Bank of Japan Abandons Rate Hike Bias

May 5, 2008

Since ending in 1Q06 their five-year long policy of zero short-term interest rates and heavy injections of excess liquidity, officials at the Bank of Japan had not hidden their intention to gradually return short term interest rates to normal and higher settings. Target rate increases of 25 basis points were implemented in July 2006 and February 2007. Economic conditions did not allow a third advance to 0.75%, but only at the end of last month was the prediction of more increases discarded. At the same time, the central bank cut its forecasts for projected economic growth to 1.5% in the current fiscal year to March 2009 and 1.7% in the year to March 2010. Japan has been heavily dependent upon net exports for its growth, and that will be true again when first quarter 2008 data are released on May 16th. The yen has been undervalued for some time. On a trade-weighted basis, it averaged 131.6 in 2002-6, 117.7 in 1H07, 118.0 in 3Q07 and 120.3 in the final quarter of last year. The yen’s trade-weighted index more recently rose to 128.1 on average in 1Q08 and 129.0 last month. This appreciation and softer global demand will make it harder in the future for net foreign demand to compensate for sluggish domestic demand.



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