Annual Report on

The Japanese Economy and Public Finance


- Japanese Economy Heading for New Growth Era

with Conditions for Growth Restored -

Cabinet Office

Government of Japan

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Section 2 Prospects for Overcoming Deflation and Related Challenges

    Amid the continued economic recovery since 2002, moves toward overcoming deflation have made progress, with signs of a change of the trend in long-term price declines. Deflation is an economic phenomena that did not occur in advanced countries during the postwar period. Attention is now focused on policy measures that are necessary to overcome deflation and push price inflation rates into positive territory in the process of normalizing the economy.
    Here, we would like to discuss measures from the perspective of financial policy, after outlining changes in economic situations and the prospect for overcoming deflation.

1. Recent Price Trends and Future Outlook

(1) Deflationary situation showing improvement

(Improvement of deflationary situations seen from various price indices)
    There are various economic indicators showing price trends, and they all showed year-to-year declines since around the late 1990s, when the Japanese economy fell into deflation of continuous price declines. Moves toward overcoming deflation have at last begun to appear amid the particular situation where, as we discussed in Section 1, economic recovery has been continuing despite deflation. We would like to verify such moves toward overcoming deflation by using price indices in economic statistics.
    First, domestic corporate goods prices (year-to-year), a price trend that corresponds to the upstream in economic activity stages, have been on the rise since 2004, on the strength of rising international commodity prices, against the backdrop of the global economic expansion brought about by China's and some other countries' economic development and the inflow of speculative funds. Consumer prices, a price trend at the consumer level, have been positive year-on-year since November 2005, as the effects from the reduction in telephone and other public utility charges have gone away, and energy-related items, such as petroleum products, electric bills, and city gas charges, have contributed to pushing up prices.
    On the other hand, the GDP deflator (year-to-year), which corresponds to per-unit price of added value produced in Japan, has declined for eight consecutive years. The degree of decline of the GDP deflator has been moving horizontally, as the import deflator has been contributing to price declines since 2004, reflecting a rise in crude oil prices. However, the degree of decline of the domestic demand deflator has been on a narrowing trend and the deflator posted a positive growth of 0.1% in the January-March quarter of 2006 (Figure 1-2-1).
Figure 1-2-1 Changes in Corporate Goods Prices (Domestic Demand Products), Consumer Prices (General, excluding Fresh Food), and GDP Deflator

(Decline of GDP deflator caused by increases in import prices)
    The GDP deflator is an implicit deflator that is obtained by dividing nominal GDP by real GDP, and it is an indicator showing "home-made" price fluctuations based on domestic factors. Its movements indicate fluctuations of added value (profit and wage) per production unit. Therefore, if, for instance, a rise in crude oil cost is not sufficiently passed on to product prices, or not passed on at all, the profit and wage decrease by that amount, resulting in pushing the GDP deflator lower than otherwise. It is necessary to keep in mind that the GDP deflator, due to its nature, may move differently from other price indices. For this reason, in order to understand upward pressure on prices in domestic economic activities, it would be effective to pay attention to price trends of final goods, etc.
    The domestic demand deflator is an important indicator to understand the price trends of domestic demand as a whole. The private final consumption expenditure deflator (hereinafter referred to as the personal consumption deflator) is also an important indicator to assess price trends, as it covers basically the same area as the consumer price index. A comparison of the consumer price index (general) and the personal consumption deflator shows that although the consumer price index is in the neighborhood of zero percent, the personal consumption deflator still remains in negative territory, standing at minus 0.2% in the January-March quarter of 2006. This is due to the following reasons: 1) The consumer price index is compiled by the Laspeyres fixed-base method, which tends to cause an upward bias, while the personal consumption deflator is compiled by the Paasche chain index method; 2) The consumer price index covers about 600 representative items, while the personal consumption deflator is more comprehensive, covering about 2,000 classified items, and uses not only the consumer price index but also other price data, such as the corporate goods price index and the agriculture price index; 3) With respect to health-related items, if the self-pay ratio increases, the index for the health care-related items in the consumer price index rises, while the personal consumption deflator is not influenced by such a change in the self-pay ratio (Figure 1-2-2). Incidentally, we should keep in mind that it is difficult to use the consumer spending deflator for the overall assessment of current price trends, as it, unlike the consumer price index, does not permit factor analyses and is published on a quarterly basis.
Figure 1-2-2 Changes in Consumer Price Index and Personal Consumption Deflator, and Difference in Compilation Method

