The Bank of Japan's Even Keel

The BOJ opts not to raise ultra-low interest rates amid the U.S. subprime mortgage crisis, even though they may encourage risky investments

by Kenji Hall

Japan's central bank wasn't left with much of a choice. On Aug. 23, the Bank of Japan surprised nobody with its decision to leave its benchmark interest rate target unchanged. Only a month ago, BOJ Governor Toshihiko Fukui was dropping hints that a rate rise would soon be in the offing. In the end, the BOJ reached the conclusion that investors had hoped it would: It isn't worth rattling global markets any more than the turmoil in the U.S. subprime mortgage sector already has.

But that puts Fukui in a bit of a bind. Ever since the BOJ ended its five-year-old, easy-loose monetary policy in March, 2006, and adopted an informal inflation target of 0% to 2%, Fukui has made no secret that he wants rates to go higher. He and other bank officials have frequently encouraged the idea by repeating a favorite phrase: "the normalization of monetary policy."

But what does it mean? While the concept of "normalization" underpins every BOJ rate decision, bank officials have never publicly defined it. "It's not at all clear what's considered to be normal," says Macquarie Securities economist Richard Jerram.

An Inexact Science

BOJ officials have said they don't like low rates because it encourages risky investments. In July, policy board member Kiyohiko Nishimura blamed Japan's ultra-low rates for driving Japanese retail investors to seek higher-yielding securities overseas, which in turn has kept the yen weak. It's also made Japan a magnet for a lot of excess cash with the so-called yen-carry trade, in which investors borrow at cheap rates in Japan and invest it elsewhere, distorting capital flows. Before last week's gyrations, the yen was near a 22-year trade-weighted low against other currencies, after adjusting for inflation.

Even in the most ideal conditions, predicting a "normal" level for rates is an inexact science. Many economists rely on basic measures of economic activity, growth-rate trends, and inflation to build their forecasting models, while keeping an eye out for any aberrations in the government's monthly data releases.

A straw poll of several economists found that a normalized rate might be somewhere between 1% and 3%. But it's debatable whether rates should even be headed higher anytime soon. Though the economy is on its longest growth streak since World War II, land prices are rebounding, and corporate investment in new factories and equipment is strong, the "shadow of deflation remains," says Lehman Brothers (LEH) economist Hiroshi Shiraishi. "Our view is that it's premature for the BOJ to raise rates."

Complaints About Murky Methods

When the BOJ's next move will come is an open question. Macquarie's Jerram thinks that a hike to 0.75% could come as early as October while Lehman's Shiraishi is penciling in a rise for November. Nikko Citigroup doesn't expect one until the first quarter of 2008.

The lengthy debate over BOJ jargon underscores how much work the bank has in making its policy decisions more transparent. The bank's job is to keep the economy on an even keel by tweaking interest rates and knowing when financial markets require it to open and close the money spigot. The sooner the bank can improve its communication with the market, the better its chances of avoiding springing any nasty surprises on investors.

In the past, economists have raised complaints about the BOJ's murky methods. For instance, nobody is certain whether the BOJ is using consumer prices or a broad measure of Japan's economy, called the gross domestic product deflator, as the main gauge for inflation. Unlike officials at the U.S. Federal Reserve, BOJ officials also refrain from talking about where they think inflation pressures might emerge. If the BOJ won't specify what it's watching, economists and investors will have a harder time predicting its next move.

Short-Term View Better for Now?

To be sure, such a strategy gives the BOJ more leeway in justifying policy shifts. BOJ officials themselves talk about a pragmatic approach—something they've dubbed "flexible gradualism"—in which the conditions dictating rate policy are constantly changing. That's fine, but some economists might question whether the bank is making adjustments based on a close reading of economic data or on a conceptual notion of where rates should be.

And what's the worst that can happen to the economy if the ultra-low-rate policy is maintained? "The economy might grow a little bit faster. You might get inflation that's positive rather than negative," says Jerram. "The things they're concerned about seem to be so far in the distant future that it would be better to worry about the damage an overly tight policy is having

Hall is BusinessWeek's technology correspondent in Tokyo
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