Prospects for the Japanese Economy in 2008

Japan's economic growth for fiscal year 2007, ending March 2008, will likely slow to around 1.3% with housing starts and capital investment falling sharply following the implementation of stricter standards for buildings. Since Japan's potential growth rate is estimated around 1.5%-1.7%, the demand-supply gap has deteriorated somewhat in FY2007, loosening the demand-supply balance, pulling the GDP deflator inflation rate down to negative 0.6%. As such, the real growth rate continues to exceed the nominal growth rate. The decline in the GDP deflator amid the rising prices of crude oil and other primary commodities corresponds to the fact that the corporate sector, unable to transfer the increased costs to prices, has been reducing payroll costs to maintain profitability. For companies, input prices continue to increase. However, given weak domestic demand, additional costs are not sufficiently passed on to prices because companies fear that daring to raise prices could lead to declining sales volume, with a negative impact on sales figures. As the wage rise remains modest, no dramatic increase in consumption can be expected and Japan's economic growth will likely remain low through the remaining months of FY2007.

In FY2008, however, construction starts will begin to recover and if the yen remains around its current level and the Chinese economy continues its rapid growth, the Japanese economy is expected to grow by around 2%. Yet the recovery of domestic demand will be slow and improvement of the GDP deflator inflation rate will be extremely modest. Therefore, the rate of nominal growth for FY2008 will differ little from that of real growth and the continuation of the real growth rate exceeding the nominal growth rate will not return to normal until around the end of the fiscal year.

This recovery scenario for the Japanese economy, however, contains some risks. One is the possibility of the Chinese economy overheating. The Chinese economy is increasingly coming to resemble the Japanese economy in 1972-1973. Back then, there was a storm of opposition in the country against "yet another revaluation" of the yen that would have followed the one under the Smithsonian Agreement of 1971, and Yasuhiro Nakasone, then minister of international trade and industry, suggested that the Bank of Japan (BOJ) accommodate some inflation from the overheating economy so as to avoid a further appreciation of the yen against the dollar. Thus, the BOJ abided by a policy of no tightening and no revaluation, resulting in high inflation in 1973. The same may happen to China this year. China's consumer price index (CPI), which used to hold steady around 1%-2%, began to rise sharply in 2007. Its preliminary CPI for October 2007 was up 6.5%, by far exceeding the government's annual CPI growth target of 3% or below. Consumer prices are thus increasing at an accelerated pace. But the Chinese central bank has been unable to act quickly enough to tighten monetary policy, fearing that higher interest rates will further encourage capital inflows. The result is large negative rates of interest on deposits in the real term. In the meantime, wages are being raised by nearly 20% year on year. Unless the People's Bank of China (PBOC) acts quickly to implement a substantial rate hike, China's consumer price will quite likely post a double-digit increase in 2008. If this happens, the government will have no choice but to adopt an aggressive tightening policy, which risks triggering a post-boom bust.

In the United States, there is increasing risk that the subprime loan problem will delay economic recovery. If the U.S. economy further slows and the Federal Reserve implements further interest cuts, the interest rate spread between the dollar and the yen will narrow, increasing upward pressure on the yen. In regard to the U.S. economy, the housing sector is not in good shape, particularly in the private housing business, but capital investment and exports remain relatively firm. One reason behind this is the weaker dollar as U.S. exports to China and Europe remain robust. Therefore, the corporate sector has not been affected as badly as the household income situation. Though housing starts are falling, employment for construction workers is not so bad. This is because new construction starts for commercial buildings, factories, and so forth remain fairly strong, helping keep employment relatively stable despite declining housing starts. The future course of the U.S. economy will be greatly influenced by the pace of rate cuts by the Fed. Financial markets are already discounting further rate cuts.

Under all these circumstances, the BOJ will continue to be forced to walk a tightrope in maneuvering monetary policy in 2008. If the two downside risks of economic stagnation overseas and yen appreciation materialize simultaneously, the Japanese economy may very well once again slip into deflation as the BOJ would be left with little room for lowering interest rates. After raising the benchmark overnight call rate target to 0.5% in its February 2007 monetary policy meeting, the BOJ showed willingness to raise it further as soon as last summer. Due to financial market turmoil following the U.S. subprime loan problem, the BOJ has been delaying the move. The BOJ should be responding prudently to the situation, properly monitoring the steadiness of growth in domestic demand and the progress made by companies in transferring costs to prices. The BOJ should refrain from raising interest rates for some time.