(Price shift in moderate progress from upstream to downstream at corporate level)
    The delay in domestic price shift, a factor contributing to holding down the GDP deflator, began to show signs of change at the beginning of 2006. Final goods prices in the domestic corporate goods price index turned positive in November 2005 for the first time in 13 years (See Figure 1-2-1). However, the final goods prices, excluding exchange rate factors and special factors (rises in petroleum product prices), are still continuing their decline on a year-on-year basis. At the same time, however, the degree of the declines has narrowed gradually, indicating that the price shift to downstream is making moderate progress (Figure 1-2-3).
Figure 1-2-3 Changes in Corporate Goods Prices (Final Goods Prices)

(2) Points to keep in mind when assessing price trends from economic indicators

(Consumer prices are close to the actual feeling held by the entities of economic activities, but require adjustment for petroleum products and other special factors)
    When assessing price situations, it is important to judge the background of upward pressure on prices, etc. in a comprehensive manner, by using various economic indicators in addition to price statistics, while keeping in mind the nature of each price index. Among various price indicators, consumer prices are the closest to the actual feeling about prices held by households, corporations and other economic entities and are the most important indicator in conducting economic activities, such as production/investment and labor supply/consumption.
    When studying the underlying trend of consumer prices, the "core index" is used, as it excludes from the "general index" the fluctuations of various special factors that do not reflect supply-demand situations of the domestic economy, such as weather factors, international commodity market movements, and institutional factors. In the US and European countries, foods and energy are generally excluded from the core index. In Japan, since the weight of foods is large, the problem is that the weight left after the exclusion is too small(12). Aside from the method of excluding specific items on an ad-hoc basis, there is "trimmed mean CPI," which excludes certain percentages of high and low volatility items(13). Although this method has merits, in that it allows the elimination of the arbitrariness in selecting items to be excluded and is less susceptible to fluctuations caused by special factors, it also has demerits. For instance, if items that are on a declining trend irrespective of special factors, such as personal computers, are excluded, the index becomes biased. There is another method for interpreting consumer prices, a method which excludes special factors for specific reasons. However, since there are no clear standards for citing reasons for excluding special factors, the arbitrariness cannot be eliminated in this method. It has another demerit in that long-term time-series data cannot be produced, as items excluded change over the course of the year. Still, the method is helpful for assessing current price trends (Figure 1-2-4).
Figure 1-2-4 Core Indicators for Consumer Price Index
    The price indicators all show that prices stopped declining and began to rise from late 2005 to early 2006. Of them, consumer prices, excluding petroleum products and other special factors, have been moving steadily, narrowing the margin of decline from the latter half of 2004 and posting a positive growth of 0.2% in April 2006 (Figure 1-2-5). However, the rising pace is extremely moderate at present.
Figure 1-2-5 Changes in Consumer Prices excluding Petroleum Products and Other Special Factors
    With respect to consumer prices, a base revision is scheduled for late August 2006. Since the consumer price index is calculated by the Laspeyres method, fixing items surveyed and their weight to the base year, it tends to cause a bias, as it does not take into account changes in consumption behavior, such as a shift in demand to goods whose prices go downward as the years progress. The fact that the level of index returns to base year = 100 will have major impacts, along with changes in survey items and their weight. For instance, since the average price index of personal computers (desktop) for 2005, which stood at 17.7 on the 2000 base, returns to 100 on the 2005 base, its contribution to the index decline will increase by about 5 times. The calculation of year-on-year changes will be revised retroactively starting with January 2006. If we recalculate the index based on 2005 being 100, and correct the weights by using the Family Income and Expenditure Survey, etc., the index is expected to drop by 0.2~0.3 percentage point after the revision (Figure 1-2-6). This suggests that as of spring of 2006, consumer prices as measured by the formula of "excluding petroleum products and other special factors" were still moving in the neighborhood of zero percent.
Figure 1-2-6 Estimate of Impacts of Consumer Price Base Revision

