Japan: "Solidarity" Cut from BoJ Tomorrow

For a change, the outcome of tomorrow's monetary meeting at the Bank of Japan (BoJ) will not be trivial. We now believe BoJ will cut interest rates by 25 bp tomorrow. This is despite comments from Deputy Governor Yamaguchi earlier this week that didn't indicate an imminent rate cut - instead, he stuck to the existing BoJ line that monetary policy is already "very accommodative". Our main arguments are:

BoJ to revise GDP and inflation forecast sharply down

First, from a macroeconomic viewpoint BoJ can justify a rate cut (see chart 2) although an interest rate cut will probably not make much difference to either growth or the exchange rate. In connection with tomorrow's meeting, BoJ will release new GDP growth and inflation forecasts. We expect both to be revised down sharply (Please see table on page 3 for latest BoJ forecast and current Danske Bank forecast). We are most uncertain about how much BoJ will revise its inflation forecast for fiscal year 2009 (FY 09). In fact we now reckon that inflation will turn negative again for a while around the middle of next year, which means that the spectre of deflation could make an unwelcome return to the agenda. For FY 09 as a whole we expect inflation to drop to 0.4%, which is significantly lower than BoJ's current 1.1% inflation forecast for FY 09. However, as mentioned above, the impact on growth from monetary easing will be modest, partly because the impact on household income of lower interest rates is significantly negative due to households' considerable net liquid assets. Hence it will be left increasingly to fiscal policy to stimulate growth. The Japanese government is expected to announce an additional JPY 5 trillion stimulus package later today. This package would correspond to about 1% of GDP.

New measures to stabilize domestic financial markets might be announced

Second, since the last BoJ meeting on 7 October, JPY has appreciated (see chart 3) sharply and the pressure on domestic banks has increased as the sharp drop in stock prices has cut into banks' capital base. By cutting interest rates, BoJ might hope to ease some of the appreciation pressure on JPY, but it is certainly no miracle solution. As long as we are in a deleveraging scenario, the appreciation pressure will remain. Some additional measures to stabilize domestic financial markets might be announced in connection with tomorrow's monetary meeting. Among other things, an old program from 2002 allowing BoJ to purchase shares from commercial banks is expected to be reactivated; further, there exists the possibility that BoJ could be allowed to purchase commercial paper directly in the market.

It will look like a "solidarity" rate cut

With the rate cut unlikely to have a major impact either on the economy or the exchange rate, it could partly be regarded as a "solidarity" cut. A solidarity rate cut was advocated by Economic Minister Yasono earlier in the week. Yasono said that while he did not believe a rate cut would have any significant impact on either the economy or the currency, "... It would be meaningful for Japan to cut rates to demonstrate the importance of international cooperation when other central banks are lowering rates". Some are arguing that by not participating in the last round of coordinated rate cuts, Japan actually weakened its negotiating position when it asked for coordinated G7 currency intervention last weekend. Hence, "by joining the gang again" Japan might be in a better position to push exchange rates on the agenda at the important G20 financial crisis summit in Washington next month.

The forward O/N target rate for the 31 October monetary meeting is currently trading at 0.32% (mid price). Hence, we are close to fully pricing a 25 bp rate cut tomorrow. Disappointing the market has not been a winning strategy recently. We expect BoJ to remain on hold at 0.25% for next year

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

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