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Monday, July 31, 2006

JAPANESE PERSPECTIVES

BOJ should have based hike on consumer needs, worldwide inflation trend


The Bank of Japan raised the unsecured overnight call rate from virtually zero to 0.25 percent at the end of its July 13-14 Policy Board meeting and hiked the official discount rate from 0.1 percent to 0.4 percent.

The hike, which had been anticipated since the central bank lifted the quantitative easing policy in March, ended the 5-year, 4-month-old "zero-interest-rate" policy that had been in effect since March 2001.

The move effectively gives the central bank access to its two major policy tools -- interest rates and liquidity adjustments -- and gives it room to lower interest rates if the economy again takes a turn for the worse.

The development also means normalization of an extremely unusual situation in the Japanese monetary market, a situation that was necessitated by the need to prevent a financial crisis.

Why has the BOJ decided to raise interest rates at this point?

The central bank had earlier pledged that the zero-rate policy would be maintained until it has confirmed that consumer prices have returned to positive territory on a year-on-year basis and that it is confident they will not slip. The consumer price index has risen by more than 0.5 percent on year for five months in a row. Wholesale prices are up about 3 percent.

Japan will almost certainly break its postwar record of uninterrupted economic growth in November, surpassing the 57-month-long boom between 1965 and 1970.

By making the decision to raise interest rates, the BOJ is believed to have determined that consumer prices are unlikely to re-enter negative territory.

So what will the impact of the interest rate hike be?

With its huge debts, the public sector faces an increase in debt-servicing costs from the rate hike. The government did not openly oppose the BOJ's decision, but it is already engaged in yet another tug-of-war with the central bank over the timing of the next rate hike -- which is expected sometime in the near future.

Here, it goes without saying that interest rate hikes will serve as market pressure to discipline the public sector.

The hike is not expected to have a major impact on the private sector, however, because Japanese companies will be able to cover their capital investments with profits and write-offs of existing assets.

Some people worry the hike could hit the stock market, but companies that can't withstand even a minimum increase will inevitably drop anyway.

Critics continue to argue that things will be tough for smaller companies, but those with prospects for future growth will have little problem raising funds, because banks are ready to lend to promising firms.

What to do with small businesses that do not have promising or competitive features -- or sons or daughters willing to take them over -- is a matter to be addressed via structural reform of the economy, rather than monetary policy.

In the housing sector, interest payments on housing loans will increase by roughly 2 trillion yen, but since higher interest rates will boost income on savings by 6 trillion yen, home owners should see a net gain of 4 trillion yen.

From an international perspective, the BOJ's latest hike is taking place after a string of no fewer than 17 monetary tightenings by the U.S. Federal Reserve, and the European monetary authorities are still raising rates. Driving this trend is the continuing climb of crude oil prices, which is being fueled by geopolitical risks linked to Iraq, tensions over Iran's nuclear program, and the recent missile launches by North Korea.

BOJ Gov. Toshihiko Fukui has denied the central bank is planning successive rate hikes, but the expanded interest rate gap with the United States and Europe has already led to a decline in the yen against the dollar.

An upsurge in crude oil prices means a greater transfer of income from Japan to oil-producing countries, and the yen's weakness accelerates that trend.

Import prices are as much as 18.5 percent higher than they were a year ago, and the latest consumer price index came in 0.6 percent higher than a year ago, meaning depositors who receive interest rates of between 0.1 to 0.2 percent are still losing purchasing power.

In other words, Japan's true interest rates are effectively stuck in a negative range of between 0.4 percent and 0.5 percent. Given this situation, the author believes the BOJ should have raised the key rate directly to 0.5 percent.

Monetary policy is supposed to promote people's wealth, and in that respect, the central bank should quickly respond to changes in the international environment and introduce policies that prioritize the interests of consumers.

Growth led by domestic demand remains one of Japan's unfulfilled promises to the international community.

Teruhiko Mano is a professor at Seigaku in University Graduate School.


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