(Upward pressure on prices rising as seen from the real economy)
    In order to judge if the economy is in a deflationary situation or not, it is important to understand the situation of upward pressure on prices from the actual economy, in addition to understanding the price indicators showing the results of such pressure.
    First, let us take a look at the situation of GDP gap (percentage of real GDP relative to potential GDP) with respect to demand aspects. The GDP gap is positively correlated with the inflation rate in the long run. However, if the inflation rate falls below a certain level, it does not fluctuate as much as the GDP gap(14). Though it is necessary to keep this in mind, the GDP gap has been basically continuing its improvement since 2002, after undergoing a temporary slowdown from the autumn of 2004 to the summer of 2005, and posted a positive growth of 0.2% in the October-December quarter of 2005, the first rise to positive territory in nearly 8 years since the January-March quarter of 1997(15) (Figure 1-2-7).
Figure 1-2-7 Changes I GDP Gap
    Next, with respect to supply aspects, let us take a look at unit labor cost (labor cost necessary for one-unit production) that is correlated with prices. In recent years, the unit labor cost has been pushed down by a decline in wages, but correlations between unit labor cost and consumer prices have weakened(16). More recently, the unit labor cost is moving horizontally, with improvement in labor productivity and a rise in wages canceling out each other, a phenomenon generally seen in economic recovery periods. However, the year-to-year growth of unit labor cost is still in negative territory (Figure 1-2-8). If the unit labor cost keeps rising from wage aspects in the days ahead, however, it could become a factor pushing up prices from cost aspects.
Figure 1-2-8 Change in Unit Labor Cost
    As just described, the environment surrounding prices, such as GDP gap and unit labor cost, shows that it is not a risk factor for worsening deflation, although we have to keep in mind that both GDP gap and unit labor cost have weakened their correlations with consumer prices.

(Accelerated situation of expected inflation rate leading to higher prices)
    Inflation expectation not only affects economic activities through real interest rates but also influences decisions on labor supply through real wages. It is believed that the acceleration of economic activity entities' expected inflation will eventually lead to upward pressure on actual prices.
    Household's inflation expectation has basically been on a rising trend, although it fluctuates slightly as it is greatly influenced by trends of petroleum product prices, etc. and the volume of information(17) (Figure 1-2-9). Regarding corporations' inflation expectation, the output prices DI (diffusion index) of the TANKAN survey shows that although the DI nonmanufacturing industry has kept rising moderately, the DI for manufacturing processing industries is moving horizontally. However, the output prices DI for corporations facing consumers more closely shows that both goods and service prices DI are on a rising trend.
Figure 1-2-9 Households' and Corporations' Inflation Expectation
    According to the projection by a group of private economists (ESP Monthly Survey of Japanese Economic Forecasts), the output prices DI is expected to move horizontally in FY2006, but is expected to rise moderately in FY2007.

Column 4

It is after the war that inflation has taken root internationally

    In the post-war world, there are few cases where a major advanced country fell into a deflationary situation in the sense of a sustained decline in prices. Before the war, however, deflation was not an unusual phenomenon worldwide*. In the era of the gold standard or before, the amount of money supplied was controlled by the amount of gold, silver or other metal. Therefore, before World War I, long-term price fluctuations were relatively small, with prices seesawing in a narrow range in the short term, although there were inflationary situations caused by an increase in gold or silver output and mintage (Column 4 Figure). During wars, countries issued paper money recklessly to raise funds irrespective of the amount of gold or silver they owned, resulting in rising inflation. After the wars, they were plagued with deflation to contain the inflation. (Examples: Seinan War and Matsukata deflation).
Column 4 Figure: Historical Changes in Prices
    An international gold standard system with an automatic balance-of-payment adjustment mechanism was established in the 1870s, and was adopted by advanced countries, as it was seen as an international monetary system bringing stable economic development. After the outbreak of World War I, the countries withdrew from the gold standard system, but still later, they tried to return to the gold standard system, with then Japanese government of Prime Minister Hamaguchi lifting the gold embargo. Returning to the gold standard system was a common understanding in those days, and deflation was incorporated in policy measures as an adjustment process. However, in the latter half of the 1920s, gold-inflowing countries like the United States and France adopted gold-sterilization policies in order not to increase money in circulation in their countries, disrupting the gold standard system's automatic balance-of-payment adjustment mechanism. As a result, the world depression became even more serious, and in the end, the international gold standard system collapsed.
    It is a post-war phenomenon that inflation has become a chronic event. Under the Bretton Woods regime, where gold and the dollar were pegged, the United States, or the key-currency country, provided dollar through a huge amount of overseas aid, mainly through the Marshall Plan, and the countries enjoyed relatively stable economic growth. In this situation, the downward rigidity of wage and price had been institutionalized and inflation has become a chronic event, partly due to the development of labor unions. As a result of the shift from the Bretton Woods system to the current managed currency system, the central banks of various countries have come to be able to adjust money supply without worrying about the kind of physical limitations they felt under the gold standard system. This may have helped inflation become a chronic event.
(*) For detail, see Okamura (2001) and Kitamura (2002).

