Bank of Japan Left Leaderless

Ongoing political squabbles between the ruling LDP party and opposition DPJ party now in control of the upper house of the Diet, Japan's legislative branch, have lead to a leadership vacuum at the Bank of Japan. The Prime Minister has had two nominees for the Governor position voted down by the upper house over the last week. Former BoJ Governor Fukui's term has ended, however, and recently appointed Deputy Governor Masaaki Shirakawa was given a battlefield promotion to Acting Governor while the political wrangling continues.

The opposition DPJ has said they are concerned about the central bank's independence and the perceived parachuting of senior government officials into other positions. Each of the two rejected candidates had held the same senior position at the Ministry of Finance and it was felt this would give the current government too much influence over monetary policy. However, the opposition's two suggested nominees did not exactly break the mold, recommending the current head of the Asian Development Bank and a less senior official at the Ministry of Finance. This process reeks of political wrangling and attempts to force an election.

The first proposed candidate, current BoJ Deputy Governor Muto, seemed to be in the "normalization" camp - the belief exceptionally low rates lead to bubbles and are bad for medium-term economic prospects. Also, one of the former deputies whose term just ended was the sole dissenter last February when the BoJ raised rates to 0.50%. He has been replaced with the new Deputy (and acting Governor) Shirikawa who also appears to be in the normalizationist camp and would need further evidence to be convinced to cut rates. The second Gubernatorial candidate voted down, Tanami, on the other hand, is quoted as having said he would take "decisive action" to stem "downside risks" to growth.

Unfortunately, there is no indication as to who may be the next nominee or eventual Governor. If the nominee is closer to the Prime Minister or Ministry of Finance, there may be some bias towards the dovish spectrum. Japan is facing the highest public debt burden of any G-7 economy, and the administration would prefer a candidate more willing to work with the needed fiscal tightening to come. Also, there is some fear that as an Acting Governor, Shirikawa would not be invited to the G-7 meeting in April. In light of the global financial turmoil, this may increase political pressure to get an official nominee in place as we get closer to those meetings.

Our own economic forecasts see the Japanese economy contracting in the first quarter of 2008, but after that, being able to sustain real GDP growth in the range of 1.0-1.5% - not stellar, but certainly not suggesting a pressing need to cut interest rates from their already stimulative 0.50%. Moreover, while core consumer price inflation remains in marginally deflationary territory at -0.1% y/y, the headline figure is now running at 0.7% y/y. Even with some moderation expected in the second half of 2008, headline inflation should manage to stay in positive territory. Lastly, this recent acceleration in inflation has meant real interest rates in Japan have fallen by nearly a full 100 bps since September with no move from the BoJ. Therefore, we believe there is much less scope for interest rate cuts in the near term than the almost two-thirds probability priced in to markets right now. However, there is a tremendous amount of political risk associated with this given the uncertainty over who will ultimately be at the helm.

TD Bank Financial Group

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