Why did the Bank of Japan keep rates on hold?

published 22 January 2007

There tend to be few reasons for UK-based financial market operators to wait up until 3.30am in the morning (or, alternatively, to get up that early) but, for the aggressively committed, the eagerly awaited Bank of Japan base rate decision might just have been one of them. Interest has centred both on the economic justification for a second 0.25% point hike in the Official Discount Rate (to 0.5%) in just six months and the political ramifications of such a move. Make no mistake, a rate hike was always a possibility. The Bank of Japan sets the country's base rate with regard to its perception of the inflation outlook in two years time, much as our own Bank of England is supposed to do and in that context there are ample reasons to tighten policy in the country's fourth consecutive year of economic upswing but the Bank held rates steady and unleashed a storm relating to its independence from political pressure.

Pressure on Bank of Japan over interest rates

Heading into the base rate decision the stakes were high and rising. On 13th January the Asahi newspaper indicated that a rate hike might be on the way. Whilst the paper might simply have been acting as agent provocateur its angle, indicating to some extent what the general public's consensus expectation might be, was significant in that respect. On Wednesday 17th the FT picked up on the story and it too suggested that the balance of probability was marginally in favour of a rate hike. Back in Japan the response of the ruling LDP's Secretary General, Mr Hidenao Nakagawa was to claim that the Bank would be held responsible for any policy mistake it made including, possibly, a change in the law further to circumscribe the Bank's independence!

In addition to considerable external pressure, the Bank's governor, Mr Toshihiko Fukui had the oppressive weight of historical policy mistakes to weigh up too. Most significant of these was the Bank's failure, not to cut rates quickly enough in 1991-92, but its failure to raise them fast enough in the mid-1980's to limit the extent of the late-1980's bubble a move which we all now know with the benefit of hindsight, contributed to the "lost decade" over the 1990's.

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The economic argument for a further nudge on the monetary tiller is pretty compelling. The country's annualised economic output growth is forecast to be 2.0% over 2007 and an update is due on 13th February. The Bank's Monetary Policy Committee is well aware of incipient capacity constraints and potential labour shortages as well as the potentially inflationary consequences of rising asset prices, property prices in particular. Note, too, that the country's savings ratio is high in a historical context and that many savers would actually welcome a rate hike as it would provide a welcome boost to savings income and the corporate sector remains in good shape with strong corporate earnings growth likely over the next twelve months.

Arguments against a Japanese interest rate hike

Interest rate hike dissenters argue, however, that from mid-2007 economic growth may be harder to achieve, largely due to a slowdown in capital spending and export growth as the US economy slows. To give the economy the best possible chance of achieving a "soft landing" they argue, monetary policy must remain loose to ensure that demand and supply-side potential remain broadly in balance.

The Bank's MPC is currently in broad agreement with this latter assessment, anticipating only modest economic growth and limited pick up in inflationary pressure, however, Japanese monetary policy setting is predicated not just on the outlook for growth and inflation but also greater flexibility to take those other factors identified by supporters of a rate hike into question. In such circumstances the Bank may judge that these latter factors are sufficient to destabilise the economy over the mediumterm. Were that to be the case then a rate hike could have been justified. Unlike the European Central Bank, whose second tier factors (such as growth in monetary aggregates and bank credit growth) are pretty clearly defined, in Japan these second tier factors are less clearly delineated and the extent to which they are open to question does limit their use as an effective justification for policy action.

Japan interest rate decision: closest vote in three years

On the morning of 18th January the Bank's MPC voted 6 3 in favour of keeping rates on hold. As such it proved to be the closest decision in over three years and represented a significant departure from the 9 0 decision of the previous month. The initial reaction was, as expected, in the currency market where the yen slipped to c121 against the dollar, its lowest level since end-2005. Given that the decision could have gone either way, financial market operators had had plenty of opportunity to discount the decision. As such no strong move in the currency was anticipated.

However, what has changed as a result of this decision is our perception that Japanese base rates could end the year very much higher than current market consensus (0.75%) which would certainly have paved the way for an aggressive yen appreciation against the dollar. Independent economists continue to suggest that a neutral monetary position after four consecutive years of growth should be closer to 2.5% than today's ultra-low levels. Whilst Mr Fukui indicated, in the accompanying statement, that the Bank of Japan would endeavour to get rates back up to this level the confluence of ebbing inflationary pressure, coupled with clear political influence (Mr Nakagawa is a close ally of Prime Minister Mr Shinzo Abe) resulted in what can only be described as a pretty half-hearted assertion of policy desire on the part of the Bank's governor.

Where next for Japanese interest rates?

In the wake of this decision all eyes will turn to the 13th Feb economic report. Any indication that growth rates have come under pressure, coupled with ebbing inflation pressure in the wake of the oil price slide, could set the seal on any further near-term scope for policy tightening. Rate doves and yen hawks have had a field day following this decision. It now seems prudent to lower our expectation for the country's base rate to reach, perhaps, 1.0% over the next 12 months from the previous (aggressive) 2.5%. This severely limits the yen's scope to appreciate much against the dollar. We had previously forecast that the currency might hit 95 against the dollar. We now anticipate a level of 107, largely the consequence of dollar weakness, not yen strength. Lowered expectations for higher base rates does, however, go a step further towards vindicating our overweight stance on Japan in our Select Portfolio.

By Jeremy Batstone, Director of Private Client Research at Charles Stanley