(3) Outlook for price trends to overcome deflation

(What overcoming deflation means)
    Deflation is a continuous decline in prices. The Japanese economy, which had been in moderate deflationary situations since the late 1990s, is showing improvement in the spring of 2006. In order to overcome the deflationary situations, it is necessary for prices to keep a stable rise and pass the point of no return.
    In order to understand the situations of rising prices, we evaluate the trends of CPI, the GDP deflator and various other indicators. As already described in detail, it is necessary to assess the trends of prices reflecting domestic economic activities, while assessing the individual characteristics of various price indicators. In order to ascertain that a price increase has been stable and passed the point of no return, it is necessary to understand not only the trends of prices but also the situation of upward pressure on prices in the real economy. Trends of the GDP gap showing supply-demand situations of the macro-economy as a whole, and trends of unit labor cost showing upward pressure on prices from cost aspects are important information to that end.
    When assessing the overcoming of deflation, it is necessary to look at various economic indicators in a comprehensive manner from these perspectives. With the economic statistical indicators obtained so far showing improvement in the environment surrounding prices, moves toward overcoming deflation are expected to continue steady progress.

(Countervailing factors for upward pressure on prices)
    Although moves toward overcoming deflation have made progress, there are several points to keep in mind with regard to the extent of future price increases.
    First, a global disinflation is in progress, caused by an increase in supply capacity, against the background of economic development of China, India and other so-called BRICs countries. A study of the impact of import pressure on consumer prices in Japan shows that the deflationary pressure of import competition items, excluding electrical products, has been decreasing since 2003 and now stands at nearly zero percent (Figure 1-2-10). However, a study of inflation rates in the US and EU shows that, though core inflation rates stand at about 2%, the inflation rates of goods are close to zero percent (Figure 1-2-11). It is unclear if prices of goods have become an inflationary pressure.
Figure 1-2-10 Impact of Supply-Side Factors on Prices
Figure 1-2-11 Changes in Prices by Goods/Services in US and EU
    In the US and European countries, service-related prices are contributing to a rise in inflation rates, but in Japan the rate of change in service prices has become extremely small in recent years(18).
    Second, price competition has intensified against the background of deregulation in wide ranging areas. A study of the impact on consumer prices of the deregulation factor, consisting mainly of telephone and other public utility charges (but, electric power and gas are excluded), shows that the factor contributed minus 0.2% to the consumer price index in 2005 (See Figure 1-2-10). As for the impact of deregulation on distribution aspects, a calculation of the transportation/commerce margin ratio by using the National Accounts shows that the ratio has been on a declining trend since 1995. However, it has begun to show signs of stopping declining in recent years, suggesting that the deflationary pressure on distribution aspects has eased (Figure 1-2-12).
Figure 1-2-12 Changes in Transportation/Commerce Margin Ratio
    Third, the improvement of product performance brought about by technological innovation contributes to price declines. Take, for example, personal computers whose performance has increased conspicuously. The average price index of personal computers in 2005 dropped to 17.7 from 100 in 2000. This is due to the fact that prices are measured based on the principle that quality is constant. Therefore, when there is quality improvement in a product, the price of the product declines even if there is no change in the price paid by consumers. With respect to electrical goods whose quality improves fast, a comparison of year-to-year changes in contribution in the years (1986 and 2001) following the base years, when upward bias was small, shows that electrical goods contributed about minus 0.4% to price declines in 2001, compared with about minus 0.3% in 1986, despite the fact that the weight of electrical goods in consumer prices remained almost unchanged.

2. Trends of Financial Policy

(1) Quantitative easing policy contributed to keep interest rates stable at low level.

(Quantitative monetary easing lifted)
    The Bank of Japan, at its Monetary Policy Meeting in March 2006, decided to change the operating target of money market operations from the quantitative easing policy, which had been in place for five years since March 2001, to short-term interest rates (the uncollateralized overnight call rate), and to encourage the call rate to remain at effectively zero percent. At the same time, the Monetary Policy Meeting also introduced a new framework for the conduct of monetary policy, including clarification of "price stability."

