Still Curing Yesterday's Disease

Despite robust growth, Japan's central bank is coddling the economy

It looks like the real deal in Japan. The Nikkei stock index has vaulted up 15% this year, hovering at a four-year high. Japan's 4.4% jobless rate is the lowest since 1998. And the country's economic expansion is now in its 44th month and shows no signs of losing oomph. Barclay's Capital Japan (BCS ) is forecasting real gross domestic product growth of 2.8% for the fiscal year ending in March, vs. 1.9% this year. And in a country once hammered by free-falling land prices, Japan's leading business magazine, Nikkei Business, just published a cover story entitled "Mansion Bubble," about Tokyo's overpriced luxury condo market.

The Bank of Japan, however, is still acting like it's treating a sick economy. As it has for the past four years, the central bank is flooding the country's interbank money market with massive reserves. The BOJ opted for this so-called quantitative easing program back in 2001 -- on top of a "0%" target for a key short-term interest rates begun in 1999. The policy made sense when the economy labored under the yoke of recession and was saddled with a weak bank system and falling prices that crushed corporate profits. But most of those ills have been cured. Even the specter of deflation is fading away: Market watchers expect seven years of price declines could be history by yearend. "We will get a positive consumer price index by the end of the year," predicts Alan Wilde, director of fixed income and currency at Baring Asset Management in London.

For all these reasons, many global money experts predict the BOJ, led by its highly regarded governor, Toshihiko Fukui, will dial back the ultra-loose monetary policy at the first whiff of inflation. Yet the BOJ is under massive political pressure from Prime Minister's Junichiro Koizumi's government to move glacially. The government debt load is some $7 trillion, about 150% of GDP and the highest among industrialized economies. A sharp rise in rates could crater the bond market and create a fiscal crisis. The debt already costs about $165 billion to service each year, or 22% of total government outlays.

Until recently the government hasn't had to work too hard to meet its debt obligations, since benchmark 10-year bond yields averaged 1.3% from 2001 to 2004. But they are now at 1.44% and likely will head higher in anticipation of a BOJ move. What's more, the stock market is starting to siphon capital away from bonds. If yields spike to 3%, Tokyo might have to get serious about tax hikes or other austerity measures. Given that scenario, Finance Minister Sadakazu Tanigaki has predictably warned that it's too soon to declare victory over deflation and allow rates to climb.

Not all BOJ officials buy Tanigaki's thinking. Policy board member Atsushi Mizuno, for example, has been talking up strategies for restoring normalcy to the interest rate structure. He also downplays talk of a bond meltdown, saying that a stronger economy and corporate profits will mean far more tax revenues. Indeed, private economists think a modest rate hike -- say, 25 basis points -- could come in mid-2006 without causing a bond market upheaval, if it's sold as a return to a normal monetary policy rather than the first shot in a steady credit tightening campaign. "It depends on how well the BOJ explains it to the markets," says Satoru Ogasawara, an economist with Credit Suisse First Boston in Tokyo.


For his part, Fukui has made clear he is in no hurry, and his voice will likely sway others at the bank. In fact, the BOJ is underwriting Koizumi's fiscal policies by buying Japanese government paper outright, to the tune of about $12 billion a month. If Fukui opts for inaction, the central bank could lose its hard-won credibility as an independent player -- and tempt Koizumi to put off politically painful reforms such as spending cuts. "They could be accused of monetizing" government debt, says John Richards, research head at Barclays Capital in Tokyo. Japan's consumer price index and year-on-year inflation likely may turn positive by yearend, forcing Fukui's hand. If he wants to be a true guardian of price stability, he may have to part ways with Koizumi.

By Brian Bremner in Hong Kong

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