BOJ Says Economy `Sluggish,' Holds Key Rate at 0.5%

By Mayumi Otsuma

Oct. 7 (Bloomberg) -- The Bank of Japan acknowledged that a recovery in the world's second-largest economy may be delayed, saying there are ``substantial uncertainties'' about the outlook.

``Economic growth has been sluggish and these conditions may persist for some time given that the slowdown in overseas economies is becoming clearer,'' the bank said today after leaving the benchmark rate at 0.5 percent in a unanimous vote. It said the economy will pick up ``in the longer run.''

The Nikkei 225 Stock Average dipped below 10,000 for the first time since December 2003 today on concern the seizure in credit markets will deepen a slowdown in the country's export markets. Morgan Stanley cut its growth forecast for Japan today, saying the economy will shrink in the year ending March 31 as companies cut investment and global credit dries up.

``The pressure for a rate cut is increasing,'' said Hideo Kumano, chief economist at Dai-Ichi Life Research Institute in Tokyo and a former central bank official. ``The Bank of Japan is admitting the recovery will be delayed, given the weakening economy and tumbling markets.''

Banks around the world are hoarding funds, crippling money markets in the U.S. and Europe as the crisis that brought down Lehman Brothers Holdings Inc. spreads. The turmoil has wiped $21 trillion from world stock markets in the past year and prompted investors to sell higher-yielding assets and buy yen.

`Longer Run'

``Although there are substantial uncertainties, the economy, in the longer run, is expected to return gradually onto a moderate growth path'' as energy costs ease and markets abroad pick up, the central bank said. The words ``in the longer run'' were absent from last month's statement.

Japan's currency is trading near a three-year high against the euro and the strongest in five months versus the dollar, and that may hurt exporters, Economic and Fiscal Policy Minister Kaoru Yosano said today.

The yen weakened to 102.61 per dollar at 2:08 p.m. in Tokyo from 102.67 shortly before the announcement. The Nikkei fell 2.8 percent to 10,178.51 after earlier reaching as low as 9,916.21.

The Reserve Bank of Australia slashed its benchmark rate by one percentage point to 6 percent today, the biggest reduction since 1992.

Bank of Japan policy makers will release projections for gross domestic product and inflation on Oct. 31. The central bank in July lowered its forecast to 1.2 percent for the year ending March 31 and 1.5 percent for the following year.

Lower Growth

``The Bank of Japan will probably lower growth projections not only for the current fiscal year but also for the following year,'' said Takehiro Sato, chief Japan economist at Morgan Stanley in Tokyo. ``With overseas economies facing liquidity issues, we anticipate a wave of freezes or reductions in capital spending plans, which is likely to affect domestic consumption.''

Deepening market turmoil in recent days has increased investors' expectations for a rate cut. Investors see a 31 percent chance the Bank of Japan will lower borrowing costs by December, according to calculations by JPMorgan Chase & Co. using overnight interest-rate swaps. The odds of a reduction by March are 50 percent.

``We expect the BOJ to ease monetary policy by 25 basis points as early as October-December in response to growing downside economic risk and tightening financial conditions resulting from yen appreciation and the stock-market decline,'' said Tetsufumi Yamakawa, chief Japan economist at Goldman Sachs Group Inc., who also cut his growth forecast for Japan today.

Little Support

Izuru Kato, chief market economist at Totan Research Co. in Tokyo, said a rate cut would provide little support for the economy, though it can't be ruled out ``if global financial turbulence exacerbates.''

Other analysts say a reduction won't be an easy option for a central bank that says Japan's monetary conditions are already ``accommodative.'' Should ``downside risks'' decrease, the bank must consider the risk that keeping rates low for too long may overstimulate the economy, today's statement said.

``Given that BOJ board members consider current interest rates sufficiently accommodative, they wouldn't casually choose to cut rates,'' said Jun Ishii, chief fixed-income strategist at Mitsubishi UFJ Securities Co. in Tokyo.

Economy Minister Yosano said last week cutting the key rate ``wouldn't be effective'' because it is already low.

Policy makers also said global inflation remains high and price expectations at home need to be watched closely.

Rate Cut

All 31 economists surveyed by Bloomberg News expected the benchmark overnight rate to stay at 0.5 percent today. Of 25 economists who gave predictions through June, two said the bank will cut rates and the rest expect no change. Governor Masaaki Shirakawa will speak at a press conference at 3:30 p.m.

Recent data suggest Japan's companies may face the revival of three excesses of inventory, capacity and labor that weighed on growth since an asset bubble burst in the 1990s. Shirakawa said last month the absence of these problems will shelter the economy from a significant slowdown.

Industrial output fell at the fastest pace in at least five years in August as shipments declined, pushing the inventory- shipment ratio to the highest level since March 2002. The central bank's quarterly Tankan survey released last week showed fewer companies had labor shortages and large manufacturers said they had excess capacity for the first time since 2005.

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