Annual Report on the Japanese

Economy and Public Finance

2003-2004

- No Gains Without Reforms IV -

July 2004

Cabinet Office

Government of Japan


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Section 4 Prospect of Overcoming Deflation

    The present period of economic recovery, which started in the beginning of 2002, has now continued for two and a half years. During this period, the deflation trends have gradually become mild, prices of domestic corporate goods have increased slightly, and consumer prices have remained flat. Nevertheless, temporary factors such as the higher co-payment of medical insurance and the rise in the price of rice have pushed up consumer prices to some extent, and in overall terms the economy has not yet attained a breakaway from the condition of mild deflation. As long as such deflation trends continue, the increase in the outstanding balance of real debt will delay the resolution of the non-performing loans issue and will undermine the soundness of the financial systems. Also, the constraint on nominal interest rates that prevents them from falling below zero will limit the effects of monetary policies. Furthermore, the increase in the outstanding balance of real debt in the government sector as well as the shrinking tax revenue will make the restructuring of public finance very difficult. If an external shock occurs under such economic conditions, there is a high possibility that economic policies will be unable to respond in a flexible manner, and the recovery will lose its momentum. Therefore, in order to set the Japanese economy on the path to sustainable growth, it is necessary to overcome deflation and to make every possible effort to prevent the recurrence of deflation trends. In this section, various aspects of the recent price trends from the perspectives of demand, supply and finance will be examined, and the modalities of monetary policies required for overcoming deflation will also be discussed.
   
1. General Prices Staying Flat
   

Slight increase in price of domestic corporate goods price as a result of higher material prices
    Looking at the trends in prices of domestic corporate goods, the upward trends in the international commodity market have contributed to an increase in prices of raw materials since the end of 2002, which in turn has been pushing up the price of intermediary goods from the second half of 2003 (Figure 1-4-1). On the other hand, prices of final goods continue to fall and the impact of higher costs on product prices at the downstream has not been significant. Furthermore, the breakdown of final goods shows that the rise in rice prices has resulted in a temporary increase in prices of non-durable consumer goods, while prices of capital goods and durable consumer goods have almost consistently continued to fall.
Figure 1-4-1 Trends in Domestic Demand Products Under the Corporate Goods Category
    As for the transfer of the increase in raw material prices to manufactured goods prices, according to a survey carried out by the Ministry of Economy, Trade and Industry (METI) in March 2004, the pass-through significantly advanced in upstream raw-material industries such as non-ferrous metals and iron and steel, but in downstream industries closer to the consumers, such as automotives and electronics, between 70% and 80% of the surveyed companies responded that they had not been able to allow the pass-through to their product prices (Figure 1-4-2). When asked why it was difficult for them to allow the pass-through, most companies responded that intensive competition made it impossible to allow the increase in raw material prices to feed through to the price of manufactured goods. Comparing the current situation with past transfer of increases in raw material prices to consumer prices (for goods, excluding fresh food), during the first and second oil shocks of the 1970s the increase in the cost of crude oil was almost immediately reflected in an increase in consumer prices, while the jump in raw material costs today and back in 1999 is thought to have a limited impact on consumer prices (Appended Figure 1-19). Also, in order to statistically examine the impact of raw material prices on consumer prices, a VAR model using those two variables was estimated to measure the ripple effect of the rise in raw material price on consumer prices (for goods, excluding fresh food). The result of the estimation shows that the impact of the rise in raw material price on consumer prices is much more significant when data for 1970 to 1989 was used than when the data for 1990 onward was used (Figure 1-4-3). This suggests that against the backdrop of intensifying domestic and international competition, it might have become difficult for companies to allow the increase in raw material prices to feed through the price of manufactured goods.
Figure 1-4-2 Extent of Shift to Manufactured Goods Prices
Figure 1-4-3 VAR Analysis of Raw Material Prices and Consumer Price Index (Impulse Response)

