The Transition to a New Pattern of Growth:
Policy Management During Japan's Escape From Deflation
(A Revised Economic Forecast for Fiscal 2005-2006)
July 05, 2005
The Japanese economy has been in an adjustment phase since mid-2004. Recent months have brought progress with inventory adjustments in the electronic devices sector and consumer spending shows hopeful signs but there are still a number of causes for concern, including the deceleration of exports and slower growth of corporate profits, and, overall, the economy remains on a "plateau".
Any attempt to predict the course of the Japanese economy from the second half of fiscal 2005 through fiscal 2006 must be based on an assessment of three key factors: (i) the outlook for the US and Chinese economies and for Japan's exports, (ii) the trend of business results and capital investment and (iii) the outlook for incomes and consumer spending.
(i) After a slight deceleration in the short term, the growth of the US economy is likely to start gathering momentum from about the autumn of 2005. The Chinese economy will continue to grow at a rapid pace, but imports will continue to slow due to a pause in the drive by foreign companies to establish operations in China, among other factors. Under these conditions, the slowdown in Japan's exports is set to continue in the short term and it is likely to be the beginning of 2006 before export growth begins to accelerate once more.
(ii) In terms of business performance, the momentum of profit growth among Japanese companies is diminishing, especially in manufacturing industry. However, as efforts to restructure in recent years have enhanced profitability, the actual level of profit remains high and capital investment is holding firm.
(iii) Income and employment conditions are improving at a gentle pace, but the scheduled increases in the burden on the household sector, including the cutting or abolition of the fixed-rate tax reduction, are of a scale that cannot be ignored. Consumer spending, although set to avoid an outright crash, is likely to remain sluggish overall.
These factors suggest that, although economic adjustments are inevitable in the short term, a recovery trend will begin to emerge from around the autumn of 2005 through the first half of 2006. However, the continued growth of the burden on the household sector will act as a brake on the economy and the "stop-go" conditions are likely to continue.
Thanks to the restructuring of the corporate sector that began in earnest in the second half of the 1990s, Japan's growth pattern has started to show signs of structural change. First, in the 1990s, exports had an important influence on capital investment and even on the movements of the economy as a whole but, in recent years, their influence on capital investment has declined and, consequently, so has their influence on the economy as a whole. Second, the cyclical mechanisms of the macro economy (the inventory cycle, the capital investment cycle, the wages spending mechanism) observed in the past are becoming less well defined. Increasingly, the economy tends to fluctuate in an irregular fashion rather than following a regular and repeated cycle.
In this light, fiscal 2005-2006 can be positioned as a transitional period during which the Japanese economy will move over from cyclical, external demand-led growth to growth based on innovation with a balance between internal and external demand.
Given the relationship between wages and prices, it is likely that the economy will make its escape from deflation some time during 2006, and, against a backdrop of improving productivity in the manufacturing sector and efforts to curb wages in the non-manufacturing sector, it is likely that prices will remain stable after the escape from deflation.
Given this assessment of economic trends, the government and the Bank of Japan should consider the following policies:
(i) It is likely that the conditions that will make it possible to change the framework of quantitative monetary easing will begin to come together in early 2006. However, as a first step towards the normalization of interest rate functions, having taken due care to establish a consensus with the markets, the Bank of Japan should go back to a zero interest rate policy. In view of the slow pace of economic recovery and the disinflationary trend that are likely to ensue, the pace at which interest rates are increased should be a gentle one.
(ii) Although the abolition of the fixed-rate tax reduction and the raising of the consumption tax rate are vaguely described as being "for the sake of social security", what vision of social security forms the basis of this statement is uncertain. Priority should be given to the presentation of a vision for social security. During fiscal 2005 and 2006, priority should be given to the discontinuation of quantitative monetary easing with a view to achieving the normalization of interest functions as rapidly as possible.
(iii) 2005-2006 should be positioned as a transition period and, in this sense, the recovery potential of the economy is still low. The government and Bank of Japan should devote their energies to "growth-promoting policies" that will support a smooth transition to a new pattern of economic growth.
For more information on the content of this report, please contact: Yamada, Ogata, Ishikawa the Japan Research Institute, Limited.