BOJ's big message: this recovery is for real

Amid the dozens of headlines that followed the Bank of Japan's ending of an ultra-easy monetary policy, one message rang loud and clear: the central bank is sure that this time around the economy will flourish.

"We've had five years of quantitative easing and near on a decade of deflation, so the move is a sign of confidence in the economy," said Peter Jolly, head of research at National Australia Bank in Sydney.

"It is an unequivocal statement in that regard." Yesterday, the Bank of Japan (BOJ) finally halted a policy known as quantitative easing, under which it flooded banks with excess funds. The practice began as an emergency measure in 2001 and ended up lasting five years.

Instead of targeting the amount of money sloshing around banks, the BOJ will now target overnight lending rates.

As expectations of a move mounted, so did attempts by politicians to twist the BOJ's arms. The last thing they wanted was a repeat of a monetary policy blunder five and a half years ago.

In August 2000, the BOJ pushed up rates from zero to 0.25 per cent only to lower them again seven months later in the face of economic weakness.

The embarrassing retreat led to the central bank swallowing the idea of quantitative easing, an unorthodox idea that many central bankers did not like.

This time, since the BOJ is not expected to actually start raising rates higher until later in the year, economists said the recovery will not be hurt by the prospect of higher loan costs.

Japan's economy grew at an annualised rate of 5.5 per cent in the last three months of 2005, well above US and European growth rates in the same period and in stark contrast to Japan's own anaemic performance over most of the last decade and a half.

"This time they felt that the underlying indicators were much more resilient," said Arjuna Mahendran, chief economist at a private banking arm of Credit Suisse in Singapore.

Ms Mahendran cited spending by consumers and companies as key evidence of this.

"What's more important is that it is a domestically led recovery rather than one based on just exports."

Latest data shows industrial output increased for a sixth straight month in January, rising 0.3 per cent.

And even if Japanese rates did rise, analysts say companies would not be hurt too much because they have manageable debt levels, ample cash and solid earnings.

The end to quantitative easing is largely symbolic, economists said, since the BOJ made it abundantly clear it was in no hurry to start raising interest rates.

"The Bank of Japan went with the safe option," said Standard Chartered economist Mike Moran. "Clearly it wants to remove excess liquidity but at the same time make very well signalled, gradual policy moves."

For some analysts, the BOJ's desire to raise rates only gradually stems from the August 2000 trauma.

To others, the motivation is to assure the government that the recovery will not be derailed by a premature end to super-loose monetary conditions.

Politicians' anxiety should be soothed, analysts said, by the BOJ's decision to start telegraphing its intention by adopting a "reference rate" of zero to two per cent for inflation.

In this regard, the BOJ is joining a trend among central banks globally to make policy goals transparent.

Even one of the BOJ's more vocal critics, ruling Liberal Democratic Party (LDP) lawmaker Kozo Yamamoto, welcomed the adoption of the reference rate.

But political opposition was likely to remain, analysts said.

"The BOJ may want to move early to raise rates, but they should expect a big battle. It likely won't happen until October or later," said Hiromichi Shirakawa, chief economist at UBS Securities.

The political nervousness over the central bank decision comes from a nagging worry that deflation could come back to haunt the country.

After all, Japan endured deflation for seven years and recent data has only showed three consecutive months of inflation.

"It will be a good thing if they pull this off. It was a calculated move and they were worried about what they did in 2000 when they prematurely raised rates," said Ms Mahendran.

At a glance the idea of falling prices sounds appealing: consumers get to pay less.

But deflation is also a sign of economic weakness. It discourages businesses from investing for expansions and it makes their debt more expensive to pay back.

Deflation also means companies have less pricing power and this ultimately creates fresh economic headaches such as rising joblessness.

During the past year, however, there have been growing signs of a solid rebound in the economy.

Speculation that the BOJ could end its ultra-easy monetary policy as soon as this week intensified after data on Friday showed a greater-than expected rise of 0.5 per cent in Japan's core consumer price index from a year earlier.