Japan: Rates Unchanged, Slightly Softer View

The Bank of Japan (BoJ), as expected, left its leading O/N target rate unchanged at 0.5% in a unanimous decision at today's monetary meeting. BoJ's "View of the Economy" and the press briefing was slightly soft but overall there were only minor changes compared to the July view.

Looking more closely at the details, there were only minor changes in the BoJ "View of the Economy", now released as part of the policy statement. The August statement "economic growth has been sluggish" has replaced "economic growth is slowing further" (see page 2 for policy statement). In addition BoJ believes "growth will remain sluggish for the time being" but eventually return to a moderate growth path. At the press briefing Board Governor Shirakawa stated the economic recovery may be delayed, but a major deterioration in the economy is unlikely. Although headline inflation will probably exceed BoJ's 0%-2% price stability range in July, the bank continues to play down inflations risks. At the press briefing Shirakawa said he sees no signs of a second round impact from the recent spike in inflation.

Overall the risk assessment has been left unchanged. BoJ sees downside risk to growth from both the global economy and the impact on domestic demand from higher energy and commodity prices. That said, there are signs of increasing concern about the global economy. For the first time it directly mentions weak exports as part of the reason for the current weakness in growth. On the other hand BoJ find some comfort in the recent decline in crude oil and commodity prices. Commodity prices leveling off is now explicitly mentioned as a reason for a return to a moderate growth path.

Outlook: Downside risk to the economy continues to outweigh upside risk to inflation and, unlike ECB, BoE and the Fed, inflation is currently not a major constraint on monetary policy. In the end it will be all about growth. However, BoJ still regards monetary policy as very accommodative and suitable for the current situation and really there is not a lot BoJ can do to stimulate the economy. The longer term concern for BoJ remains the need to eventually "normalize" interest rates to avoid past mistakes of being overly accommodative for too long. Thus we probably need to see a prolonged deterioration in Japan's economy for BoJ to even start considering cutting.

Our view remains that BoJ will remain on hold for the next year and the next move eventually will be up. Since the last monetary meeting on July, markets have marked down the probability of a rate hike within the next year and the yield curve has flattened considerably (see chart 1 and chart 2 on page 3). With all O/N forwards up to 12M currently trading very close to 0.5% (Chart 1) our "unchanged" scenario is fully priced. Although we believe the next move by BoJ will eventually be up, we believe the market is unlikely to start aggressively pricing in a higher probability of a rate hike in 2009 with the near term outlook for the Japanese economy very weak and BoJ possibly softening its view further. On the contrary markets are probably more likely to start pricing in a higher probability of a rate cut in the short run. This is already happening with the long forwards trading slightly below 0.5%.

Impact: No major impact. 6-9 FRA up slightly by 2 bp to 0.805%, 2 Y JGP yield unchanged at 0.66%, and JPY slightly weaker after the policy announcement. However, JPY overnight has mostly been driven by increased risk aversion in the market.

BoJ View of the Economy

August 2008

Economic growth has been sluggish against the backdrop of high energy and materials prices and weaker export growth. While growth will likely remain sluggish for the time being, it is expected to return to return to a moderate growth path as commodity prices level out and overseas economies move out of their deceleration phase".

" It (CPI inflation) is expected to gradually moderate after being somewhat elevated in coming months. These suggest that the possibility of the economy remaining on a sustainable growth path with price stability is relatively high"

" If downside risks to the global economy turn out to decrease, this will increase the risk of possible swings in economic activity and prices due to prolonged period of accommodative financial conditions"

July 2008

Economic growth is slowing further reflecting weaker growth in business fixed investment and private consumption. While growth will likely remain slow for the time being, it is expected to return to moderate growth thereafter".

"CPI inflation is expected to gradually moderate after being somewhat elevated in coming months. These suggest that the possibility of the economy remaining on a sustainable growth path with price stability is relatively high"

" If downside risks to the global economy turn out to decrease, this will increase the risk of possible swings in economic activity and prices due to a prolonged period of accommodative financial conditions"

Danske Bank

Disclaimer

This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets' research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.