Japan starts down the rate-cycle pathTOKYO - As widely expected, the Bank of Japan (BOJ) bid farewell to its unusual zero-interest-rate policy of nearly six years, raising short-term interest rates at a two-day meeting of its policy board that ended on Friday.
The decision reflects the central bank's confidence in the strength of the Japanese economy, which has seen accelerating growth and falling unemployment. The move was also based on the judgment that the risk of the economy slipping back into a deflationary spiral has significantly receded.
The central bank raised its target for the unsecured overnight call rate, which it uses as the key target rate in the short-term money market, to 0.25% from nearly 0%. It also raised the official discount rate - which effectively serves as the cap on the overnight interbank rate because the BOJ provides loans to banks at the rate through its Lombard standby lending facility - from 0.1% to 0.4% per annum.
The decision to raise the unsecured overnight call rate was a unanimous vote among the nine members of the policy board, including BOJ Governor Toshihiko Fukui. The decision to increase the official discount rate was made by a 6-3 count.
In mid-June, Fukui said monetary decisions should be "made early" and "in small increments". In an attempt to dispel fears of a possible sharp rise in interest rates, Fukui reiterated on Friday that the central bank will not act on rates precipitously. Rather, even after lifting the zero-interest-rate policy, the BOJ intends to adjust interest rates at a moderate pace to maintain "easy money" and help ensure Japan pulls its economy out of the lingering deflation completely.
Market players have already shifted their attention to the timing of possible subsequent rate hikes and their pace. Many expect the central bank to jack up interest rates only once or twice at most during the current fiscal year ending in March 2007.
The BOJ's long-awaited decision marks a significant watershed in monetary policy for the world's second-biggest economic powerhouse, which had taken what many called an "abnormal" step of keeping interest rates effectively at zero to nurse its ailing economy back to health. The BOJ's rate hike also comes at a sensitive time for the world economy. The two other big economic zones - the United States and Europe - are on a similar monetary tightening trend. In late June, the US Federal Reserve raised interest rates by a quarter of a percentage point to 5.25%, the highest level in more than five years and the Fed's 17th rate hike in a row. Earlier this month, the European Central Bank (ECB) held its key interest rate steady at 2.75%, but signaled an increase as early as next month.
Recent upbeat economic data have confirmed that Japan's economy is gaining strength, raising expectations of rate hikes by the BOJ at this week's policy board meeting. The unemployment rate for May fell to 4%, the lowest level in eight years. Corporate earnings are also growing robustly. And most importantly, prices are continuing to rise. The nation's core consumer price index (CPI), which excludes volatile prices of fresh foods, rose 0.6% year-on-year, for the seventh consecutive monthly gain.
The BOJ's closely watched "Tankan" quarterly survey of business sentiment among Japanese firms, released earlier this month, showed a surge in business confidence among major Japanese manufacturers for the April-June quarter, and found that corporate capital spending by major Japanese firms is expected to post the strongest growth since fiscal 1990 - 11.6% on average - during fiscal 2006. In the previous Tankan survey in March, a capital spending increase of only 2.7% had been forecast for fiscal 2006.
The Japanese economy, as measured by gross domestic product (GDP), has expanded for five consecutive quarters as of the January-March period, the latest quarter for which figures are available. The Cabinet Office recently revised upward the government's annual economic growth forecast for fiscal 2006, which ends in March 2007, citing a pickup in domestic demand and stronger corporate profits. The office said Japan's GDP will rise 2.1% in real terms in fiscal 2006, up from the previous forecast of 1.9%.
The government is leaning toward declaring, at a July 19 monthly meeting of cabinet ministers involved in economic policy, that the Japanese economy will get out of deflation within the year. Meanwhile, Prime Minister Junichiro Koizumi is to step down in September when his current three-year term as president of the ruling Liberal Democratic Party (LDP) - and hence as premier - expires. The planned July 19 announcement will be taken as an effective declaration of victory in the fight against deflation. Defeating deflation and putting the Japanese economy back on a solid growth track may be remembered as the biggest accomplishment Koizumi made during more than five years in office.
By raising rates, albeit at a moderate pace, the BOJ wants to avoid an overheating resulting from excessive corporate capital spending - a scenario that now looks more likely given that Japanese firms were found in the latest Tankan survey to be on an investment spree - and ensure a sustainable economic expansion.
Japan's economy "continues to expand moderately" and is expected to "expand for a sustained period", with consumer prices likely to continue following a positive trend, the BOJ said in a statement. Against this backdrop, the stimulus effect of the BOJ's zero-interest-rate policy has "gradually amplified", raising the possibility for economic activity and prices to make "large swings" ahead, the bank said, explaining the reason for its dramatic move. "Today's decision will contribute to ensuring price stability and achieving sustainable growth in the medium and to long term," the statement said.
Before Friday's decision, Economy Minister Kaoru Yosano had said ending the zero-interest-rate policy would be the right way to go, but urged the BOJ to carefully balance its decision against a possible slowdown in the US economy and recent weakness in the Tokyo stock market.
A long-anticipated move
Speculation about the BOJ's rate hike this week began to swirl early this month. Long-term interest rates have since been on an upward trend, with the yield on Japan's benchmark, 10-year government bond rising to about 1.97% this week. The money market had already factored in a rate hike of 0.25% this month, leading the central bank to conclude that such a small rate of increase will not have a negative impact on the economy. The BOJ's cycle of rate increases is widely expected to be gradual and slow. If that is the case, the end to the era of zero rates will probably have little, if any, negative impact on corporate Japan.