(Effects of quantitative monetary easing: financial system stability and interest-rate stability at low level)
    The quantitative easing policy was 1) the provision by the Bank of Japan of ample liquidity to raise the outstanding balance of current accounts far exceeding the amount the financial institutions having current accounts at the Bank are required under the reserve requirements system and 2) the commitment by the Bank of Japan to continue providing ample liquidity until the year-on-year rate of change in the consumer price index (excluding fresh food, a national basis) stably registers a zero percent or higher. In those days, amid the rising financial system uneasiness, there were concerns about the possibility that the Japanese economy may fall into a vicious cycle of deflation, or so-called deflationary spiral, in which a decline in demand caused by economic slowdown causes a decline in prices, and this in turn cause a further decline in demand. The quantitative easing policy was adopted with the aim of preventing a continuing decline in prices and establishing a foundation for sustainable economic growth.
    Specifically, as the effectiveness of the quantitative easing policy, first, "the effect on the stability of financial system" can be pointed out. Provision of ample liquidity exceeding the required reserve amounts at the time of strong financial system uneasiness contributed to meeting the liquidity demand from financial institutions and averting the kind of large-scale credit crunch that occurred in 1997 and 1998. Under the quantitative easing policy, the removal of the full deposit guarantee was implemented smoothly as planned without confusion in April 2005.
    The second effect is "the effect on keeping interest rates stable at a low level." Amid the continued decline in consumer prices (year-to-year), the commitment of 2) above had generated a market expectation that a zero interest rate environment would continue for a certain period of time, resulting in medium- and long-term interest rates also remaining stable at low levels (so-called "duration effect"). From the perspective of effects on the real economy, the "stabilization of interest rates at a low level" in the financial market helped realize an easy corporate financial environment. With the credit spread of corporate bonds declining, financial environment as seen from the perspective of the corporate sector, is now the most favorable since the 1990s. It can be said that the corporate sector has reduced "the three excesses" in this favorable financial environment (Figure 1-2-13).
Figure 1-2-13 Quantitative Easing Policy

(Effects of stabilizing interest rates at low level as seen from duration effects)
    Here we look at the "effect of stabilizing interests at low level" by using Euroyen futures (3 month) that reflect the market expectation of the yen-interest rate. Regarding the central bank's policy interest rate (uncollateralized overnight call rate), the expected duration of the zero interest rate environment becomes shorter in line with the improvement in price development, and the duration effects ceases to exist when the criterion that the year-on-year rate of change in the CPI is registering zero percent or higher on a sustainable basis is fulfilled. The expected duration by the market of the quantitative easing policy continues to (period until Euroyen futures (3 month) exceed its average rate recorded during the zero interest-rate policy), shows that it was longer than one year in the summer of 2005, but gradually became shorter as consumer prices (year-to-year) narrowed the margin of decline. It was shorter than three months in late February 2006, when the consumer price index for January 2006 (up 0.5% from a year early, posting a year-on-year rise for three consecutive months) was announced. Against the background of these expectations by market participants, the quantitative easing policy was lifted in early March (Figure 1-2-14).
Figure 1-2-14 Duration Effect of Quantitative Easing Policy
    Meanwhile, long-term interest rates (10-year government bond yield on the secondary market) rose to the 1.6% level in the latter half of 2005, reflecting improvement in business sentiment and higher stock prices. However, the yield on 10-year government bonds remained stable at a low level through the period of the quantitative easing policy. (It is necessary to keep in mind that long-term interest rates in Japan have increased their correlation not only with domestic factors but also with overseas interest rates, as will be analyzed in Section 3.) Given the fact that, after the lifting of the quantitative easing policy, long-term interest rates rose higher and moved at around 1.8~2.0% in April and May, it can be said that the duration effect, which was based on the assumption that the policy interest rate (short-term interest rate) will remain at zero percent for a considerable period of time, extended to long-term interest rates and that the outlook for long-term interest rates was influenced by the lifting of the quantitative easing policy.

