Japan signals end of world's cheap money eraIn a historic policy change, the Bank of Japan (BOJ) on Thursday scrapped its five-year-old super-loose monetary policy and returned to a more conventional regime, but said it would still keep short-term interest rates around zero for some time.
The BOJ's nine-member policy board decided by a 7-1 vote (one member was absent because of illness) to switch to the unsecured overnight call rate as a monetary adjustment target, rather than using the outstanding balance of current-account deposits held by private financial institutions at the central bank. Two government representatives - one from the Finance Ministry and another from the Cabinet Office - attended the policy board meeting as observers. But they did not invoke their rights to request the postponement of the vote on a policy change until another meeting. The board decision is made by a majority vote. The two government observers have no voting right.
Thursday's decision marked the first time in about 15 years, except a brief period in which the BOJ hastily lifted the zero-interest rate policy from the summer of 2000 to early 2001, that the central bank had reversed its policy to one of tightening.
BOJ governor Toshihiko Fukui told a news conference the central bank made the policy change as an uptrend in consumer prices has taken root amid the steady economic recovery, which fulfilled the central bank's self-imposed conditions for lifting the ultra-loose policy. Fukui had said earlier that the end to "quantitative easing" wouldn't mean an immediate tightening in policy but would be a stepping stone toward a more "normal" monetary policy and "a return to more neutral interest rates".
The BOJ had vowed that it would stick to the quantitative easing policy until deflation, which has long plagued the Japanese economy by depressing corporate earnings and wages, is beaten. The BOJ had specifically said it would maintain the quantitative easing policy until year-on-year changes in the core consumer price index (CPI), which excludes volatile prices of fresh foods, remain stable above zero.
Under the quantitative easing policy, which the BOJ introduced in March 2001, the bank has flooded the nation's financial market with excess cash in the hope of encouraging borrowing and lending, while anchoring short-term interest rates at near zero. But with a recent spate of economic data showing that a recovery is taking root and persistent deflation is abating in the world's second-largest economy, the BOJ's departure from the ultra-loose monetary policy as early as this week had been widely expected.
Japan's gross domestic product (GDP), the total value of goods and serviced produced in a nation, expanded for the fourth quarter in a row during the October-December quarter, posting a robust 1.4% growth from the previous quarter and an annualized 5.5% growth in real, or price-adjusted, terms. The year-on-year change in the core CPI has been out of negative territory for four straight months from October, with the latest data for January showing a rise of 0.5%.
Meanwhile, the BOJ's policy shift signals that an era of cheap money around the world is drawing to a close, boosting the risk of volatility in global financial markets. Interest rates have been rising in the United States since 2004 and they recently began heading higher in Europe as well. The US Federal Reserve raised interest rates for the 14th time in a row at the end of January. Borrowing costs rose a quarter of a percentage point to 4.5%. Rates have increased from 1% over the past 19 months and are now at their highest level since April 2001. The European Central Bank (ECB) also raised interest rates by a quarter of a percentage point to 2.5% this month - the second change in rates in four months.
In Japan, as the BOJ has pumped a massive amount of liquidity to maintain a balance of 30 trillion to 35 trillion yen of current accounts held by private banks at the central bank, the unsecured overnight call rate, which serves as the money-market benchmark, has stayed at 0.001-0.002%. But the current-account balance is expected to decline to the legally required level of about 6 trillion yen (US$50.7 billion) in several months. As the supply of funds tightens, there had been fears that the overnight call rate, which banks charge one another, could spike. Japan's official discount rate, at which the BOJ provides funds to financial institutions facing liquidity constraints, is 0.1%.
Market participants, not only in Japan but also abroad, have been closely watching the effects of the BOJ's move, whose implications are not limited to the Japanese economy alone. Analysts point out that the process the BOJ has started after more than a decade of near-zero interest rates and five years of quantitative easing could ripple through global capital markets for years to come. Some of the excess cash the BOJ pumped into the financial system has flown into higher-yielding investment choices, including US Treasuries and bonds of India and other emerging economies.
There are concerns in the United States that if Japanese rates rise, Japanese capital that has flown into the US could start to return home. Foreign investors, who have already played a leading role in the rally on the Japanese stock market in the past year or so, could begin investing more broadly in Japanese assets. This could push US interest rates higher and the dollar lower, as Japanese investors shift away from US assets.
