets as well as paying attention to how the economy and prices respond.

I would also like to consider the impact on various economic agents of raising the short-term interest rate. Roughly speaking, since net borrowers pay interest and net savers receive interest, raising the short-term interest rate increases the burden on net borrowers and increases interest income for net savers. Therefore, the impact of raising the short-term interest rate differs depending on, for example, whether a household has a housing loan and whether a firm has borrowings or has savings in excess of its borrowings. Furthermore, I think it is necessary to pay attention both to the channels through which short-term interest rate hikes affect economic activity and to the changes in the economic and price situation that led to the rate hikes, in addition to interest rate developments.

For example, looking at household savings and liabilities by age group of the household head, households in their 40s or younger have larger liabilities, while those in their 50s or older have larger savings (Chart 14). Thus, disregarding various assumptions, interest rate hikes, on average, tend to increase the burden on households in their 40s or younger and be more beneficial for those in their 50s or older. When considering the impact of interest rate hikes, however, it is also necessary to take into account the fact that (1) the extent to which short-term interest rate hikes are reflected in mortgage rates depends on the decisions of the lending financial institutions and, in many cases, a mechanism is in place to prevent sudden increases in monthly loan repayments and (2) many households with a housing loan are working households, some of which benefit from wage increases.

Households in their 50s or older have significant net savings, and their interest income is expected to increase in line with a rise in deposit interest rates -- although the extent of the rise will depend on the decisions of financial institutions. Moreover, an increase in stable interest income is highly likely to improve the sentiment of households that have been reluctant to withdraw the principal of their deposits, preferring to save up for retirement.

Turning to the corporate sector, while firms have long been net savers on a flow basis, reducing borrowings and accumulating funds on hand, the proportion of debt-free or de facto debt-free firms -- defined as firms whose cash and deposits exceed their total amount of borrowings -- has been increasing (Chart 15). Hence, the corporate sector is likely to be more resilient to the impact of short-term interest rate hikes than in the past. In addition, solid corporate profits are expected to mitigate the effects of higher interest payments if the outlook for Japan's economy mentioned earlier is realized -- namely, that the economy will grow at a pace above its potential growth rate, as a virtuous cycle from income to spending gradually intensifies. Furthermore, on a different note, if interest rates rise and function effectively as a hurdle rate, firms, to survive, will be pressured to concentrate their business resources in areas that earn enough profits to cover the interest cost -- in other words, businesses with high added value.¹ Consequently, this is expected to stimulate business metabolism and raise productivity.

Interest rate hikes will also have an impact on the government. Speaking in general terms, it is important to steadily ensure the market credibility of fiscal management.

The Bank will continue to attentively assess the impact of changes in the policy interest rate, including the effects described earlier, and conduct monetary policy as appropriate, in response to developments in economic activity and prices as well as financial conditions.

Thank you.

Regarding the hurdle rate function of interest rates, see Tamura, N., "Economic Activity, Prices, and Monetary Policy in Japan," speech at a meeting with local leaders in Aomori, March 27, 2024,
https://www.boj.or.jp/en/about/press/koen_2024/ko240403a.htm