Overview

On July 14, with Japan's escape from deflation now virtually accomplished, the Bank of Japan discontinued its "zero interest policy". The focus of monetary policy will now shift to the question of the pace at which policy interest rates should be raised. One key aspect will be the pace at which prices rise.

The major factors involved in pricing decisions include (i) the money supply, (ii) the supply-demand gap, (iii) foreign exchange rates, (iv) import penetration, and (v) labor costs. The influence of the supply-demand gap cannot be disregarded, but in recent years, labor costs have become the most important factor. As to the money supply, if anything, the relationship appears to have been "reversed", so that it is now prices that influence the money supply.

Although the supply-demand gap does have an influence on prices, the extent of its influence has been reduced, in relative terms, by economic globalization. This is because the globalization of economic activity has tended by relieve the bottleneck of domestic supply capacity by facilitating the adjustment of import volume.
Due to intensifying competition between imported and domestic products, overseas labor costs have come to influence domestic labor costs, and pressure has come to bear on both wage structures and price structures to fall into line with the global standard. As a result, the influence of labor costs on prices has increased.

One means of predicting the pace at which prices are likely to rise in future is to consider the likely trends of the constituent elements of the unit labor cost (nominal wages/labor productivity), namely (i) nominal wages and (ii) labor productivity. While the pace of wage growth is set to remain slow, it is likely that the pace at which labor productivity increases can be maintained, and the pace of growth of labor costs is therefore likely to be slow. Consequently, the pace at which prices rise on a CPI basis is also likely to remain slow.

Thus, although Japan is expected to see a structural stabilization of its CPI, the focus of attention at present is the possibility that, with the prices of crude oil and other natural resources still rising, the high cost of raw materials will lead to a rise in the CPI. Until now, however, the cumulative rate at which rising raw material costs passed on to consumer goods prices has been falling, and consumer goods prices have been stable overall. This is because (i) enterprises have tended to absorb the deterioration in trade conditions due to the rise in the price of crude oil and other natural resources by cutting or curbing personnel costs rather than passing the rise in costs on to consumer goods prices, and (ii) the global economic growth that is the reason for the rise in the price of crude oil and other natural resources has helped to stabilize the CPI by generating increased business sales, the cyclical improvement in productivity helping to curb the unit labor cost.

Thus, although the CPI is likely to continue to stabilize, in the event of significant delay in bringing interest rates to an appropriate level, there is a risk that distortions in the distribution of resources will arise (for example, a resource "bubble" or a fall in equipment efficiency), and that economic fluctuation will be accentuated. In simple terms, it is possible thatthe usefulness of the CPI as a criterion for deciding monetary policy has declined, and, in this sense, as long as Japan is expected to see a sustained economic recovery, it is important that interest rates continue to move steadily towards a more appropriate level, whether the CPI is stable or not.

However, with the restoration of fiscal soundness becoming a key policy issue, the fact that the spending cuts and tax increases this entails will exert deflationary pressures makes it essential that monetary policy should also take account of this issue. Taking account of the need to restore fiscal soundness, it would be appropriate to consider what is the ideal pace for the restoration of policy interest rates to normal levels, in two stages, as follows:

Stage 1 (2006-2007):
At present, given that the rise in the price of natural resources is limited and efficiency of investment is being maintained, there is no need for haste in raising policy interest rates. For the time being, the drive to reduce expenditure should be stepped up and, while taking account of the need to restore fiscal soundness, interest rates should be raised at a gentle pace, in line with the theoretical pace according to the Taylor Rule (with a target of 1% by the end of fiscal 2007).

Stage 2 (up to the end of fiscal 2008):
Once expenditure cuts have led to prospects of the restoration of a primary balance, as long as the economy continues to recover, interest rates should quickly be raised to an "appropriate (median)level" (= latent growth rate + appropriate inflation rate = middle of 2-3% range), whatever the trend of the CPI.

For more information on the content of this report, please contact: Hisashi Yamada, the Japan Research Institute, Limited.

Tel: 03-3288-4245
E-mail：yamada.hisashi@jri.co.jp

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