Consumer prices staying flat
    Consumer price has been flat since the second quarter of 2003. However, institutional factors such as the higher co-payment in medical insurance and other factors such as the temporary rise in price of rice due to a poor rice crop have pushed up consumer prices to some extent. The contribution level of such factors on a year-on-year basis as of March 2004 is about 0.5%. Yet, even if such factors are excluded, the margin of decline in consumer prices has been gradually narrowing.
    In order to examine what categories of products in consumer prices rise and what categories continue to fall, categories were classified on the basis of the movement of consumer prices (excluding prices for fresh food) as of the first quarter of 2001 and the first quarter of 2004 (Figure 1-4-4). The relative weight shows no change in the proportion of the items rising and falling, 52 versus 48. However, when the categories with falling consumer price are further classified into categories with a 2% or more decline in consumer price and categories with a less than 2% decline in consumer price, it becomes clear that between the first quarter of 2001 and the first quarter of 2004, the proportion of categories with a 2% or more decline in consumer price has dropped significantly, from 19% to 14%, while the ratio of categories with a less than 2% decline in consumer price has increased by that much. Therefore, even if the impact of the recent rise in the price of rice is excluded, the drop in the ratio of categories with a significant decline in consumer prices indicates that deflation is gradually easing off. Looking at specific categories, among the categories with a continued 2% or more decline in consumer prices are electronics, including personal computers, while the categories for which the decline was moderated include clothing. However, the significant decrease in the consumer price of personal computers and other items is mostly a reflection of quality adjustments implemented with consideration to technological progress upon calculating the consumer price index (CPI). Also, some 70% of the items with a continued increase in prices are services, such as tutorial fees, and among the goods for which consumer prices are increasing are rice and other products.
Figure 1-4-4 Relative Weight of Categories Rising/Falling in CPI Index

Demand factors contributing to easing deflation
    One of the factors behind the easing of deflation is the slight tightening in supply and demand conditions resulting from the economic recovery. As previously mentioned, the current increase in raw material prices is not sufficiently reflected in prices of final goods and consumer prices. Nevertheless, supply and demand factors are contributing, albeit gradually, to easing of deflation. The size of the GDP gap is often used as one of the standard measure representing the relation between supply and demand conditions and prices. However, regarding the correlation between the GDP gap and the inflation/deflation rate, it is known that when the inflation rate falls below a certain level, the changes in the inflation rate do not respond sufficiently to the changes in the GDP gap. Furthermore, various problems are pointed out with regard to the measurement of the GDP gap(11). In fact, changes in the GDP gap, consumer price and GDP deflator indicate that there is a positive correlation among these variables in the long run. However, during some periods the correlation between the two variables weakens(12) (Figure 1-4-5). In 2001 for instance, the negative GDP gap expanded, but the margin of decline in consumer prices was not that big.
Figure 1-4-5 Demand factors and CPI, GDP deflators
    These are points that must be taken into consideration. Still, from the beginning of 2002, when the period of economic recovery started, up to the beginning of 2004, the narrowing of the GDP gap reduced the extent of decrease in consumer prices (for goods, excluding fresh foods) by 0.8 percentage points. The effect of institutional and temporary factors must be taken into account when assessing the reduction of the extent of decrease in consumer prices, but still the economic recovery is contributing to the gradual easing of deflation.
    On the other hand, regarding the relation between the GDP gap and the GDP deflator for the period from the beginning of 2002 to the beginning of 2004, the GDP gap shrank, while the extent of decline in the GDP deflator expanded, which indicates that the correlation between the two is weakening.
   
Deflation factors ease on supply side also
    Another element behind the easing of deflation is that the supply side factors have started not to contribute as much to the decline in prices as at a certain point in time. In order to clarify the impact on prices of different factors on the supply side, such as technological innovation, deregulation, and increase in the import penetration rate, items in CPI were broken down into three large categories: categories that changed because of the technological innovation factor, categories that changed because of the deregulation factor and categories that changed due to the import competition factor, with electronics placed in a separate category as an item that is simultaneously impacted by the increase in import penetration rate as a part of the import competition factor and by technological innovation (Figure 1-4-6). According to the result of this estimation, the deregulation factor temporarily turned positive from the end of 2003 through to the beginning of 2004 with the recent increase in air transport fares, and as for the import competition factor, the extent of decline has been shrinking since the beginning of 2003 mainly for products such as clothing(13). On the other hand, regarding items such as personal computers and cameras, whose performance was improved due to the technological innovation and adjusted using the hedonic index (items for which the improvement in quality is reflected in reduction of price), the negative contribution has remained almost unchanged since around the middle of 2002. The total contribution of the supply side factors was pushing consumer prices down by between 0.7% and 0.8% in 2001, but as of the beginning of 2004 the negative contribution of the supply side factors shrank to 0.2%. As for the individual impact of each of the three supply side factors, the reduction in the negative contribution of the deregulation factor was influenced by a temporary increase in air transport fares, but it basically reflects the temporary pause in the fall of regulated fares in the most recent years. Regarding the import competition factor, the narrowing of the margin of decline in clothing and other products reflects the fact that the import penetration rate has already reached a certain level. As for the technological innovation factor, on the other hand, some decrease is expected to continue in the future, due to the technological advancement in the area of new products such as digital electronics and decrease in prices.
Figure 1-4-6 Impact on Supply Side Prices

Column 1-2

Why did the rate of decline in the Private Non-Residential Investment deflator expand?
   