Friday's rate hike comes about four months after the BOJ scrapped its "quantitative easing" policy and switched 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.
Fukui said then the central bank made the policy change because an uptrend in consumer prices had taken root amid the steady economic recovery, which fulfilled the central bank's self-imposed conditions for lifting the quantitative-easing policy. Fukui had said earlier the end to the 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".
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. 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 CPI remain stable above zero. Since it ended the quantitative-easing policy in March, the BOJ has steadily reduced excess liquidity in the banking system, paving the way for a rate hike.
Before Friday's rate hike, the BOJ last raised rates in August 2000, when it increased the overnight call rate to 0.25% from zero, despite opposition from the government. But as the nation's economic woes deepened soon afterward in the wake of the burst of the dot-com bubble in the US, the BOJ faced a barrage of criticism for prematurely lifting the zero-interest rate policy. It was forced to lower the rate to 0.15% in February 2001 and then to zero again in March 2001, where it stayed until Friday. Prior to August 2000, the BOJ also had another period of zero rates - from February 1999 until August 2000.
When the BOJ scrapped its quantitative-easing policy in March, some analysts expected the central bank to be very cautious about raising rates. They said the BOJ remained traumatized by its policy debacle in the summer of 2000.
The LDP-led government and the BOJ have often clashed over policy - most recently over the scrapping of the quantitative-easing policy. This time, too, some government officials, including Chief Cabinet Secretary Shinzo Abe and Finance Minister Sadakazu Tanigaki, had warned until the last minute against an early increase in rates, fearing such a step could choke off a budding economic recovery.
But those who think the BOJ should be allowed to get its way seem to have prevailed. Koizumi has said in recent days the timing of a monetary policy change is "something that the BOJ should decide, with a close eye" on price movements, thus suggesting he would respect the central bank's decision. It is very likely, however, that the LDP coalition will put political pressure on the central bank over what it deems any hasty move toward further rate hikes.
In a bid to prevent a sharp rise in long-term interest rates - a serious concern for the government - the central bank also decided on Friday to 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. The government has not wanted 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. In an apparent effort to assuage concerns within the government about sharply higher borrowing costs, the BOJ emphasized in its statement that "very low interest rates will probably be maintained for some time" and that future changes will come "gradually".
The Fukui distraction
In recent weeks, the BOJ has been distracted from its monetary policy management as Fukui faced a growing chorus of calls to resign over his controversial investment in a fund set up by disgraced investor Yoshiaki Murakami, who was arrested in early June for insider trading. Opinion polls showed that the majority of Japanese think Fukui should step down. The public was particularly irked by the fact that Fukui's investment more than doubled over the last seven years, while regular bank savings accounts paid hardly anything due to the central bank's zero-interest-rate policy. Opposition parties have demanded his immediate resignation. But Koizumi's ruling coalition has defended the embattled BOJ governor.
Although Fukui's investment was not illegal and did not violate the bank's internal rules, it received a barrage of criticism over an alleged conflict of interest. Fukui said in late June he would take a 30% pay cut for six months. He also said he would give to charity the 10 million yen (US$86,378) principal, as well as any profits made through the investment in the Murakami fund. In response to lingering public anger over Fukui's investment in the Murakami fund, the BOJ decided earlier this month to revise internal rules to require the governor and other members of the policy board to disclose information on their financial assets. Unlike cabinet members or lawmakers, BOJ governors have not been required to disclose personal assets. The rule changes will also impose tighter restrictions on personal investments by senior BOJ officials.
The quasi-scandal came at a delicate time for the BOJ, which was mulling the timing of a rate hike after scrapping the quantitative-easing policy. Market expectations of a rate hike in July at one time receded due to the scandal, but grew again amid a recent spate of strong economic data. This apparently provided the central bank with strong ammunition to push through a rate hike without running the risk of hurting its credibility and neutrality.
Without such a recent bundle of upbeat economic data, this week's ending of the zero interest rate could have generated criticism that the BOJ had forced through the rate hike because it wanted to emphasize its independence from the government. On the other hand, if the BOJ had defied expectations and delayed its decision on lifting the zero-interest-rate policy, it could have been criticized for bowing to the government because the central bank is indebted to the government for its backing of Fukui in his investment scandal. This time, the BOJ may have made a proper monetary-policy judgment, based on objective economic conditions. But the central bank still faces the daunting task of steering monetary policy in the post-zero-rate period with a view to ensuring sustainable economic growth.
Meanwhile, major Japanese banks, including Bank of Tokyo-Mitsubishi UFJ and Mizuho Bank, are set to raise their interest rates on ordinary deposits in line with the BOJ's decision to end its zero-interest-rate policy. They are planning to lift their ordinary deposit rates to 0.1% per annum from the current 0.001% on Tuesday, the next business day in Japan. They are poised to raise their interest rates on time deposits as well. Major banks have gradually raised their rates on time deposits since the BOJ scrapped its quantitative-easing policy in March. But the interest rates on ordinary deposits have been kept at 0.001% as short-term money market rates have been stuck at almost 0% because of the BOJ's zero-interest-rate policy.
Hisane Masaki is a Tokyo-based journalist, commentator and scholar on international politics and economy. Masaki's e-mail address is [email protected].