Japan: BoJ Fears a Return to Deflation

Overview: Bank of Japan (BoJ) today, as expected, left its leading O/N target rate unchanged at 0.1% in a unanimous board decision. In addition, BoJ revised its GDP forecasts sharply lower for both FY 2008 and FY 2009. Although BoJ still avoids using the D-word, it appears that it is becoming increasingly concerned about the possibility of a return to deflation in Japan. With the O/N target rate close to zero, the O/N target rate is no longer the main monetary instrument. As we stressed in our recent paper, BoJ has effectively turned to some kind of quantitative easing with the main focus on maintaining credit flows and boosting BoJ's balance sheet. Moving in this direction, BoJ today announced the final detail in its plans to purchase commercial paper and will possibly soon start to purchase corporate bonds outright in the market.

Details:

• In connection with today's monetary meeting, BoJ released revised forecasts for GDP growth and inflation (see table below). Compared to the board members' previous forecasts from October 2008, GDP growth for FY 2008 and FY 2009 was revised sharply lower to -1.8% (previous: 0.1%) and -2.0% (previous: 0.6%), respectively. As seen in table below, BoJ's GDP forecasts are now more negative than our latest GDP forecast. While we do not know the details behind the bank's GDP forecasts, we reckon that the board members assume that GDP growth will continue to contract in H1 09 on the back of an extraordinarily sharp contraction in GDP in Q4 08 (-1.7% q/q according to our latest estimates).
• The inflation forecast for FY 2009 was cut to -1.1% from 0.0%, and more importantly the longer term FY 2010 inflation forecast was cut to -0.4% from 0.3%. In today's policy statement, it appears that BoJ is becoming increasingly concerned about Japan possibly returning to deflationary territory: "Turning to prices, there is a possibility that the inflation rate will decline further if downside risks to economic activity materialize or commodity prices fall. In this case, the risk of a decline in medium- to long-term inflation expectations of firms and households warrants attention."
• BoJ today announced the final details in its plans to purchase commercial paper. The CP purchasing program will last until March 31 2009 and the limit on BoJ's total purchase will be JPY 3 trn. Commercial paper with maturities less than three months and a1-ratings will be eligible. In addition BoJ will examine direct purchase of corporate bonds, and eligible collateral for BoJ lending was broadened further by including commercial paper and corporate bonds issued by real estate investment corporations.

Implications: The latest BoJ forecasts paint a very bleak picture of the Japanese economy: despite a sharp contraction in Q4 08, the economy will most likely continue to contract in H1 09 and there are increasing risks of a deflation scenario. However, we are unlikely to see another (small) interest rate cut, as most BoJ board members believe slightly positive interest rate are preferably to zero rates, to improve the efficiency of the money market. Hence, the leading O/N target rate is likely to remain unchanged at 0.1% well into 2010. The very bleak outlook will increasingly force BoJ to consider "unorthodox" easing measures. BoJ is already moving in this direction, albeit reluctantly. The initiatives announced today are modest and the growth in the BoJ monetary base and balance sheet has still been modest compared to the Fed, Bank of England and ECB. That said, we should not expect short term miracles from the BoJ's efforts to increase credit availability for the private sector. The current weakness in the Japanese economy has primarily been driven by an external demand shock, and not a domestic credit crunch as in the US and most of Europe.

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

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.