Japan Rate Hikes: All Eyes on BOJ

The Bank of Japan’s nine-member monetary policy committee just began a two-day meeting to decide whether to hold rates or increase them for the first time since July. Most analysts reckon the BOJ committee, chaired by Governor Toshihiko Fukui, will raise rates in Japan by 0.25% to 0.5%. More than two-thirds of 52 economists surveyed by Bloomberg News said they expect a rise.

One big reason is, with deflation seemingly conquered, Japan’s continuing economic recovery — now the longest expansion since World War II — remains on track with the economy expected to grow by more than 2% in fiscal 2007 [see BusinessWeek.com, 1/10/07, "Japan: Slow and Steady Does It"].

Fukui’s determination to gradually raise rates toward a “normal” level of about 2%, high corporate profits, and strong exports are other important factors. “The big structural risk of a relapse into deflation is just not there,” says Jesper Koll, chief Japan analyst at Merrill Lynch (MER) in Tokyo. “Banks are lending, the economy is growing and land prices are rising. It doesn’t need interest rates close to zero. This is a normal economy.”

Signs of Weakening Resolve Indeed, many economists reckon a rise Thursday will be the first of several this year. Masaaki Kanno, chief economist at JP Morgan (JPM) in Tokyo, expects a rise this week and further rises in August and November. “The market has more or less incorporated a rise this week,” Kanno says. Richard Jerram, an analyst at Macquarie Securities in Tokyo believes rates could even creep higher. He believes the BOJ may ratchet up rates to 1.25% by yearend.

Yet as decision day approaches, there are increasing signs that the BOJ’s resolve may be crumbling amid fears of weak consumer spending and political pressure. In Wednesday trading, yields on the newly issued 10-year cash bonds briefly fell to 1.675%, hitting the lowest level since December, 2005, as investors revised their view that the BOJ would almost certainly hike rates. The yen, meanwhile, also weakened against the dollar and euro.

The Japanese media played a big role in changing expectations. The Nihon Keizai, Japan’s best-selling business daily, reported today that weak inflation and consumer spending — the missing link in Japan’s economic recovery — mean a rate rise this month is unlikely. “The Bank of Japan may refrain from an immediate rate hike to give itself more time to analyze consumer spending and price trends,” the paper noted. Kyodo News, a newswire, and public broadcaster NHK also said it was becoming more likely the BOJ would keep rates on hold.

Bid to Assert Independence The impact of political interference, though, is less clear. On one hand, chieftains in Japan’s ruling Liberal Democratic Party have made no secret of their desire for the BOJ to tread carefully. On Jan. 14 LDP Secretary-General Hidenao Nakagawa, wary of a rise in rates, called on the government to exercise its right to ask for a delay in the interest rate vote. Chief Cabinet Secretary Yasuhisa Shiozaki added on Monday that he hopes the BOJ will consider the government’s view when making policy.

Some economists reckon the LDP’s heavy-handed approach could backfire. Macquarie’s Jerram reckons that the BOJ may feel the need to assert its authority with a rate rise. “The pressure, if anything, can have the opposite of the desired effect,” he says. “The bank may want to make clear there are no doubts about its independence or credibility.”

Just as important is that the BOJ’s Fukui is well aware of the risks of doing nothing. By leaving rates unchanged, the BOJ runs the risk that companies will begin misallocating resources and making unwise investments, such as building unnecessary factories or offices because credit is too cheap. Merrill’s Koll reckons that could already be happening. “Whether they hike on Thursday or not, the Japanese economy can easily withstand interest rate increases of up to 1%,” he says.