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The Short-Term Outlook for Consumer Prices and Monetary Policy
- The Switch to "Zero-Interest Policy" Could Come as Early as 2nd Qtr 2006 -

October 18, 2005

Overview

Amidst expectations of a narrowing of the supply-demand gap and a rise in the price of gasoline and kerosene, a rising trend in consumer prices (excluding fresh foods; year-on-year change) is likely to emerge as early as the final quarter of 2005 and become established by the spring of 2006, as the effects of the sharp reduction in land-line telephone call charges and the reaction to the rise in the price of rice last year begin to tail off.

However, as long as the upward trend in the price of crude oil does not accelerate, the pace at which consumer prices increase is likely to be a gentle one. This is because the three following factors are likely to have a stabilizing effect on prices:
(i) An influx of cheap foreign manufactured goods into the Japanese markets
(ii) The low recovery potential of wages
The incentive to raise the price of services, which is closely related to the level of wages, will be limited.
(iii) The sharp eye of the household sector for price
The current tendency of the household sector - namely, to cut back spending as far as possible, wherever it can be cut back, so as to be able to increase spending on luxuries is likely to grow stronger. Under these conditions, it is likely that the prices of essentials will continue to fall.

A review of the statements by various members of the Monetary Policy Meeting since September reveals that almost all share the view that the policy of quantitative monetary easing will be discontinued in the first half of 2006.
Given the need to (i) ensure that the upward trend of consumer prices has become established and (ii) avoid the period immediately before and after the end of the fiscal year, during which the supply and demand of capital goods becomes unstable, among other considerations, quantitative monetary easing is most likely to be discontinued some time in the April-June quarter of 2006.

What method is most likely to be adopted for the discontinuation of quantitative monetary easing? Although, at present, views within the Monetary Policy Meeting appear to be divided, given (i) the need to ensure that the change of policy framework is achieved smoothly, as an "extension" of current policy, (ii) the need to take account of long-term interest rate trends, (iii) the need to allow the functions of the short-term markets to recover, and (iv) the possibility that the CPI, although remaining within the positive range, will record only a slow rate of growth from the spring of 2006, among other factors, it is most likely that, once the three conditions for the discontinuation of quantitative monetary easing are satisfied, switch to "an interest rate policy under which the target rate is 0% (a 'zero-interest policy')".

At present, the financial services market is gradually making allowance for a reversion to the zero-interest policy "from about the spring of 2006". The phase-by-phase trend of interest conditions in the wake of past changes in monetary policy suggests that, in future, rates for one-term-forward 3-month interest rate futures will rise towards a level of around 0.5% while 3-month spot rates will strengthen to around 0.15%, and then stabilize at those levels.
Meanwhile, although some allowance for error must be made in predicting medium-to-long market rates, as the feasibility of discontinuing quantitative monetary easing increases, it is likely that 5-year swap rates will move towards a level of around 1.2% and the yield on 10-year government bonds towards a level of around 1.7%, both ranges within which they will stabilize.

For more information on the content of this report, please contact: Makoto Ishikawa, Tetsuro Okada the Japan Research Institute, Limited.

Tel: 03-3288-4524
E-mail:ishikawa.makoto@jri.co.jp,okada.tetsuro@jri.co.jp

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