No Rate Rise In Japan

BOJ keeps its key interest rate unchanged, citing upbeat forecasts, though it may tighten credit later. But is this a ploy? And is it warranted?

Put yourself in Toshihiko Fukui's shoes. The governor of Japan's central bank has been a stabilizing figure during his four-year tenure. He has restored the Bank of Japan's credibility and begun the process of weaning the economy off its ultra-cheap-money dependency. And while the BOJ kept its key rate unchanged at 0.5% on Oct. 31, Fukui reminded the financial markets that he wants to tighten monetary policy the first chance he gets.

Almost no one had expected Fukui and his nine-member policy board to act now. Indeed, this is not the time for the BOJ to be nudging interest rates higher, especially since it's still possible that problems in the U.S. home loan market might make life miserable for Japan Inc. A rate rise at this junction just might slam the brakes on Japan's longest expansion since World War Two.

That leaves Fukui in a bit of a pickle. The 72-year-old governor has just four and a half months left in his term, which ends in mid-March, 2008. Under his watch, the BOJ abandoned its 0% interest-rate policy in July, 2006, for the first time in nearly six years. It pushed up rates again, to 0.5%, in February. One last rate hike before he exits the scene would be a fitting way to end things. More than anything else, it would symbolize Fukui's resolve to restore normalcy to an ultra-loose monetary policy. That would help the bank counter criticism that cash borrowed at low rates in Japan has found its way into risky investments around the globe.

Rate Hike Could Happen in Early 2008

To raise rates, Fukui needs the economy to continue chugging along at a moderate clip. The bank's near-term outlook remains upbeat. "A virtuous circle of growth in production, income, and spending is expected to remain in place" in Japan, the bank said in its semiannual report, "Outlook for Economic Activity and Prices," released on Oct. 31. According to Fukui & Co., there's no hard evidence that the U.S. or Europe are in imminent danger of a recession. Growth in Japan should hit 2.1% next fiscal year through March, 2009, and inflation could reach 0.4%. So the BOJ plans to "adjust the level of interest rates gradually in accordance with improvements in the economic and price situation."

Many economists suspect the BOJ is already preparing for its next tightening. Lehman Bros. (LEH) economist Hiroshi Shiraishi is predicting it could happen as early as the first quarter of 2008.

But Shiraishi and some other economists think the BOJ is being disingenuous. They wonder if the bank is painting an excessively rosy economic picture to curb investor optimism. "If now the governor says 'we're seeing weak momentum in the economy,' market participants will instantly perceive that as a sign that the BOJ won't hike rates in the next two years or so," says JPMorgan (JPM) economist Masamichi Adachi.

Wages Have Been Stagnating

The BOJ's concern is that without the threat of a rate hike looming, investors would pile into Japanese stocks, driving prices higher. If the U.S. or European economies then suddenly take a turn for the worse, it would send Japanese stocks crashing to earth. "That's what the governor wants to avoid," says Adachi, a former BOJ employee.

The ploy isn't without its own risks. "In terms of official communication channels, they've been continuing to send signals that they want to adjust rates, but they haven't done that," says Lehman's Shiraishi. "It makes a mockery of the official communication [between the BOJ and the markets] and their credibility will be damaged."

Recent data suggest that not all is well. Though big companies' earnings are healthy, their fattening fortunes haven't made consumers any more willing to open their wallets and splurge. One big reason: Wages have been stagnant for months. And consumers could get even stingier. In September, new housing construction fell 44%, to its lowest level in four decades. If soaring oil prices boost the cost of doing business in Japan, companies might think twice about sharing their profits with employees, postpone bigger bonuses or pay rises, and further crimp consumer spending.

Only a couple of hours after the BOJ announced its policy decision, the bank revised downward its own growth forecasts. The bank now expects gross domestic product to gain 1.8% this fiscal year through next March, instead of the 2.1% it was predicting back in April. And it dropped its expectation for a whisker of inflation this year. The bank now thinks consumer prices (excluding fresh foods) will stay flat this fiscal year, rather than rising 0.1%. If data over the next couple of months remain dreary, Fukui & Co. may have to rethink the bank's approach.

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