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 5 Summary

    In this section, the current status of the economy and the fiscal/monetary policy trends that have been described so far are summarized, and important points to keep in mind regarding future economic and fiscal trends are examined.

(The recovery is likely to be sustainable)
    In Section 1, regarding the current status of the economy, we made analyses of recent developments by sector, such as household and corporate sectors, and the characteristics of the current economic recovery as seen from medium- and long-term perspectives. Since getting out of a temporary slowdown in mid-2005, the Japanese economy has been continuing its recovery, with consumption, investment and external demand contributing to the recovery in a balanced manner. Behind this is the fact that, while the behavior of the corporate sector has been normalized after post-bubble adjustments, the improvement in labor supply and demand is having a favorable impact on the household sector.
    There is no doubt that the healthier corporate and household sectors are making a big contribution to the prolonged economic recovery. Furthermore, as external factors supporting the economic recovery, the world economy has been recovering steadily and foreign exchange rates and domestic financial conditions have remained relatively stable. Meanwhile, a sharp rise in crude oil prices is potentially a big destabilizing factor. However, as long as the rise is due to an increase in demand brought about by global economic growth, its profit-squeezing effect will be offset to some extent by the demand-creating effect of the world economy. Moreover, since malignant inflation caused by higher crude oil prices is under control in Japan and other countries, the rise would not hamper the economic recovery.

(The possibility of risk factors becoming real is not large, but caution is needed)
    The probability of sustained economic recovery is high. However, it is usually the case that a long-lasting economic recovery causes some strains in the economy to accumulate due to economic entities' biased expectations. From this perspective, it is necessary to keep paying attention to the trends of business investment and inventory investment that tend to show major cyclical fluctuations. Business investment is mostly consistent with growth in the overall economy, and inventory is stable on the whole. However, even when they look balanced on the macro-economic level, they are imbalanced industry by industry. As industries are expanding their production capacity, it is necessary to keep in mind that a discrepancy between demand and production may lead to a major production adjustment.
    As to external environment, it is necessary to pay attention to world economic trends and the rise in interest rates worldwide. While the world economy is continuing its steady recovery, the huge current-account deficits of the United States are financed by capital inflows from Asian countries and oil-producing countries etc. As a global rise in interest rates is expected, it needs to be watched carefully whether the US can continue to expect stable capital inflows and, if such inflows stop, what will happen to the world economy.

(Overcoming of deflation now in sight)
    As to recent price trends, all price indicators show that prices are declining at a slower pace or beginning to rise. As to the environment surrounding prices, the GDP gap is now in positive territory and the unit labor cost is also expected to decline at a moderately slower pace. In addition, households' and corporations' inflation expectations are on a rising trend. Judging from the trend of prices and their underlying factors, the Japanese economy has gotten out of the situation where prices keep declining and is now in the situation where prices are not likely to keep falling again. In other words, overcoming of deflation is now in sight.
    However, consumer prices are only rising at an extremely moderate pace, excluding specific components that do not necessarily reflect supply-demand factors of the domestic economy. Points to keep in mind with regard to future price movements are the possibility of downward revision of the consumer price index in connection with the benchmark revision in August this year and, in the medium and long terms, the extent of future price increases, while giving due consideration to the impacts of globalization and deregulation.
    With overcoming of deflation now in sight, in order to ensure sustainable economic growth under stable price conditions, it is necessary for the Government and the Bank of Japan to make joint efforts. It is desirable that the Bank of Japan, based on its "A New Framework for the Conduct of Monetary Policy," will continue to support the economy from financial aspects by implementing effective monetary policy management, while taking market conditions into account.

(Impacts of rising interest rates should be kept in mind)
    In early 2006, stock prices were firm reflecting the economic recovery, and interest rates began to rise moderately as the quantitative easing policy was lifted. Long-term interest rates have increased their correlation not only with domestic factors but also with overseas interest rates. If long-term interest rates rise swiftly and sharply, it would have a major impact on each economic entity. For instance, the increase in the debt servicing cost caused by a sharp rise in long-term interest rates would far exceed the increase in tax revenues generated by the economic recovery, worsening the fiscal conditions of the government sector. Our estimate shows that if a rise in long-term interest rates is in line with economic recovery and is moderate, the impact of the increase in interest payment burden on corporate earnings can be absorbed by an increase in sales, etc. However, it should be noted that higher interest rates may adversely affect corporate earnings through the appreciation of the yen. Financial institutions' appraisal losses on their bond holdings can be offset with increases in periodic income and appraisal gains on their stock holdings. However, for the financial institutions that are unable to expect gains and whose capital base is weak, it is necessary to be mindful of a sharp rise in interest rates. As to household sector, since the household sector has more deposits and postal savings than its borrowings, a rise in interest rates would lead to an increase in interest income. However, for the households having housing loans with floating interest rates, a rise in interest rates increases their interest payment burden.

(Importance of balancing fiscal reconstruction and economic growth)
    In Section 4, we have discussed trends in fiscal policy. As the population ages and fewer babies are born, leaving fiscal deficits as they are could become a major risk factor for sustainable economic growth in the future. Although the primary balance of the central and local governments has been improving in recent years thanks to the expenditure reform efforts and sustained economic recovery, the mandatory expenses, such as social security expenses, are expected to increase due to the aging of population. Therefore, in order for the government to achieve a surplus in the primary balance, it is necessary to make considerable policy efforts from both the aspect of expenditure and revenue. At the same time, it is also important to promote the enhancement of growth potential and competitiveness, which is the foundation of every economic policy, and utilize them to achieve fiscal soundness. To this end, it is important to steadily carry out reforms presented in the "integrated reform of expenditure and revenue" and "The Economic Growth Initiative."

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