David Lipton, First Deputy Managing Director

Good afternoon, everybody. It’s a pleasure to be back here in Tokyo for our annual consultation visit.

Over the last few days, I’ve had the opportunity to meet with Deputy Prime Minister Aso, Minister Amari, BoJ Governor Kuroda, FSA Commissioner Hatanaka, and other senior officials. As always, they were extremely generous with their time and in sharing their views with us. We discussed recent economic developments in Japan and the situation of the global economy.

This year’s consultation focused on the progress that’s been made under Abenomics and the policy agenda here in Japan going forward to consolidate the important gains seen so far. As we have said before, Abenomics represents a unique opportunity for Japan to make a decisive break from deflation, low growth, and rising public debt.

But to build on the progress that’s been seen over the last year, it is important that all three arrows – not just the monetary arrow – carry the policy agenda forward. This is in the best interest of Japan’s economy and will also generate positive spillovers for the rest of the world.

By contrast, an incomplete Abenomics program that relies too heavily on the monetary arrow could raise financial stability risks here in Japan, lead to an undue weakening of the yen and possibly have adverse spillovers for the global economy. So let me briefly summarize the main conclusions of our consultation.

Over the next year, Japan’s economy looks set to weather the effects of the consumption tax hike and continue growing above potential. Although there will some inevitable contraction in the current quarter as a payback for the elevated rush demand that was seen before the consumption tax increase, we believe that the underlying growth momentum remains strong – you can see that in the tight labor market conditions, high capacity utilization, and strong investment in the first quarter. We project growth will be 1.4 percent this year in 2014 and 1 percent in 2015.

Inflation and inflationary expectations have risen gradually. Looking ahead, we see the economy continuing to make steady progress toward stable 2 percent inflation as the output gap closes, and as inflation expectations rise with increases in actual inflation. But for this to happen, the drivers of growth need to rotate from stimulus to private sector activity, guided by all three arrows.

Structural reforms have been progressing, but for potential growth to be lifted decisively, more ambitious and concrete measures will be needed in the upcoming June policy announcement with respect to the growth strategy. Specifically: Raising the labor force participation of women and encouraging immigration of high-skilled labor would offset ageing-related declines in the labor force, while reducing labor market duality would raise productivity and help boost wages; Ensuring that the designated special economic zones become effective laboratories for broader, nation-wide deregulation in agriculture and services would help raise investment; and Implementing comprehensive corporate governance reform and enhancing the role of the financial sector as a growth engine would enable a more productive use of saving and the emergence of new growth sectors. Without measures along these lines, we see potential growth stuck below 1 percent, potentially well below 1 percent, and below the level to put the government debt as a share of GDP on a declining path.

Fiscal policy must also lend support to the rebound by focusing on medium-term sustainability, thereby raising confidence and taking the tail risk of a disorderly spike in bond yields off the table.

The first stage increase in the consumption tax rate is a major accomplishment. Following through with the second stage increase expected in October 2015 would be an important next step toward putting public finances on a more stable footing.

More generally, we believe a concrete plan for post-2015 fiscal consolidation is needed to maintain confidence while also creating the space for responding flexibly to any near-term downside risks that will materialize. This will become all the more essential if the corporate income tax is cut.

Regarding monetary policy, with inflation and inflation expectations making steady progress toward the 2 percent target, we do not see the need for additional easing from the BoJ at this point. However, should the increase in inflation and inflation expectations begin to stall, the BoJ would need to act quickly to change the parameters of QQE. I should mention, however, that the effectiveness of sustained monetary easing depends crucially on implementing complementary fiscal and structural reforms.

Transmission of monetary easing to the broader economy, which is ongoing, also depends on the health of the financial sector. The BoJ’s purchases of longer-term JGBs under the QQE policy have reduced the risk of capital losses for banks from an increase in interest rates. Under Abenomics, as banks boost credit growth, and possibly seek overseas lending opportunities, we may see new risks and supervisors will need to remain vigilant.

Turning to the external assessment, I should mention that this assessment is subject to wide uncertainty given that the policy changes underway are attempting to simultaneously raise inflation and growth while lowering government debt as a share of GDP over the medium-term. Assuming the implementation of growth and fiscal reforms under Abenomics, we now assess that Japan’s external position is broadly in line with economic fundamentals. We will of course monitor developments closely as the implications of Abenomics for the trade balance and for capital flows become more clear, and that may entail changing the assessment going forward.