The closely watched timing of the BOJ's interest-rate rises depends on price movements down the road. What the BOJ said, and the new policy framework it adopted for monetary policy on Thursday, suggest that the central bank is very likely to begin to move toward interest-rate hikes once the CPI rises by 1% or more.
Clear message to markets
In announcing the decision to end its ultra-easy policy, the BOJ sent a clear message that the transition toward what Fukui calls "more neutral interest rates" will be slow, saying benchmark interest rates will remain near zero for some time and that it will only gradually reduce the amount of liquidity in the banking system. The BOJ is widely expected to keep interest rates around zero, where they have been for most of the past seven years, at least until the second half of this year.
The central bank said it will gradually lower the current account deposit balance toward the legally required level of around 6 trillion yen from the current range of 30 trillion to 35 trillion yen over a period of a few months to ensure stability in the financial markets. Fukui indicated that the BOJ will maintain roughly the current level until the end of March, taking into account expected strong demand for funds toward the March 31 end of fiscal 2005. Fukui also said he wasn't also implying that once the account balance is lowered to the legally required level, short-term rates would soon start to rise above 0%.
In a bid to prevent a sharp rise in long-term interest rates, the central bank also said it will continue to buy 1.2 trillion yen worth of government bonds a month outright 'for some time' to help prevent volatility in the bond market. Fukui said, however, that the BOJ must "eventually" reduce its buying of outright Japanese government bonds at some point from the present 1.2 trillion yen per month. He added that, in doing so, the BOJ will "take appropriate steps so as not to shock financial markets".
The government does not want to see any hasty interest-raising move by the BOJ for fear of sharp rises in long-term interest rates, which would lead to a rise in government debt-servicing costs. Japan's fiscal condition is the worst among major industrialized countries, with public debts, including those owed by local governments, expected to reach 775 trillion yen at the end of fiscal 2006, or about 150% of the nation's GDP. The Finance Ministry estimates that every 1% rise in long-term interest rates, which are now around 1.6%, the government debt-servicing cost will increase by at about 1.5 trillion yen or more. The fiscal 2006 government budget plan, now pending in the diet (parliament), calls for 18.8 trillion yen in debt-servicing outlays. Of this amount, 8.6 trillion yen will be used to make interest payments.
New policy framework
With Thursday's policy change, the BOJ also adopted a new policy framework for monetary policy aimed at guiding market expectations now that the quantitative easing has been abandoned. According to the new framework, the BOJ policy board will "review its basic thinking on price stability, and disclose a level of inflation rate", which it believes reflects price stability from a medium- to a long-term perspective. That level currently translates into annual core consumer-price changes of about 0% to 2%, and most board members' median figure is around 1%, the BOJ said.
The introduction of the desirable price-rise range is widely seen as a compromise with the government and the ruling coalition to gain their support for a policy shift as they have proposed setting an inflation target to raise the price increase rate to a certain level. The majority of the nine-member BOJ policy board members have been opposed to - or at least reluctant about - the idea, raising questions about the effectiveness of such a target and claiming that it would become difficult for the central bank to implement flexible monetary policies.
Setting an inflation target would have the merit of boosting transparency in BOJ policy, but at the same time it would have the demerit of depriving the central bank of room for flexible policy implementation. Fukui stressed that the presented price range is different from an inflation target adopted by overseas central banks such as the Bank of England or the more relaxed inflation reference target employed by the ECB.
Prime Minister Junichiro Koizumi had suggested on Monday that he didn't think the time was ripe for a policy change, saying the economy was still not out of deflation. But on Thursday, after the BOJ's policy turnaround, the prime minister said he respected the central bank's decision to end the quantitative easing, as he believes it was made after thorough discussions. Koizumi also said the BOJ's release of the board's view that price stability would mean on-year changes in the CPI of between 0% and 2% was a message that the central bank was willing to continue cooperating with the government to fight deflation.
Economy Minister Kaoru Yosano also said on Thursday that it's too early to start talking about lifting short-term interest rates, but praised the increased transparency of the central bank. The new BOJ policy framework also "gives higher predictability to markets and the public and is praiseworthy because (the BOJ) is fulfilling its responsibility to explain" its policies, he said.
