Global Insight Perspective | |
Significance | The Bank of Japan (BoJ) has raised the leading uncollaterised overnight call rate by a quarter-of-a-percentage point to 0.50% with a majority vote of eight to one. |
Implications | The central bank remains wary of another bubble building in the economy as levels of liquidity in the financial system remain high and growth accelerates. |
Outlook | Global Insight maintains its expectation that interest rates will be increased gradually as soft patches persist in private consumption. Two further hikes are expected in the leading rate throughout the course of 2007, bringing it to 1.0% by year-end. |
Pre-Emptive Tightening
The Bank of Japan (BoJ) ended a seven-month hiatus in monetary policy as its nine-member policy board voted to raise the leading interest rate. The uncollaterised overnight call rate was raised by 25 basis points to 0.50%, its highest level in over a decade. The monetary policy voted eight to one in favour of the hike, with deputy governor Kazumasa Iwata voting against the increase. It marked the first time in the central bank’s history that its governor and deputy governor have diverged over policy. The policy rate was raised from effective zero to 0.25% in July 2006 after the BoJ abandoned its quantitative easing policy, aimed at inflating the monetary base, in March of that year.
Outlook and Implications
The central bank ascribed the move to risks associated with the economy’s accelerating growth. In the fourth quarter of 2006, growth surged to a two-year high of 4.8% in annualised terms. Quarter-on-quarter, the economy expanded by 1.1%. The acceleration in momentum was fuelled by a rebound in private consumption from contraction in the third quarter. Household spending has been supported by expanding capacity as firms increase levels of business investment amidst buoyant earnings. The outlook is further reinforced by strengthening external conditions. The downturn in the United States associated with the correction in the housing market has proved shallow, bottoming out in the third quarter of 2006, while Chinese growth shows few signs of abating. These sequential developments are described by the BoJ as a deepening "virtuous circle".
An Assertion of Independence
Today’s rise in interest rates also stood as an assertion of the BoJ’s independence against political interference. The Ministry of Finance has publicly aired its disquiet over precipitous hikes in interest rates. On one hand this reflects a craven concern over the increasing burden of servicing Japan’s huge public debt load.
However, the government remains more hawkish over the underlying strength of domestic demand and more wary of choking the recovery. Inflation data still remain weak. Consumer prices have risen but this is mostly attributable to the impact of fuel prices and the weakness of the yen. As the fuel effect subsides, consumer prices could turn negative in coming months. Core consumer prices, which exclude fresh food, rose by 0.1% in December, slowing from a 0.2% gain in November. Concurrently, the GDP deflator continues to fall, declining by 0.5% in the three months through December from the year before
Weak inflation reflects the relatively soft state of private consumption growth relative to the current strength of the labour market. However, wage growth has been comparatively flat, as buoyant corporate earnings are invested in plants and the paydown of debt. In 2006, average wages rose by just 0.2%, according to Ministry of Finance data, barely rebounding from a decade of sustained attrition.
Squashing a Bubble
Raising interest rates when price pressures remain weak and even negative may appear counter-intuitive. For the BoJ, however, the primary risk is of another bubble building in the system as the monetary stance remains too accommodative vis-à-vis strengthening demand. Although growth in monetary aggregates has stalled, the financial system remains highly liquidity. Concurrently, the transmission of monetary policy adjustments has lagged and variable delays. Pre-emptive monetary tightening is required before the expansion is firmly under way. Detrimental upwards pressure would be exerted on long-term rates if the BoJ was seen to be slow in containing any potential overheating in the economy. The former 0.25% level of interest rates was viewed as neutral in the context of current rates of GDP growth.
Given the balance of forces acting on monetary policy, further increases are expected to remain highly gradual over coming years in deference to the gradual recovery expected in private consumption. The strategy gives the BoJ latitude to tighten more aggressively if growth exceeds expectations or to hold or even cut if the recovery unexpectedly reverses. Within this framework, Global Insight expects the BoJ to implement a further two-staged hikes in the target rate over the course of 2007, bringing it to 1.00% by year end.