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Governor Ueda, I’m really delighted to be talking to you at this interesting and important time about the Japanese economy, and may I congratulate you on your appointment as governor. Could we start by your giving us sort of a little explanation of where you think the Japanese economy is overall in terms of its current growth rates and prospects? And then we can turn to monetary policy and the challenges you face there.
Certainly. Let me begin by saying thank you for giving me this opportunity to appear in this programme. If I could start with where the economy is at the moment, including where inflation is, I think we are doing OK or fairly well on the real GDP front. In fact, real GDP grew by about 2% in the first half of this year. On domestic demand in the first quarter and from net– on net exports in the second quarter, we expect a solid domestic demand to continue in the second half of the year.
Now, turning to inflation, it’s a bit complicated. But let me just first say the headline inflation hit a peak of about 4% earlier this year. And it’s now down to about 3%. But this is due to energy subsidy given by the government.
Core inflation– that’s inflation, [INAUDIBLE], energy, and food– is about 2.6%, which is above our inflation target. But even the core measure of inflation we think contains a lot of temporary factors. Therefore, underlying– what we call underlying inflation, which strips out temporary forces, we think is still a bit below 2%. That’s basically where we are on inflation and GDP.
So let’s follow up on this crucial question of inflation. You wished to achieve 2% inflation. You have a target to achieve 2% inflation on a sort of stable and sustainable basis. It sounds as though you’re getting quite close to that objective. How close do you think you are, in fact, to achieving not just this noteworthy rise in inflation, which is shown in the core measure however defective, but in a more sustainable way? Are you nearly there, or how do you analyse this?
So let me start by explaining more carefully what the recent inflation dynamic in Japan has looked like. I think it is broadly similar to what’s been happening in other countries. Let’s say it contains two components. The first component is the pass-through of import prices to domestic prices, as happened in many other countries. And then there’s a second component which is emerging. That is a cycle between wages– domestic wages and prices with some help from aggregate demand.
Now, we think the first component, although still containing, it’s going to wane in the months to come, while on the other hand, the second component has been slowly rising. We think it will keep rising. Actually, our inflation forecast, let’s say, two years out, which more or less reflects the second component, is only slightly below 2%. But we think there’s a lot of uncertainties about whether it will keep rising this way.
For example, the rate of growth of wages, which is at around 2% at the moment will need to continue and at slightly higher rates. Because in order to have inflation of prices of 2%, assuming positive productivity growth, wage growth will need to be a bit higher than 2%.
Also, we would like to see more evidence of spillover wages to domestic prices in order to be comfortable with this forecast of inflation two years out to be at around or slightly below 2%. So in the sense, we are very interested in what will happen in the next round of wage negotiations in the spring of next year. Let me stop there. And if you have any–
Of course. This is a fundamental question. So what you’re suggesting is that it is possible, possibly even likely, that inflation expectations and behaviour in the economy, including wages, are moving towards your target. But you’re not absolutely– you’re not certain of this. And you are, I assume, very reluctant to be caught in some sort of trap in which it falls back again, and you lose this remarkable moment of what is apparent success after decades of very, very low inflation or even deflation.
Right. There are, of course, risks on both sides. Inflation may overshoot our forecast, or it may undershoot. But in the case of overshooting, I think we will be able to deal with it by raising interest rates. In the case of undershooting, it will be rather difficult to deal with it, given the effect of zero lower bound on interest rates and other constraints or problems with non-traditional monetary policy measures.
It seems in some way that Japan has actually benefited from this global inflation upsurge in a sense because it was the one country that was really worried for a long time about ultra low inflation. And maybe what has happened has actually sort of shocked the economy into the condition that– or helped to shock the economy into a condition that the Bank of Japan has been trying to achieve for many, many years.
Yes. In a sense, you could say something like a global– commodity price inflation acted as a coordinating device for wage and price-setters in Japan. Previously, businesses were reluctant to pass on cost increases to prices because they thought that others will not follow. Now, they have changed their behaviour in such a way as to raise prices of their products because other people are going to do the same or have done the same, as a result of a fairly large increase in import prices.
I think that’s a very interesting idea. Another way of putting it might be that it has broken, or at least attenuated, the hold of the disinflationary or low inflationary psychology that you and your predecessors have talked about so often, including to me.
Yes. Yes. So in a sense, what I said– called the first component of inflation dynamic and the second component are not quite independent of each other. Something like the second round effects of import prices have created the second dynamic I just talked about.
Let’s talk, then, about what this might mean for policy. From what you say, you’re obviously very cautious about declaring victory in your long battle against ultra low inflation. But you have also– or the bank has over now a long time, particularly under your predecessor, Mr Kuroda, adopted very aggressive monetary policies by world standards in terms of both quantitative easing, and even more so, yield curve control. And you have in the process, of course, also accumulated very large holdings of government debt.
So how do you see the path forward on policy, given, one, the uncertainty you mentioned, and given the hope– let’s suppose this happens– that inflation is in the process of moving in a stable manner to your target?
So to simplify the matter, we have this [? flawed ?] guidance that says we will keep the yield curve control framework, which includes negative short-term interest rate, until it is necessary for inflation to be at 2% in a sustainable manner. As I was saying, we are making progress toward achieving this, say, goal, but there’s still some distance to cover. Now, it’s– before we can scrap this [? flawed ?] guidance.
Now, it’s quite uncertain how long this distance will be. It could be fairly short, or it could be very long. Now, at this point, we hadn’t quite determined– decided on in what order we would terminate each of the measures we are employing at the moment when we can declare that 2% inflation is in sight in a sustainable way. It’s too early to determine what specifically we will be doing when we seriously normalise the policy stance.