(2) Monetary policy at the exit from deflation

(Market stabilization functions required of monetary policy at the phase of overcoming deflation)
    Although the trend of interest rates is governed by various factors, if the framework of monetary policy has to be altered as described above, it is necessary to pay attention to the effect through the expectation formation channel of the market. In other words, when monetary policy management is to be changed, such as by lifting quantitative monetary easing and ending the zero-interest-rate policy, it is necessary to present an alternative framework to stabilize market expectations.
    If we take this into consideration, it can be said it would be reasonable as a specific financial policy management (i) to promise beforehand that low interest rates would be kept for a certain period, even when the economy is at the exit from deflation (or holding off monetary policy response to developments in the real economy). In addition to this, the following measures can be thought of: (ii) Given the risk of returning to deflation and its cost, it would be reasonable to set a not-too-high inflation target rate (or inflation target range) while avoiding the loss of confidence in the central bank and the destabilization of inflation expectations (inflation targeting) (Bernanke et al. [1999]); (iii) In view of the fact that the price level has declined and deviated from the optimum price path due to deflation, some people propose setting a target for raising prices to a certain level where prices would have stayed if they were not impacted by deflation, and allowing a higher inflation rate until the target is achieved (price level targeting) (Ito and Mishkin [2005]). Incidentally, some major countries have announced their definition of an inflation target or price stability in numeric terms in order to achieve "price stability" in the medium and long terms.
    In the following section, we would like to review the new framework for the conducting of monetary policy, announced by the Bank of Japan at the time of the lifting of the quantitative easy policy, from the perspective of the stabilization of market's expectation formation and the financial policy for the exit from deflation.

(Introduction of a new framework for the conduct of monetary policy)
    When the Bank of Japan lifted the quantitative easy policy, the central bank announced that it will 1) shift to an interest rate policy, 2) continue the zero-interest policy for some time, even after the lifting of the quantitative easy policy, 3) gradually reduce the outstanding balance of current accounts over a period of a few months, and 4) conduct money market operations through short-term money market operations, and continue to purchase long-term government bonds at the current amounts for some time. With regard to 2), the Bank of Japan says that if it is judged that inflationary pressures are restrained as the economy follows a balanced and sustainable growth path, an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time ("Current View on Monetary Policy").
    In addition to the "Change in the Guideline for Money Market Operation" above, the Bank of Japan announced the introduction of a new framework for the conduct of monetary policy in order to ensure the transparency of its policy and stabilize market's expectation formation given the shift from "the quantitative easing policy" to "the interest-rate policy." The process of the new monetary policy management consists of three elements: (i) clarifying of "price stability," (ii) examining economic activity and prices from two perspectives, and (iii) outlining "Current View on Monetary Policy," based on the examination above.
    Regarding (i), the Bank presents 0~2% (median rate: around 1%) as a level of inflation rate that the nine Policy Board members understand as price stability from a medium- to long-term viewpoint ("understanding of medium- to long-term price stability"). It says the rate will be reviewed annually. The first perspective in (ii) is the process of examining, as regards economic activity and prices one to two years in the future, whether the outlook deemed most likely by the Bank of Japan follows a path of sustainable growth under price stability (0~2%). The second perspective in (ii) is the process of examining, after sorting out "upward fluctuation factors" and "downward fluctuation factors" in the outlook deemed most likely by the Bank of Japan, risk factors (for instance, risk of asset inflation and deflationary spiral) that will significantly impact economic activity and prices when they materialize, although the probability is low. Finally, in (iii), the Bank of Japan will, in the light of examinations from the two perspectives described above, outline, "the Current View on Monetary Policy," and publish it on a regular basis.

(Proper communications between the central bank and the private sector is important)
    The numerical value of "0~2%" presented as an "understanding of medium- to long-term price stability" in the clarification of "price stability" has invited some discussions as to how it will be used in Bank of Japan's monetary policy operations(19). The Bank of Japan says that the numerical value merely shows the width of inflation rate that each member of the Policy Board understands as price stability and that it is not intended as a kind of inflation targeting framework that aims to achieve price stability within a certain period by setting a numerical target. However, since the new framework was introduced to ensure the transparency of monetary policy management, and future monetary policy is determined with the "understanding of medium- to long-term price stability" of 0~2% in mind, market participants are likely to use it as a tool to read the future monetary policy of the central bank.
    Incidentally, there is what is called the Taylor Rule as one of the methods for setting interest rates. It is a monetary policy rule to derive a policy rate (uncollateralized overnight call rate, in the case of Japan) in accordance with economic conditions. Specifically, it is a rule to derive a policy interest rate in accordance with the magnitude of deviation of the current inflation rate from the long-term target rate and of the supply-demand gap from the equilibrium value. We estimated the policy rate derived from the Taylor Rule based on the inflation rate of 0~2% presented as an "understanding of medium- to long-term price stability." Specifically, assuming target inflation rates are from 0 to 2 percent, we estimated policy interest rates derived from the rule by using consumer price indices and the supply-demand gap estimated by the Cabinet Office. The estimation results show that the current interest rate level is in positive territory (Figure 1-2-15). With regard to the interpretation of the interest-rate level derived from the estimation, there are several points to keep in mind, such as supply-demand gap measuring errors and a lag in the ripple effects of the monetary policy(20). There are problems in deriving monetary policy management patterns on the basis of a mechanical rule. It is extremely important to have a system to stabilize economic activities by enhancing the transparency of monetary policy and thereby facilitating private sector's expectation formation. From this perspective, it is hoped that the Bank of Japan and the private sector will have proper communications under the "New Framework for the Conduct of Monetary Policy."
Figure 1-2-15 Interest Rate Trends Estimated by the Taylor Rule

