BoJ Cuts by 20 bps and Revises Growth Sharply Down
The Bank of Japan (BoJ) this morning cut its leading O/N target interest rate by 20 bps to 0.3% in a split 4-4 decision. Three dissenting board members voted for cutting the O/N target rate by 25 bps (most likely Suda, Nakamura and Kamezaki) and one member voted for leaving the leading interest rate unchanged at 0.5% (most likely Mizuno). The rest of the board, including board Governor Shirakawa and his two deputy governors, voted for a 20 bp cut. At the press briefing Shirakawa said that they did not want to cut by more than 20 bp, because that might disrupt the functioning of the money market. A 25 bp rate cut was expected.
In addition, the basic loan rate was cut by 25 bps to 0.5% and it was decided to start paying a 0.1% interest rate on excess reserves at BoJ. The basic loan rate is the loan rate at which financial institutions can borrow directly from the BoJ. Broadly speaking the interest rate on excess reserves will be the floor for money market rates and the basic rate will be the ceiling. Hence, the main purpose of cutting the basic rate more than the O/N target rate and introducing interest payments on excess reserves is basically to reduce volatility in money market rates. Both these measures were approved unanimously by the board members. Before today's monetary meeting there was some speculation that BoJ might choose to cut only the basic interest rate to reduce money market volatility.
Arguably BoJ has already turned to quantative monetary targeting and is leaving itself considerable monetary flexibility. BoJ states that with financial stress increasingly hurting financial markets in Japan, it intends to provide sufficient liquidity; this might induce the O/N interest rates in the market to decline below the targeted level (the leading interest rate). Providing adequate liquidity is more important than steering the O/N market interest rate close to the targeted 0.3% level. This gives BoJ considerable monetary flexibility.
BoJ today released the board members' revised inflation and GDP forecasts. The forecasts provided are a median and a range (see table). BoJ revised both its GDP growth and inflation forecasts down - much lower than was expected. For financial year 2008 (April 08-March 09) GDP growth was revised from 1.2% to just 0.1% This was actually in line with our current expectations, but according to recent media speculation, the downward revision would be at most 0.5% GDP. Most important, BoJ's forecast for CPI (excl. fresh food) for FY 09 was revised down to 0.0% from previous 1.1%. This forecast in our opinion implies that inflation will turn negative sometime during 2009. With BoJ's inflation forecast for FY 09 close to the bottom of its 0%-2% price stability range, deflation could soon be back on the agenda. For now BoJ has removed upside risk on inflation as a constraint on monetary policy.
Outlook: It is not hard to justify today's interest rate cut given the current very weak macroeconomic outlook, although it probably won't make much difference to growth. Monetary policy will mainly be targeted at stabilizing domestic financial institutions, and here interest rates will take a backseat to the provision of adequate liquidity. Stimulating growth will be left to fiscal policy. With inflation possibly slipping back into negative territory next year, a zero interest rate policy cannot be ruled out. However, BoJ has already awarded itself considerable monetary flexibility. Hence we believe interest rates will remain unchanged at 0.3% at least until early 2010. This expectation is broadly priced in the market with 12M O/N forward currently trading at 0.29% (mid-price).
Impact: The financial market impact was mainly because of the sharp downward revisions by BoJ. The stock market dropped sharply with Nikkei finishing down 5%. With concerns about growth getting another boost - not just in Japan - JPY has strengthened again and is trading at 97.0 against USD at the time of writing. Bond yields are only slightly lower.
BoJ View of the Economy
Monetary Policy Statement, October 31
Outlook for Economic Activity and Prices, October 2008
Danske Bank
http://www.danskebank.com/danskeresearch
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