This will be, I think, an unprecedented process. Nobody, to my knowledge, has ever had to withdraw support of this scale and nature in an orderly manner I mean, the only comparisons I’ve been able to think of are the sorts of monetary policy that were used to support public spending during world wars. So this is an– and I can’t think of anything else quite like this since you have been intervening so aggressively for so long, and your balance sheets are so huge and so forth.
So what do you see– without describing the sequence– I understand exactly the impossibility of declaring the sequence at this stage. But what do you think the challenges will be when you get there in terms of adjusting away from these exceptional policies while maintaining the credibility of low inflation and managing, or mitigating, at least, the possible shocks in asset markets of which we’ve obviously seen quite a few recently, notably in Western bond markets. What do you think analytically the challenges of doing this are likely to be and how much do they concern you?
If I could talk about just two of the challenges we may be facing. First, on the control of long-term interest rates. So on this, if we don’t manage the process properly, we could create huge volatility in the bond market. We hope to be able to exit from this approach without creating such volatility, but we will see.
In terms of– more generally, in terms of the effects of higher interest rates on the economy and on the financial system, I guess we’ll have to proceed fairly carefully because everybody is used to the environment of low and– for long interest rate. So when we normalise short-term interest rates, we will have to be careful about what will happen to financial institutions, what will happen to borrowers of money in general, and what will happen to aggregate demand for goods and services.
There are–
It’s going to be a serious challenge for us.
You mentioned several asset markets or intermediaries. When I spoke about this last with your predecessor, he expressed I think pretty strong confidence that the Japanese banking system would prove robust to any such shocks. Do you share that view?
I think they have enough capital to weather some increase in interest rates, but it’s a matter of degree. So we’ll have to be careful. We’ll have to monitor the situation carefully, I think.
One of the issues that has been raised in Western countries, including my own, is that if a central bank owns a lot of government bonds and long-term interest rates go up, which obviously, would be part of your normalisation– now, I mean, I presume at the very least if you got inflation to a sustainable 2%, you would expect long bond yields to go to 2% and possibly a bit higher. This would reduce the market value of Bank of Japan’s holdings.
There’s quite a debate among economists and central bankers about whether the net worth of the central bank, per se is in any way important. I tend to think it’s not important. But what is your view in Japan, and what is the view of the Ministry of Finance and the government on this question?
I must say I don’t know what the views of the government or the Ministry of Finance on this question is. But our view is that, in principle, we will be able to carry out monetary policy, even with, say, negative net worth because of the confidence the public will have in our policy or in the bank will depend on whether or not we would be able to stabilise prices. And we will be able to carry out operations even with negative net worth.
But from time to time, having bad balance sheets may create a loss of confidence among the public. So we try to proceed fairly– we’ll try to proceed very carefully by, say, putting up reserves for possible losses in the future, et cetera. And hopefully, we will not– we will be able to stabilise prices and maintain confidence– the public’s confidence in the bank.
Would you have any concern about, or do you have any concern, given where you are, about the exchange rate, which has been much discussed of late. Presumably standard economics would suggest if you do normalise, the yen is likely to become stronger than it has been. Is that a concern in any way?
OK. On exchange rates. We are constrained not to talk too much about them. But let me say we want them to follow fundamentals. And we, of course, analyse carefully what kind of effects exchange rate changes would create for our inflation and output outlook. And, if necessary, we would respond to that.
Another aspect of this new situation would be the cost of funding the government will rise. And this obviously links with fiscal policy and the size of government debt. Do you think this is a significant prospective issue for Japan in what would be a very different monetary environment?
We realise this is a significant issue. But we think it’s the responsibility of the government and the parliament diet to maintain confidence in the sustainability of budget in the face of rising interest rates.
OK. Sort of final question. You’re looking from Japan into the world, which is pretty turbulent. If you look at home– we’ve discussed some of them– and abroad, what are the risks that we haven’t discussed that concern you in trying to work out the prospective path for the goals you have been set, and above all, for inflation and, of course, with it economic stability. What are the big concerns you have?
So we are concerned about many things. But let’s say we are concerned about what will happen. first of all, to the US economy. I think the baseline assumption now is they will achieve some version of soft landing, but there are risks on both sides. And if these risks materialise, they will affect us.
We also worry about what will happen to the Chinese economy, for obvious reasons. There could be some more serious spillover of what’s happening in the property sector to the rest of the economy. But the economy of China is facing serious challenge– many challenges in the midst of increasing geopolitical tensions. So these things are at the top of the list of what we are worried about going forward.
And since you mentioned that– and this really is the last thing. Do you– when you look at China, do you feel that they could possibly learn from some of Japan’s experience? They, too, are trying to manage the– consciously manage, deliberately manage, this really huge property bubble as it deflates.
I’m sure they have learned a lot from our experience. Let me say the scale of the problem relative to GDP is smaller in China now than was the case in Japan 30 years ago. But serious challenges are ahead because they want to, I guess, balance discipline with economic recovery or economic stability.
So I think although they know what should be done to restore stability in the property sector or in the economy, I’m not sure if they execute policies in time for generating stability. So we keep our fingers crossed.
Governor Ueda, thank you very much, and I wish you every success with managing to hit your target and exiting from your present policies in the smoothest possible way. It’s very important for you, and I think it’s very important for the world.
Thank you very much for giving me this opportunity.
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