Assessment of the Bank of Japan's "Outlook Report"
and the Short-Term Outlook for Monetary Policy
- Following Discontinuation of "Zero Interest Rate Policy"
This Summer, Rates Set to Reach1% by End of FY 2007 -

Overview

In its latest Outlook and Risk Assessment of the Economy and Prices ("Outlook Report"), published on April 28, the Bank of Japan has revised its forecasts of the economic trend and prices for fiscal 2006 upwards as compared with its previous forecast (published in October 2005). During fiscal 2007, which comes under the scrutiny of the Outlook Report for the first time, the BOJ forecasts that the economy will gradually decelerate towards its latent growth rate and "enter a mature phase", and that consumer prices (excluding fresh foods) will inch upwards towards +0.8%.
The BOJ also appears to be taking a further step towards the raising of interest rates, with the details of the forecast hinting at the risk that the economic trend and prices will rise.

Specifically, in the section dealing with the risks that should be taken into serious consideration in the management of monetary policy, the BOJ's comments carry a general warning of a risk that the economic trend and prices will rise, suggesting, for example, that "the stimulatory effects of monetary policy on the economy may grow stronger" and that "if business enterprises start to become more positive in their investment activities […] there will be a reaction to the excessive accumulation of capital stock". Given this stance on the part of the BOJ, one must conclude that it is only a matter of time before interest rates start to rise, and that additional interest rate increases are inevitable.
The Japan Research Institute believes that the most likely scenario is that the zero interest rate policy will be discontinued some time during the July-September quarter, and that a further interest rate rise of 0.25% will follow before the end of the fiscal year.

Although the Japan Research Institute is generally in agreement with the Outlook Report's forecast of the economic trend, the rate at which prices are forecast to rise is somewhat fast. Given that an improvement in the balance of supply and demand is at present unlikely to lead to a rise in the inflation rate, then, assuming that the economy recovers at approximately the pace forecast by the BOJ and in the absence of a significant acceleration in the rate of increase of the price crude oil and other raw materials, the rate of increase in the CPI is likely to be no greater than 0.5%.

With a view to predicting the medium-term trend of monetary policy, the Japan Research Institute attempted to estimate the appropriate level for policy interest rates according to the Taylor Rule, making a number of assumptions and using the figures given in the BOJ's fiscal year economic forecast as set out in the Outlook Report.The results suggest that the current "theoretical interest rate" is just under 0.5% and that the theoretical rate will continue to rise after the discontinuation of the zero interest rate policy. If the "actual interest rate" were raised artificially so as to catch up with the theoretical rate, the "actual interest rate" would be likely to reach 1.75% at the end of fiscal 2007.
However, the likelihood of "an up-tempo acceleration of the inflation rate" is small. Moreover, after the BOJ begins to raise interest rates, it is also likely that there will be phase when it seeks to harmonize with the government in the context of the policy mix with the reductions in expenditure implemented with a view to restoring soundness to government finances. In this light, it is probable that two policy interest rate increases of 0.25% each will be implemented during fiscal 2006 and 2007 (a total of four increases over two years), so that the "actual interest rate" is likely to reach 1.00% at the end of fiscal 2007.

Inquiries relating to the content of this report, etc. should be addressed to Okada and Ishikawa , Economics Department, the Japan Research Institute, Limited.

Tel: 03-3288-4237
E-mail：okada.tetsuro@jri.co.jp
Tel: 03-3288-4263
E-mail：ishikawa.makoto@jri.co.jp