    The Private Non-Residential Investment (referred to as the "investment deflator" hereinafter) is the price of machinery and equipment, and structures such as plants invested in by private enterprises. The investment deflator for 2003 declined by 5.4%, and compared with the decline in domestic corporate goods price, which remained at 0.8%, the rate of decline was rather significant (Column Figure 1-2(1)). The significant decline in the investment deflator contributed to the expansion in the rate of decline of the GDP deflator. What are the reasons behind the expansion of the gap between the investment deflator and the price of domestic corporate goods in 2003?
Column Figure 1-2 (1)
Comparison Between Private Non-Residential Investment Deflator and Domestic Corporate Goods Price

    Firstly, the domestic corporate goods price includes the prices of raw materials and intermediary goods, while the investment deflator combines the costs of final products such as machinery and equipment, and other structures. Therefore, it is easily impacted by fluctuations in the price of machinery and equipment, where the decline in prices is more significant. Furthermore, the domestic corporate goods price is calculated using the Laspeyres formula which fixes the weight for a standard year, while the investment deflator is calculated using the Paasche formula in which the weight changes for each year, and this difference in the index formula explains the steeper fall of the investment deflator. To check the extent to which the difference in the index formula is reflected in the gap between the investment deflator and the domestic corporate goods price, two comprehensive indexes were created for the prices of general machinery including IT and electronics (the composite ratio of IT-related machinery increased from 39% in 2002 to 42% in 2003) using the Laspeyres formula and the Paasche formula, and after comparing the two indexes, it became clear that the difference in the rate of decline was about 5% (Column Figure 1-2(2)).
    Therefore, one of the reasons for the expansion of the gap between the deflator and the domestic corporate goods price in 2003 is the fact that, as the rate of decline in prices of IT machinery expanded and the composite ratio that IT machinery occupied in the capital investment of enterprises increased, the investment deflator, which is calculated using the Paasche formula, is easily impacted by such changes in the weight. As for the future trends in the investment deflator, it seems quite unlikely that the rate of decline in the investment deflator will continue to expand further given that (i) the decline in prices of IT machinery will continue though the weight of IT machinery in the capital investment will not necessarily increase further, and (ii) it is possible that the decline in prices for structure will cease, reflecting the recent increase in the price of raw materials,.
Column Figure 1-2 (2)
Comparison between the Laspeyres Index and the Paasche Index Created from the Private Non-Residential Investment Deflator
   


2. Deflation and Monetary Policy
   

    To evaluate the overall status of deflation, the important factor is whether the financial sector continues its recovery toward normalization. This section discusses recent trends on the financial markets and effects of monetary policies.
   
Quantitative easing continues amidst persistent deflation
    Regarding the trends in short-term interest rates and the exchange rate of the yen against the US dollar from 2003 to 2004, despite the fact that short-term interest rates remained stable at close to zero, appreciation of the yen against the US dollar advanced from the second half of 2003. In an open economy, the Monetary Condition Index (MCI) is used as an indicator for the overall monetary situation including exchange rate trends. The MCI is the weighted average of real short-term interest rates and real effective exchange rates. The trends in the MCI indicate an overall easing trend from 2000 onwards, but in 2003 a change, albeit slight, toward tightening can be observed as an effect of the appreciation of the yen despite the drop in real short-term interest rates following the curtailment of deflation (Figure 1-4-7).
Figure 1-4-7 Trends in MCI and Its Factor of Variability
    Under the conditions of a mild deflation, from 2003 through to the first half of 2004 the Bank of Japan (BOJ) maintained and reinforced a quantitative easing policy. In order to expand the room for a flexible response in market operations, the BOJ raised the ceiling on the target level of its current account balance by two trillion yen in October 2003 and by further three trillion yen in January 2004, thus setting the target level at about 30-35 trillion yen (Figure 1-4-8).
Figure 1-4-8 Trends in Bank of Japan's Current Account Balance
    Also, from 2003 through to March 2004, the government and the BOJ carried out yen selling and dollar buying operations on the foreign exchange markets worth 35.1 billion yen.
   
