Japan: BoJ Keeps Interest Rate Unchanged and Remains Relaxed about Inflation

Bank of Japan (BoJ) as widely expected left its leading interest O/N target rate unchanged at 0.5% in a unani-mous decision. Focus at today's meeting was whether BoJ would start to toe the recent more hawkish ECB and Fed line on inflation. That was not the case. BoJ left its view of the economy unchanged in its Monthly Economic Report (see page 2) meaning growth is expected to slow temporarily and inflation is expected to pick up in the short run, but to remain contained in the medium term. That said, inflation risk cannot be completely sidelined. According to board governor Shirakawa "…inflation risk is rising globally" and "…(BoJ) monitors consumer infla-tion expectations and companies price setting behaviour closely." Our impression is that BoJ is currently more concerned about the deflationary impact from higher oil and commodity prices than about a possible impact on consumers' and businesses' inflation expectations.

Currently Japan is one of the few countries were headline inflation remains comfortable within the central bank's price stability target (currently 0%-2%). With core inflation excluding energy and food still barely positive Japan is only slowly moving out of deflation and it is probably the country where the need to contain inflation ex-pectations is least. Hence BoJ can afford to let monetary policy continue to be guided mainly by the development in economic activity. With growth set to weaken significantly in Q2 and Q3 we are unlikely to see a change in the current neutral bias in monetary policy in the near term and pre-emptive hikes to contain inflationary expecta-tions are out of the question.

Implications:

Bond yields in Japan have increased significantly following the recent sell-off in bond markets globally and a 25bp rate hike is now closed to being priced on a 12M horizon (see page 3). This is in line with our current ex-pectation of a 25bp rate hike by mid 2009. That said, we see increasing downside risk on our forecast for GDP growth in 2009. Hence some of the recent spike in Japanese bond yields seems overdone and the Japanese bond market could be well positioned to outperform in the short run. Especially in the short run the interest rate differential could increasingly turn against JPY.

BoJ View of the Economy

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 devel-opments in overseas economies and global financial markets, as well as the effects of high energy and material prices"

Last major change in BOJ view (March 2008):

"Japan's economy is expected to continue expanding moderately, although the pace of growth is likely to slow for the time being."

"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 the short run and the positive output gap in the longer run"

"Due attention should continue to be paid to factors such as uncertainties regarding future devel-opments in overseas economies and global financial markets"

Forecast of policy board members, April 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

Current Bank of Japan policy board

Toshihiko Fukui (Neutral), Toshiro Muto (Neutral) and Kazumaza Iwata (Dove) left in March 2008.

New board slightly more hawkish as Iwata was the most pronounced dove within the old BoJ policy board.

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

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