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The Prospects for Escape From Deflation and Directions for Financial Policy

June 30, 2004


Consumer prices (excluding fresh foods) declined by nearly 1% year-on-year in 2001 and 2002, but early in 2003 the downward trend began to slow, for the following two reasons:

(i) The deflation gap is contracting. An important reason for deflation in Japan since the end of the 1990s was the expansion of the deflation gap. However, since the second half of 2003, the emerging economic recovery has led to a rapid contraction of the deflation gap, helping to slow deflation.

(ii) Import penetration has peaked. The rapid influx of cheap manufactured goods from China and other Asian countries cannot be disregarded as a factor behind deflation in Japan. Reflecting the surge in imports, the import penetration ratio soared. However, since 2003 the import penetration ratio has also begun to fall, indicating that the downward pressure that imports of cheap manufactured goods exert on the domestic price structure has started to tail off.

In labor-intensive sectors, the production cost gap between Japan and other Asian countries has narrowed and with the deflationary pressure of the rise in the import penetration ratio easing off, the closing of the deflation gap will be an important indicator of the likely timing of Japan's escape from deflation. Assuming a latent growth rate of 1.5% and a real growth rate of 2.5%, the GDP gap is likely to become zero around the first quarter of 2005. In this light, there appears to be hope that Japan will, at least, come out of deflation in 2005.

Although there is hope that Japan will come out of deflation by the end of 2005, the basic trend of "dis-inflation" is likely to continue, even after deflation ceases, for the following two reasons:

(i) Increasing productivity will absorb the rise in raw material costs.
(ii) The stagnation of nominal wages will exert downward pressure on the price of services.

A survey of the trend of long-term interest rates and nominal economic growth in Japan reveals that, setting aside the ultra-low interest phase of the 1990s (after the collapse of the bubble economy), during "normal times" of the 1980s, interest rates followed the movement of the economic growth rate with a lag of 2-3 years.

As a state of "dis-inflation" is likely to persist for some time after Japan escapes from deflation, even if the economy continues to recover, it is likely that the stable growth rate of nominal GDP will be no greater than just over 2%.

Assuming that their relationship to the nominal growth rate is unchanged, long-term interest rates are likely to hover between 1.5% and 2.0% for the duration of fiscal 2004 and thereafter to rise only slowly, remaining between 2.0% and 3.0% over a period of 1-2 years, starting in fiscal 2005.

The problem is that the lack of a consensus on prices and interest rates during this post-deflation phase is making investors anxious and once some degree of consensus has been achieved, discontinuing quantitative monetary easing should not cause any great turmoil. Bearing in mind that the potential risks presented by excessive haste in discontinuing quantitative monetary easing are greater than the side-effects of any delay in its discontinuation, the best policy will be to continue quantitative monetary easing during fiscal 2004 and thereafter to adopt interim measures so as to allow plenty of time before its discontinuation.

In recent months, the debate on the "exit measures", to be introduced after the discontinuation of quantitative monetary easing, has intensified. With the economy performing better than expected and prospects of an escape from deflation beginning to emerge, avoiding unnecessary turmoil in the financial markets, Japan should begin debating a scenario for the normalization of financial policy right away, with a view to forming a consensus.

For more information on the content of this report, please contact
Hisashi Yamada
Economics Department

Tel: 03-3288-4245

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