Clarification of commitment to continued quantitative easing
    The question of how long the BOJ will maintain its quantitative easing policy has been attracting much attention against the backdrop of the gradual moderation of the deflation trends, and in response, in October 2003 the BOJ clarified its commitment to continue the quantitative easing policy. In particular, on its commitment to maintain the quantitative easing policy until the consumer price index (CPI) (national, excluding fresh food) registers a year-on-year growth rate that remains stably at zero percent or above, the BOJ made clear that it was underpinned by the following conditions. First, it requires not only that the most recently published CPI register zero percent or above on a year-on-year basis for a single month, but also that such a tendency be confirmed for the average of over several months as an underlying trend. Second, the BOJ needs to be convinced that the prospective CPI is not expected to register a year-on-year growth rate below zero percent. Specifically, the majority of the members of the Policy Board of the Bank of Japan, through the Outlook and Risk Assessment of the Economy and Prices (the Outlook Report) and the forecasts of the members of the Policy Board, has a vision of the prospective CPI to register a year-on-year growth rate of zero percent or above. Furthermore, the BOJ clarified that even if these conditions are met, it might be determined appropriate to continue the quantitative easing policy depending on economic and price conditions.
    This commitment to continue the quantitative easing by the Bank of Japan is believed to have reduced the uncertainty of markets over the monetary policy in the future, and produced certain effects for the stabilization of long-term interest rates afterwards. In this regard, the policy response patterns of the Bank of Japan to inflation rate and supply and demand trends as of October 2003 are compared to the lifting of BOJ's zero interest rate policy in 2000. In economics, it is thought that monetary authorities determine interest rate levels taking into account the gap between expected inflation rates and preferred inflation rates, and the GDP gap as of a given point in time. This type of policy reaction can be formulated as a Taylor Rule. According to an estimate of this type of policy reaction function by the BOJ using a Taylor Rule on certain conditions, it is suggested that, as of October 2003 when the BOJ clarified the conditions of continued quantitative easing, due to the curtailment in the GDP gap following economic recovery, implied target interest rates may have well exceeded the level seen in August 2000 when the zero interest rate was lifted (Figure 1-4-9 and Appended Note 1-5). It is quite unlikely that the actual policy making process implemented by the monetary authorities follows such a simple formula, but this estimation suggests that the clarification of conditions of continued quantitative easing by the BOJ in October 2003 was a policy decision based on a different policy reaction pattern from the one taken when the zero interest rate was lifted. Hence, the BOJ's commitment is thought to have served to calm the early jump in expectations of higher interest rates.
Figure 1-4-9 Target Interest Rate Derived from the Taylor Rule

