BOJ May Keep Key Rate at 0.5% After Economy Shrank, Prices Rose

By Mayumi Otsuma

Aug. 15 (Bloomberg) -- The Bank of Japan will probably keep interest rates at the lowest level in the industrialized world next week after the economy shrank and inflation accelerated to a decade high.

Governor Masaaki Shirakawa and his six colleagues will leave the overnight lending rate at 0.5 percent at a two-day meeting ending Aug. 19, according to all 29 economists surveyed by Bloomberg News. The rate was last raised in February 2007.

The world's second-largest economy contracted an annualized 2.4 percent last quarter, a report showed this week, as higher prices deterred spending and a global slowdown caused a drop in exports. The central bank in April shelved a policy of raising rates, and with Japan on the verge of a recession, economists say borrowing costs will stay on hold until next year at least.

``The period the Bank of Japan has to adopt a wait-and-see stance is being prolonged further,'' said Yasunari Ueno, chief market economist at Mizuho Securities Co. in Tokyo. ``It's become difficult to raise rates even by the end of 2009.''

The decline in consumer spending in the three months ended June was the first since 2006, the gross domestic product report showed on Aug. 13. Exports fell the most since the 2001-2002 recession, robbing Japan of the engine that drove its longest postwar expansion.

`Weakening' Economy

The government last week described the economy as ``weakening,'' language it hadn't used since 2001. The Bank of Japan is likely to follow suit next week by downgrading its assessment for the second straight month, said Mari Iwashita, chief market economist at Daiwa Securities SMBC Co. in Tokyo.

``The central bank will probably use an expression like `stagnating' to describe the economy, after saying it was `slowing further' last month,'' said Iwashita, who this week pushed her forecast for a rate increase to the third quarter of 2009 at the earliest from the first quarter. ``There's no chance for a rate hike, at least until the economy starts to pick up.''

Inflation driven by higher energy and commodity costs is eroding households' purchasing power and companies' profits.

Consumer prices excluding fresh food climbed 1.9 percent in June from a year earlier, the fastest pace in a decade. Prices businesses pay for fuel and materials surged 7.1 percent in July, the most since the wake of the second oil crisis 27 years ago.

Still, economic growth trumps inflation as the bank's chief concern, and analysts expect price increases will ease later this year. Oil has declined $30 since climbing to a record $147 a barrel last month. Wages fell in June, indicating there's little risk of a salary-price spiral in Asia's biggest economy.

Inflation Contained

``There's no concern about the second-round effects of inflation in Japan,'' said Kazuhiko Sano, chief strategist at Nikko Citigroup Ltd. in Tokyo. ``The bank will put more weight on the risk of the economy's deterioration as time goes by.''

Consumer price gains will probably peak at 1.8 percent in the third quarter before slowing to 1.3 percent by the second three months of 2009, according to economists surveyed. The central bank considers prices to be stable within a range of zero to 2 percent.

At the same time, the central bank isn't about to reduce interest rates because any recession will be ``mild'' and Shirakawa is wary that keeping borrowing costs low may eventually stimulate the economy too much, said Tomoko Fujii.

``Despite the recession, the BOJ will probably be reluctant to cut rates in view of potentially adverse future side effects of too much monetary stimulus,'' said Fujii, head of economics and strategy at Bank of America N.A. in Tokyo. Japan ``should be able to enter a modest recovery phase in early 2009.''

Better Shape

Japan may be better equipped to recover from the current downturn than in the three recessions since 1990 because companies have shed excess workers, factories and debt, economists said.

``Given that there is not the same excess as in the past, I don't think it's going to be one of those extended deep recessions we've typically seen in Japan,'' said Glenn Maguire, chief Asia-Pacific economist at Societe Generale in Hong Kong.

The bank will probably announce the interest-rate decision, along with a statement explaining the reasons for its judgment, by early afternoon on Aug. 19. Shirakawa will speak at a press conference at 3:30 p.m.

To contact the reporter on this story: Mayumi Otsuma in Tokyo at motsuma@bloomberg.net