Japan: BoJ Leaves Rates Unchanged, but Sees Increasing Downside Risk to Economy

The Bank of Japan (BoJ), as widely expected, left its leading O/N target interest rate unchanged at 0.5% in a unanimous decision at today's monetary policy meeting. More interestingly, the BoJ revised down its forecast for GDP growth, and is currently working on the assumption that GDP growth will be substantially below potential for the rest of the year. The BoJ's inflation forecast, in contrast, was revised substantially up, and the underlying assumption now seems to be that inflation will increase above 2% in the short run, but decline substantially below 1% next year.

The BoJ revised its forecast for GDP growth in FY 2008 (April-March) down to 1.2% from 1.5% previously (see table on page 2 for forecast). This is broadly in line with our current forecast of 1.3% GDP growth in FY 2008. It should be stressed that, as growth has been very robust in both in both Q4 07 and Q1 08, the underlying assumption behind the BoJ forecast must be that the Japanese economy will barely grow in FY 2008 and growth on a quarterly basis will be substantial below potential (we estimate potential growth to be slightly less than 0.4% q/q). The BoJ has revised its GDP forecast for FY 2009 slightly down to 1.5% from 1.7%. This is still consistent with a robust recovery in growth in FY 2009, but underlines increasing downside risk to this view.

In contrast, the BoJ has revised its forecast for CPI excl. fresh food in FY 2008 significantly up - to 1.8% y/y from just 1.1% previously (DB: 1.8%) - but left its forecast for FY 2009 largely unchanged at 1.1% y/y from pre 1.0% y/y previously. With CPI excl. fresh food currently at 1.5% y/y, the BoJ, in line with our current forecast, must assume that inflation will go above 2% in the coming months and then decline substantially below 1% next year. In our opinion, inflation will most likely decline faster than the BoJ currently expects. We base this on our expectation of at least some stabilisation in food prices and a slight decline in crude oil prices. Hence, CPI inflation could very well be below 0.5% y/y by year-end 2009, in our opinion.

Overall, the BoJ is signalling increased downside risk to the economy given that the GDP forecasts for FY 2008 and FY 2009 have been revised down and the inflation forecast for FY 2009 left largely unchanged and comfortable within the bank's price stability range. Inflationary risks cannot be completely ignored, however, as underlined by the following paragraph in today's policy statement: "..it is necessary to be mindfull of upside risks due to changes in inflation expectations of households and the price setting behavior of firms." However, inflation concerns continue to be outweighed by concerns about growth. Ultimately, the next move, which we believe will be a hike, will be decided by global growth, as underlined by the statement in today's policy decision: Meanwhile, if the downside risks to the economy turn out to decrease, this will increase the risk of possible swings in economic activity and prices due to prolonged period of economic activity. However, with increasing downside risk to both the global and the Japanese economy, we do not expect this to happen until H2 09.

BoJ View of the Economy

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 a 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 prolonged period of accommodative financial conditions "

June 2008

"Japan's economy is expected to grow at a slower pace for the time being and follow a moderate growth path thereafter".

"The year-on-year rate of change in consumer prices is projected to follow a positive trend due to the rise in prices of petroleum products and food products in a situation where overall supply and demand in the economy is more or less balanced"

"Due attention should continue to be paid to factors such as uncertainties regarding future developments in overseas economies and global financial markets, as well as the effects of high energy and material prices"

Forecast of policy board members, July 2008

Danske Bank

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