Background to declining money supply
    Despite economic recovery, the growth rate of money supply has been easing since the beginning of 2003. The growth in monetary base was on an upturn in the beginning of 2002 with the growth rate exceeding 30%, but in the first quarter of 2004, its growth rate slowed down to about 14% (Figure 1-4-10). As for M2+CD, the growth rate was at the 3%-level in 2002, but fell to the 1.5-2%-level since 2003. As for a breakdown of the contributions to monetary base by component, the contribution of the BOJ's current account balance remains significant, but the contribution of the BOJ notes since its peak in the beginning of 2002 has been on a downturn (Figure 1-4-11).
Figure 1-4-10 Trends in Monetary Base and Money Supply
Figure 1-4-11 Breakdown of Contributions to the Monetary Base
    The decrease in growth of the BOJ notes issuance balance is basically a result of a temporary pause in movements to increase hoarding of cash in line with a decline in credit uncertainty. Regarding the lower M2+CD growth, it is also a reflection of a slowdown in an increase of cash currency, and furthermore reveals the effect of other factors starting to be removed such as the increase in cash and deposits accompanying maturing of a large amount of the postal savings (fixed amount savings) that had been pushing up M2+CD since 2001 and the increase in cancellation of investment trusts in connection with the failure of Enron(14).
    As tendencies of excessive hoarding of cash have abated, a declining trend of a money multiplier is gradually easing. A money multiplier (M2+CD divided by monetary base) can be divided into the following three factors using an identical equation: a ratio of cash to deposits in the non-financial sector, a ratio of cash to deposits in the financial sector, and a ratio of reserves to deposits in the financial sector (Figure 1-4-12). An examination of the changes in these factors in time series from the second half of 2001 through to the first half of 2002, a period characterized by a steep decline in a money multiplier, reveals the following phenomena: (i) a ratio of cash to deposits in the non-financial sector increased following growing credit uncertainty, that is, there was a tendency for households, companies and others to have more cash on hand than to leave their assets in bank deposits, and (ii) a ratio of reserves to deposits in the financial sector increased reflecting the introduction of the quantitative easing policy by the BOJ, which means that private sector banks increased their current account balance at the BOJ. On the other hand, the reduction in the extent of decline of a money multiplier from the second half of 2002 onwards reflects a drop in the contribution to monetary base from a ratio of cash to bank deposits in the non-financial sector following a decline in credit uncertainty. In other words, it reflects the fact that households and companies had more assets in bank deposits than cash on hand.
Figure 1-4-12 Trends in Money Multiplier
    In addition, for money supply (M2+CD) to increase, it is necessary, through the increase in assets such as lending, to expand the balance sheets of financial institutions, which supply money. At present, the balance sheets of banks and others are expanding, but as for changes in the composition of assets, it is clear that from 2001 to 2003 the proportion of loans declined from 57.7% to 53.5%, while the proportion of government bonds and others increased by almost as much from 12.1% to 15.2% (Appended Table 1-20).
    Looking at this issue from a different standpoint, it can be said that the structural changes in the flow of funds has an impact on money supply. M2+CD represents cash and deposits held by households, companies and other entities which have a financial surplus. Therefore, a net increase in the financial assets by these entities would result in an increase in M2+CD. However, if these entities reach into their cash and deposits to purchase other financial assets or to return loans to banks, M2+CD would decrease by the same amount. In fact, the contribution ratio of repayments by households and companies to M2+CD on a year-on-year basis was -3.3% (Figure 1-4-13). On the other hand, a financial surplus held by households and companies are inextricably linked with the shortage of funds experienced by other entities, in particular the governments. At present, there has been no significant change in the shortage of funds of foreign entities, so the financial surplus of households and companies has increased proportionally to an increase in the government shortage of funds. In this sense, the expansion in the government shortage of funds becomes a factor for an increase in M2+CD. In 2003, the contribution ratio of the central government's shortage of funds (fiscal deficit) to M2+CD on a year-on-year basis was 4.1%. From the analysis above, it can be concluded that the pace of increase in M2+CD remained relatively mild, partially because, an increase in the fiscal deficits, which continued to contribute to increase M2+CD, was fully offset by the reduced lending and repayment of debts. The analysis also indicates that it is necessary to swiftly advance the disposal of non-performing loans of banks and to reduce excessive corporate debts.
Figure 1-4-13 Effect of Domestic Funds Flow on Money Supply
    As observed above, the pace of increase in money supply has temporarily slowed compared to before, but in line with the trends for economic recovery, the nominal GDP has recently been on the upturn. Consequently, monetary velocity (nominal GDP divided by M2+CD) bottomed out throughout 2003 (Figure 1-4-14). These trends in monetary velocity are seen as a reflection of the reduced money demand due to credit uncertainty and other precautionary motives. Thus, the declining trend in monetary velocity and money multiplier came to a halt, bringing the first signs of normalization in the financial systems through advancement in the disposal of non-performing loans and alleviation of the temporary credit uncertainty. Furthermore, the growth rate of M2+CD began to show a moderate increase since the beginning of 2004, and this trend is considered to be backed up by the moderated rate of decline in lending and other possibilities of expansion of money demand triggered by economic recovery.
Figure 1-4-14 Velocity of Money