(3) Money-related indicators continuing moderate increases

(Money supply increasing moderately under the economic recovery)
    A study of the trends of money-related indicators in and after 1990 (Figure 1-2-16 (1)) shows that the monetary base (Bank of Japan notes issued + currency in circulation + current account balance) posted a sharp increase in and after 1995. But a study of the growth rate of the monetary base (Figure 1-2-16 (3)) shows that it has been falling by 1-2% year-on-year since the beginning of 2006. A breakdown of the monetary base into BOJ notes issued/currency in circulation and the current account balance shows that the effect of the current account balance on raising the monetary base had been almost zero because, under the quantitative easing policy, the target balance has been kept unchanged since January 2004. After the lifting of the quantitative easing policy, the current account balance has been working as a factor decreasing the monetary base. On the other hand, BOJ notes issued/currency in circulation, which had been contributing to the increase in the monetary base against the background of a decline in opportunity cost of hoarding cash or holding BOJ notes due to concerns about the financial system, began to gradually lose their influence on increasing the monetary base after hitting a peak at the beginning of 2002.
Figure 1-2-16 Trends of Money-Related Indicators
    Money supply (hereinafter referred to as M2+CD) had been on an increasing trend since the 1990s, though not as fast as the monetary base. In contrast to the increasing trends of the monetary base and M2+CD, the nominal GDP and the consumer price index were on a moderate declining trend. Reflecting this, the monetary velocity, which is nominal GDP divided by M2+CD (Figure 1-2-16 (2)) had been on a long-term declining trend. Recent trends show that while the growth rate of M2+CD has slowed down, the nominal GDP has been increasing moderately on the strength of economic recovery, leading the velocity of money to stop declining.
    Despite the continuing economic recovery, the growth rate of M2+CD has been moving horizontally since mid-2003, hovering at between 1.5% and 2%.

(Trends of money supply seen from balance sheet breakdown)
    M2+CD (cash currency in circulation + bank deposits + certificates of deposit) is determined by the results of interactions between the demand-side showing to what extent money holders (corporations, households, etc.) held cash, bank deposits, etc. as a means for economic transactions, savings, etc., and the supply-side showing to what extent financial institutions extended credit through bank lending, etc. We can quantitatively measure each factor in the supply and demand aspects by using a method called "balance sheet breakdown" of financial assets and liabilities of the money holders (corporations, households, etc.). According to this method, M2+CD can be broken down into 1) fund shifts within the financial assets of money holders (corporations, households, etc.); fund shifts between assets covered by M2+CD and other financial assets (government bonds, stocks, etc.), 2) changes in the financial liabilities of money holders (corporations, households, etc.) through borrowing from banks and corporate bond issuance, and 3) changes in the net financial assets (net savings) of money holders (corporations, households, etc.), or, conversely, changes in financial surplus or deficit (net investment) of the government sector and the overseas sector.
    An analysis of the trends of M2+CD (Figure 1-2-17) since the latter half of 1990s shows that the "fund shift factor," stemming from financial system insecurity, and the "fiscal deficit factor," stemming from expanding fiscal deficits, have pushed the growth of M2+CD higher, while the "financial liability-decreasing factor" has held down the growth of M2+CD against the background of corporations' repayment of debts and financial institutions' cautious stance toward lending.
Figure 1-2-17 Balance Sheet Breakdown of M2+CD
    As a factor for an increase in M2+CD in the future, attention is focused on whether corporations' repayment of debts comes to an end and sustained economic recovery increases demand for funds from households and corporations, resulting in an increase in bank lending.

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