Japan: Unchanged Interest Rate and Slightly Softer BoJ Statement

The Bank of Japan (BoJ) this morning as expected left its leading interest rate unchanged at 0.5% in a unanimous decision. The statement was only slightly softer than the August statement. According to BoJ, tensions in the financial market have increased, but its view of the economy is largely unchanged.

BoJ expects growth to remain sluggish for now. It still sees considerable downside risk to growth and upside risk to inflation. Importantly it did not start to downplay upside risk to inflation despite recent declines in crude oil and commodity prices. BoJ expects inflation (excluding fresh food) to remain close to 2.5% y/y in the coming months and moderate gradually thereafter (see page 2). Based on the recent decline in crude oil prices, we think CPI inflation is likely to decline below 2% in the coming months and BoJ should soon start to soften its view on upside risk to inflation.

Concerning the recent turmoil in financial markets, BoJ's main strategy will be to provide ample liquidity short term. There has been some nervousness about Japanese banks' considerable exposure to Lehman Brothers. However, the impact on the domestic money market has still been modest compared with the US (see chart 2).

Market reactions have been dominated by the overnight AIG rescue. However, O/N forwards have declined slightly below 0.50%, indicating that the market is starting to price in a slight possibility of a BoJ rate cut (see chart 1). O/N 12M forward since Monday has declined from 0.52% to 0.47%, indicating a 10% probability of a rate cut within the next year. We expect BoJ to remain on hold for the next year. First, the BoJ board still regards monetary policy as very accommodative and with its leading interest rate at just 0.5% there is really not a lot BoJ can do. To calm financial markets in the short run it will provide ample liquidity. Second, it is increasingly likely there will be another fiscal easing taking some of the burden off BoJ's shoulders.

BoJ View of the Economy

September 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 a moderate growth path as commodity prices level out and overseas economies move out of their deceleration phase."

"The CPI inflation rate (excluding fresh food) is currently around 2.5%...it is expected to remain around this level over the coming months but to moderate gradually thereafter. Thus it is likely that the economy will return onto a sustainable growth path with price stability."

"With regard to risks factors, tensions in global financial markets have increased and there are downside risks to the global economy."

"While Japan's money market has been functioning well, the Bank will continue to strive to ensure smooth settlement of funds and maintain market stability taking into account the recent developments among the US financial institutions and their impact."

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 a moderate growth path as commodity prices level out and overseas economies move out of their deceleration phase."

"The CPI inflation rate (excluding fresh food) is currently around 2%...it is expected to gradually moderate after being somewhat elevated in coming months. Thus it is likely that the economy will return onto a sustainable growth path with price stability."

"With regard to risks factors, global financial markets remain unstable and there are downside risk to the global economy."

Forecast of policy board members, July 2008

Note: CGPI= domestic corporate goods prices, CPI= consumer prices excluding fresh food, fiscal year = April- March. Numbers in parentheses are previous BoJ forecast. Bold numbers are current Danske Bank Forecast Source: Bank of Japan, Outlook for Economic Activity and Prices and July policy statement.

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

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