3. Synthetic Judgment of Deflation and Future Policy
   

Synthetic judgment of deflation
    Next, the prices and financial situation described above are summarized. First, regarding prices, demand factors have contributed to easing deflation through tightening in supply and demand conditions following the economic recovery in Japan and abroad. In addition, while supply factors continue to contribute to deflation, compared with past trends, their contribution is decreasing. Furthermore, looking at the financial situation, money supply registered low growth, but the progress in the disposal of non-performing loans has advanced and the urge to hoard currencies due to temporary credit uncertainty has reduced, and a money multiplier (M2+CD/monetary base) and a monetary velocity (nominal GDP/M2+CD) are gradually stabilizing. Furthermore, the growth rate of M2+CD began to show a moderate increase from the beginning of 2004, and this trend is considered to be backed up by the reduced rate of decline in lending and other possibilities of expansion of demand for funds triggered by economic recovery. Thus, the economic situation in terms of demand, supply and finance is gradually advancing toward overcoming of deflation. Now the question has become about the extent to which it can be judged how the risk of continued deflation has decreased, looking in a comprehensive manner at such various environments surrounding deflation. The following factors must be considered when answering this question.
    Firstly, what kind of indicators should be used to examine prices? Depending on the price index, there are differences in the scope of examination and the standards used to measure the changes that occurred between two points in time, and every index has a certain bias, although there is a difference in degree. In this sense, there is no absolute price index, but the most appropriate price index for each case would become self-evident once the objective of each analysis is defined. Needless to say, the most important aspect in this case is the macroeconomic aspect of the price indexes(15). Unlike the world assumed by the classical dichotomy, which stipulates that prices are a monetary phenomenon and have no influence over the real economy, in the real world, fluctuations in inflation rates have a tangible impact on the real economy. More specifically, under the conditions of high inflation, (i) the cost of cash-holding increases and a considerable effort is made to avoid this, and (ii) uncertainty over relative prices and future price levels increases and thus the risk premium rises, as a result of which labor force and capital cannot be effectively utilized in productive activities. On the other hand, under the conditions of low inflation or deflation, the downward rigidity of wages pushes up the equilibrium unemployment rate. Also, under the conditions of deflation, the pressure on corporate earnings due to an increase in real debt could undermine the soundness of the financial system(16). Regarding inflation rate, from the perspective of impact on the macro economy, the most important indicator to look at is the consumer price index. This is because the rate of increase in the consumer price index, as well as wages, has a great impact on decision on labor supply by households, and it also reflects changes in prices for final corporate products and services. Needless to say, the consumer price index should also be used with sufficient awareness of its characteristics and bias(17). Furthermore, it is important to take into consideration the effect of temporary factors such as increases in fresh food and oil prices, in order to grasp fundamental price trends.
    On the other hand, the GDP deflator is an important indicator of an increase in the affluence and productivity in the economy as a whole, but specific information that it carries does not have a direct impact on the activities of economic entities(18). Therefore, price trends should be judged comprehensively from various price statistics such as consumer prices, taking into consideration the abovementioned characteristics of different types of price indexes.
    Secondly, lower risk of deflation would not be secured merely by a positive inflation rate, but require deflation not to recur even in the event of some external shocks and a mild increase in prices to be sustained. In this regard, the BOJ's commitment to continued quantitative easing clearly indicates a condition that an inflation rate is not expected to register negative values again. For instance, regarding the previously discussed correlation between the GDP gap and the inflation rate, it is believed to be necessary to stabilize actual and expected inflation rates at certain levels in preparation for the risks in the event of an expansion in the GDP gap due to an economic recession. The question of the level of economic shocks to be assumed in determining the expected inflation margin should be, with utmost caution, solved examining comprehensively all factors including various past examples.
    Thirdly, with regard to the above two points, when judging deflation risks, it is necessary to also consider whether the financial system has recovered to a fully sound condition. If the financial system has not fully recovered, monetary policy would not be able to fully exercise the easing effects necessary for preventing deflation when a shock occurs, and it would be possible that deflation will recur. From such a perspective, it is necessary to further advance the restoration of the soundness of the financial sector and to ensure stable growth in bank lending and money supply, with the objective of enabling monetary policy to fully exercise its effects.
   
Is Japan overcoming deflation?
    An examination of the current situation from the perspectives mentioned above reveals that, despite the fact that extent of deflation is easing and is approaching zero as a result of economic recovery, the process of overcoming deflation is still only half-complete. Firstly, the GDP gap was significantly reduced, but it is expected to take quite some time yet for the economy to reach a state in which deflation would not recur even in the event of some external shock, and in which a moderate increase in prices can be maintained. Secondly, the soundness of the banking sector has improved somewhat due to the progress in the disposal of non-performing loans, but the financial intermediary function has not been completely recovered as the growth in lending and money supply remains low. Against this backdrop, the transmission mechanism of the BOJ's monetary policy still has not reached a state in which it can be expected to fully exercise its functions.