Let me stop with those introductory comments and take any questions that you may have.

QUESTION: I would like to raise one simple question concerning the currency market. In this year’s consultation comment, I couldn’t find any specific comment about the Japanese yen. How do you assess the Japanese yen? It is broadly in line with the parameters so far. What is your assessment?

MR. LIPTON: As I said, we consider that Japan’s external position is broadly in line with the fundamentals over the medium-term. That’s a statement about the external balance and about the exchange rate. We’ve seen in recent months and really over the last year that the export performance of Japan hasn’t been as strong as was expected and as it might be. As a result of that, when we look at the exchange rate, we consider that a stronger yen would be unhelpful in that regard. We view the competitiveness issue as something that really must be addressed through the broad three arrow approach of Abenomics. In particular, the third arrow attempts to improve the structure of Japan and boost potential growth. It’s really a program to make the Japanese economy more efficient and more productive. Greater efficiency would presumably translate into greater productivity in the Japanese export sector and greater affordability of Japanese exports for buyers overseas. In our view, sustaining the external position is something that really depends upon the success of Abenomics generally speaking.

QUESTION: You mentioned in your remarks that an incomplete Abenomics package could lead to a weakening yen. I was wondering how exactly this might manifest and what the risks would be to Japan should the yen weaken further.

MR. LIPTON: Abenomics has been showing important signs of progress on the fronts that are the objectives of Abenomics. We’ve seen the economy move from deflation to some inflation, although the inflation rate remains low, and we’ve seen the economy grow and grow despite the consumption tax increase that has just taken place. The risk of course is that the progress seen to date might not continue, might stall, or might be reversed. Our view is that there are still conditions that could undermine success on the inflation front. The resumption of price increases has been mostly on the traded goods sector, and the non-traded goods sector has not yet seen the same degree of reflation. We know that there is a lot more fiscal consolidation required in order to put public finances on a stable and sustainable basis. Those steps will inevitably provide some drag to the economy. So there really is a lot of burden on the third arrow on bringing about structural changes that will create a more dynamic, efficient and productive economy and stronger growth. Absent that, there is the risk that it’s really quite difficult if not impossible to achieve the objectives of Abenomics, which are a resumption of inflation at the target level of the BoJ and bringing public finances on a sustainable basis.

QUESTION: An interesting report if I may say so, particularly this point about the danger of overburdening monetary policy. Paragraph 13 sort of details that. And the point about possible asset inflation is obvious. But when you say that a continuing QQE in its present form could impair market liquidity, can you explain a bit more about what you mean by that? Also, are there any other aspects of overburdened monetary policy that you haven’t covered here? If I can quickly ask you a question, which is only partly connected with Japan – obviously the geopolitical tensions in this part of the world are growing quite rapidly. When does this being to impact the credit risk perception of these countries in this part of the world do you think?

MR. LIPTON: When we talk about not putting undue reliance on monetary policy, I think the main point I wanted to make is that all of the objectives of Abenomics would be easier to achieve if the economy is growing at a more dynamic pace, that potential growth in the country has been lower in recent years than in the past. That’s because labor force is declining and that decline is likely to continue under present demographic trends and because productivity growth has not been as strong as it might be. If the third arrow of Abenomics can provide some more dynamism in growth, that will help achieve the goals of both of the other two arrows. A stronger and more dynamic economy will be one in which it’s easier to achieve the goal of 2 percent inflation in a reasonable timeframe, and that can be done with less unconventional monetary policy and otherwise. Unconventional monetary policy of course has the feature that it keeps interest rates very low, it provides a lot of liquidity to the economy, and we know from other countries that, in that setting, with low interest rates for a long period of time, financial stability risks can arise. It is best if the revival of the economy is as strong as possible so that the reliance on the BoJ in the reflation goal is kept to a minimum.

On the geopolitical risks, our institution is principally an economic institution so I will comment on it from the economic vantage point. It is clearly important that tensions between Japan and China and tensions between China and other countries be dealt with and kept from interfering with prospects for trade, finance, and growth. I don’t think we see significant problems so far. Japanese companies have been investing for a very long time outside of Japan, including in a number of Asian countries. Japanese banks are becoming more active once again in other Asian countries. We see elsewhere in Asia, trade and finance continuing to be robust. With that said, it is very important that these tensions be managed in a way that does not interfere with those activities.

Any other questions? Thank you all very much.