When asked about the BOJ-presented price range, Yosano said it was neither a reference rate nor a target. Rather, the spread given by policy board members and its mid-range of "a bit above or below a positive 1%" gives predictability to markets and the public. While most government and Liberal Democratic Party (LDP) officials praised the BOJ's new policy framework, Heizo Takenaka, a former Harvard academic and influential member of Koizumi's cabinet, expressed dissatisfaction that the BOJ had failed to set a clear-cut inflation target.
The BOJ said it will review the desirable price-rise range roughly every year. Fukui suggested that the central bank has no intention to be bound by the figure over monetary policy, saying that the BOJ is confident that it will ensure 'transparency' and 'mobility' under the new framework. The BOJ added that it will gradually adjust short-term interest rates in line with economic and price conditions after the period of effectively 0% interest rates. Some private-sector economists said the new policy framework is ambiguous enough to allow the BOJ to conduct monetary policy more freely than during the era of the quantitative easing framework.
The BOJ's move toward higher rates is widely expected to be gradual and slow, however. If that is the case, the BOJ's policy shift will have little, if any, negative impact on corporate Japan, analysts say. Some say that since growth in the core CPI is expected to slow down in April and beyond, speculation on rate rises by the end of the year has receded. Some analysts also believe that the BOJ may find it difficult to raise rates until the core CPI exceeds 1%, the median figure on consumer price rises released by the central bank on Thursday. Some also say that the BOJ will be very cautious about raising rates because it remains traumatized by its policy debacle in the summer of 2000, when it prematurely lifted - and was forced to restore only months later - its zero-interest-rate policy.
Some analysts said that the desirable price-rise range of 0%-2%, released by the BOJ, will likely dispel speculation on an imminent rise in interest rates. In fact, the stock market reacted positively to the BOJ action on Thursday as investors perceived the policy change as putting an end to weeks of market uncertainty, with the benchmark 225-issue Nikkei Stock Average jumping 2.62% to end above the 16,000 line for the first time since February 28.
After the announcement of the BOJ's decision, the US dollar temporarily topped 118 yen, while the yield on the benchmark 10-year Japanese government bond briefly fell below 1.6% for the first time in a week. The yen fell against the dollar on the likelihood that interest rates would stay low, although the yen strengthened later in the day.
Until the BOJ's Thursday decision, there were strong concerns that long-term interest rates could rise sharply if market players act according to what they think the central bank will choose to do once it jettisoned its ultra-easy monetary policy. Expectations for a policy change already had spurred selling in Japan's stock market, as an eventual increase in interest rates could discourage individual investors' purchases of stocks, while hurting earnings of many export-reliant Japanese companies by pushing the value of the yen higher against the dollar.
Seeds of new conflict
Koizumi is to step down as prime minister in September when his current three-year term as president of the ruling LDP expires. Completely defeating deflation and putting the Japanese economy back on a solid growth track will probably be remembered as the biggest accomplishment he made during more than five years in office. Meanwhile, for BOJ governor Fukui, whose term expires in two years' time, returning interest rates to "neutral" levels that neither overheat nor kill growth is widely seen as his ultimate goal.
In announcing the decision to end the quantitative easing, Fukui emphasized that the domestic economic conditions for doing so had been met. But some analysts believe other factors played a role in the timing of the central bank's decision. One factor is the US Federal Reserve Board's Federal Open Market Committee (FOMC) meeting, slated for March 28. The Fed's cycle of rate hikes could pause at or after the next FOMC meeting. If the BOJ had lifted the quantitative easing policy, it could have sparked a sharp rise in the value of the yen to the US dollar, something the BOJ wanted to avoid.
Another factor is domestic politics. Some market participants say Koizumi will officially declare an end to deflation before stepping down in September and that such a declaration will make it politically easier for the BOJ to begin to raise rates. Some analysts believe the BOJ decided to depart from the quantitative easing policy at this time to have enough time to prepare itself and markets for a rate hike around that time.
Although the LDP-led government and the BOJ had often clashed over policy, especially the timing of scrapping the quantitative easing, they seem to have reached a ceasefire, at least for now. But the desirable levels of price rises announced by the BOJ may have sowed the seeds of new conflict. Although Fukui insisted that the announced desirable levels of price rises are not a binding target that binds the central bank's policy implementation, it is possible that the government will put political pressure on the central bank over what it deems any hasty move toward rate hikes as long as price rises remain below 2%.
Hisane Masaki is a Tokyo-based journalist, commentator and scholar on international politics and economy. Masaki's e-mail address is [email protected].