Column 1-3

   Study of deflation risk by the International Monetary Fund (IMF)

    The Index of Deflation Risks created by the IMF can be used as a reference when making a comprehensive judgment of deflation. The IMF (2003a) creates the Index of Deflation Risks by compiling sets of price indicators, supply and demand indicators and financial indicators, and evaluated deflation risks for each economy. Specifically, eleven indicators, including consumer price-related indicators, GDP gap-related indicators, stock prices, exchange rates, bank lending and money supply, were computed and for each indicator, an examination was undertaken as to whether the indicator exceeds a predetermined threshold. If so, the economy was given a score of 1 on that account meaning that deflation risks existed; otherwise, it was given a score of 0, meaning that there were no deflation risks. The scores were then averaged using the simple average method or the weighted average method depending on the situation of each respective economy, and an Index of Deflation Risks was computed(19). While the highest possible score is 1, in the IMF classification, if the score exceeds 0.5, the risk of deflation is determined as high. Hence, as of 2002 the risk of deflation in Japan, Hong Kong and Taiwan was assessed as high (Column Table 1-3). If this index for Japan is updated with data as of the end of 2003, it is clear that the risks have slightly decreased compared to 2001, but the score still exceeds 0.5, which means that the deflation risks remain high. A breakdown of the index shows that while the three indicators related to the gap between supply and demand suggest no deflation risks, the three indicators related to the consumer price index still indicate the existence of deflation risks, and all five finance-related indicators imply deflationary risks (Appended Table 1-21). This is a reflection of the continued sluggish growth in money supply and bank lending, and the appreciation of the yen in 2003. Therefore, in order to steadily overcome deflation against the backdrop of the recovery in the real economy, it is necessary to restore the soundness of the financial sector and to create an environment that will allow monetary policies to fully produce their effects.
Column Table 1-3 Index of Deflation Risks (2002)
   

Policy to overcome deflation
    As observed above, the process of overcoming deflation is still only half-complete, and initiatives for overcoming deflation remain an important task on the policy agenda. Needless to say, overcoming deflation requires further improvement of the soundness of the financial sector coupled with efforts to sustain as much as possible the current economic recovery. As for monetary policy, it requires effective policy management, including measures that will lead to efficient provision of funds. The government too must advance structural reform in order to further reduce the gap between supply and demand. Furthermore, in the process of shifting from deflation to a mild increase in prices, it would be necessary to implement appropriate policy measures to eliminate the risk of slipping back into deflation.
    Next, some of the issues related to the increase in interest rates that might arise in the process of shifting from deflation to a mild increase in prices are considered.
    First, at the stage in which the quantitative easing policy of the BOJ will be lifted is nearing, there would be a possibility of a hike in long-term interest rates exceeding the expected rate of price change due to market speculation triggered by such reasons as uncertainties over the monetary policy in the future. This could be an impediment to the economic recovery. Such concerns have been raised at the BOJ's Monetary Policy Meetings as well (see minutes of the Monetary Policy Meetings held on July 14 and 15, 2003). In that sense, clarification of the conditions for the lifting of the quantitative easing policy by the BOJ in October 2003 increased the transparency of its commitment and proved effective in alleviating the fluctuation in the market triggered by the speculations. However, the outlook for the mid-term monetary policy management after the lifting of the quantitative easing remains unclear.
    Second, if long-term interest rates drastically soar in the process of shifting to a mild increase in prices, there would be a risk of valuation losses for government bonds held by the private banking sector, and the possibility that their capital base is impaired. However, it is possible that the valuation losses for such government bonds will be offset by the profit from other financial assets such as shares.
    Third, in the event of an increase in long-term interest rates, the interest payment on government bonds by the government will increase. From this perspective as well, it is necessary to further accelerate efforts for the creation of a sustainable fiscal structure.
    On the basis of such recognitions, an important issue for the monetary policy in the period of overcoming deflation will be how to efficiently provide support for the complete overcoming of deflation while preventing an excessive increase in long-term interest rates. When addressing this issue, the central bank must clarify its rules for monetary policy management in order to eliminate the uncertainty over its future policies and must obtain wide-ranging confidence and support from the market with regard to these rules. In this sense, ensuring transparent policies through disclosing guidelines on issues such as the duration and extent to which the monetary easing environment will be maintained even after deflation is overcome, and utilizing such measures to stabilize the expectations of the market through dialogue, are extremely important issues for the future monetary policy of Japan(20).
    Various debates have taken place over these issues. Some argue that conditions such as a certain rate of price change or price level should be indicated, though in any event, broader consideration will be needed.
   


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