Baby Step

At this pace, the Bank of Japan should have interest rates normalized sometime in 2014. After abandoning their zero interest rate policy (ZIRP) last July by nudging short-term rates to 0.25 percent, earlier today the central bank took a second baby step with an increase to 0.5 percent.

This AP report explains:

Encouraged by signs of robust economic growth, Japan's central bank raised its benchmark interest rate by a quarter point to 0.5 percent on Wednesday, judging that price stability and consumer spending would withstand slightly tighter credit.

The Bank of Japan's decision, which came at the end of a two-day monetary policy board meeting, highlights confidence in the continuing moderate recovery in the world's second-largest economy. The vote among the nine-member board was 8-1 in favor of the hike, the bank said in a statement.


"The bank thinks that even if prices drop, that won't cripple economic growth, and conditions were ripe for a rate hike," said Takeo Okuhara, bond strategist at Daiwa Institute of Research in Tokyo. "The bank made the right choice."
...
The Bank of Japan said Wednesday that gradual growth will likely continue amid healthy production, income and company investments, and worries were diminishing about the future of the American and other overseas economies.

Apparently they missed all those disappointing U.S. economic reports last week.

Last month, the Bank of Japan surprised nearly everyone by holding rates steady after previously signaling a rate increase. A widespread perception developed that the bank had yielded to political pressure after a weak consumer spending report - a bad impression had been left by a central bank that is supposed to operate independently from the rest of the government.

Since the last policy meeting, the world's second largest economy posted an annualized growth rate of 4.8 percent for the last quarter of 2006 making today's increase more likely, though only about half of analysts polled expected the short-term rate to be increased.

What About the "Carry Trade"?

Concerns over the effect of the rate increase on the "carry trade" were blunted by clearly setting expectations for future rate increases. Aware of the distortions that low interest rates in Japan have caused in the world's financial markets, the central bank is mindful of the potential negative impact.

This report($) from the Wall Street Journal provides the details:

"As world financial markets become integrated, the time has come for us central bankers to conduct monetary policy while keeping firmly in mind its external consequences," BOJ Governor Toshihiko Fukui told a news conference.

Specifically, the governor said the BOJ wanted to quench expectations that Japanese rates would stay very low for very long, which might cause them to take "extreme positions." He said the BOJ had in mind, among other aspects of global markets, the so-called "carry trade," where investors borrow money at Japan's low rates and invest it elsewhere where returns are higher. Mr. Fukui said such borrowing could present a risk to the global economy if unwound suddenly.

Even with the latest increase, Japan's benchmark rate is still well below its equivalent in other major nations – 5.25% in the U.S. and 3.5% in the euro zone. Central banks fix the interest rates on overnight loans, which will boost borrowing costs for companies and homeowners, and increase interest income for savers.

The carry trade, plus yen-selling by Japanese investors who want better returns overseas are thought to be major causes of the current weakness of the Japanese yen, which was ¥120.28 to the dollar in late Asian trading yesterday, down from ¥114 in December and near a four-year low. Against the euro the yen was trading at ¥158.75, which is near its historic low and compares with ¥138 a year ago.

What will hedge funds do if one day there are no extreme differentials in global interest rates? Money from Japan has been cheap for more than a decade.

Looking at the experience of Japan in the world economy over the last twenty years, China and the East Asian Tigers are deservedly wary of joining the club of purportedly free-floating currencies.