Japan: Raises its View of the Economy Slightly

• The Bank of Japan (BoJ) has today kept its leading interest rate unchanged at 0.1% and upgraded its view of the economy slightly. The bank still sees considerable downside risk to both growth and inflation.
• In addition, eligible collateral is expanded to include some foreign government bonds.
• With signs that domestic financial stress is easing and the economy bottoming out, the BoJ in our view is unlikely to announce further major quantitative easing measures. However, with a considerable output gap and negative core inflation, we think an interest rate hike before H2 10 is unlikely.

Details

In line with expectations, at today's monetary meeting the BoJ decided to leave its leading O/N target rate unchanged at 0.1% in a unanimous decision. In addition, the bank decided to expand the range of eligible collateral to include government bonds from the US, the UK, Germany and France.

The BoJ has raised its view of the economy slightly. It now believes the economy is bottoming out, driven mainly by a recovery in industrial production and exports, while domestic demand is expected to continue to weaken in the short run. Based on the detailed BoJ view of the economy in Outlook for Economic Activity and prices released in April, it appears that the BoJ believes growth will turn positive in H2 09 but not exceed potential before 2010.

The BoJ expects inflation to continue to decline further into negative territory in the short run but expects deflationary pressure to ease by late 2009. The bank still sees mainly downside risk on both inflation and growth compared with its main scenario.

Full BoJ policy statement

Assessment & Outlook

There were no major surprises at today's monetary meeting. There had already been wide press speculation about the expansion of eligible collateral to include foreign government bonds and a slightly more positive view of the economy was only a minor adjustment.

In line with the BoJ we believe the Japanese economy is bottoming out. However, contrary to BoJ (and market consensus), we believe GDP growth could be substantially above potential in the early recovery phase starting with Q3 and Q4 this year. As we expect the recovery to be largely driven by an end to inventory cutting and the impact of fiscal easing, we are more concerned about the recovery's strength and sustainability in 2010. However, during the summer, signs of stabilisation and recovery are likely to become more pronounced and the BoJ is likely to raise its view further later this summer.

In addition there are signs that the BoJ's quantitative (or non-conventional if you prefer) easing is working. Growth in the monetary base has accelerated and interbank interest rates (TIBOR), corporate and commercial paper yields have declined significantly recently. Hence, we do not expect the BoJ to introduce new major quantitative easing measures and thus think it is unlikely to step up its purchase of government bonds further.

However, with the output gap likely to remain substantial and core inflation likely to continue to ease until late 2009, we are still far from the BoJ even considering removing some of its quantitative easing measures or increasing its leading interest rate. An interest rate hike before H2 10 is unlikely to happen in our view.

Danske Bank
http://www.danskebank.com/danskeresearch

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