Bank of Japan May Be Heading Back to `Zero Interest-Rate World'

By Jason Clenfield

Nov. 1 (Bloomberg) -- The Bank of Japan's interest rates may be headed back to zero.

Governor Masaaki Shirakawa and his board yesterday cut the key overnight lending rate by 20 basis points to 0.3 percent, abandoning a two-year struggle to raise the lowest borrowing costs among major economies. Three of the eight members argued for a deeper cut of 25 basis points and one wanted no change.

``We are headed back to a zero interest-rate world,'' said Tomoko Fujii, head of economics and strategy at Bank of America Corp. in Tokyo.

Should interest rates return to zero, the Bank of Japan may not be alone. Federal Reserve Bank of San Francisco President Janet Yellen said this week that the U.S. central bank may cut the benchmark rate close to zero from the current 1 percent level if the economy remains weak.

Shirakawa, 59, cast the deciding vote yesterday after the board was evenly split for the first time since the central bank gained its independence from the government 10 years ago.

The Bank of Japan will do its utmost to get the economy growing again ``through maintaining accommodative financial conditions,'' it said in a statement accompanying the reduction.

Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group in Tokyo, said this language suggests the bank will keep rates low until the global economy picks up. He's not related to the central bank governor.

``It'll be very difficult for the Bank of Japan to avoid reintroducing the zero-rate policy,'' said Credit Suisse's Shirakawa, who used to work at the central bank. ``The question is only when.''

Back to Deflation

The bank's twice-yearly outlook issued yesterday may partly explain the reason for the reduction in lending rates.

Inflation may fall back to zero percent next fiscal year, the bank predicted. It also slashed its growth forecast for the year ending March to 0.1 percent from 1.2 percent in July.

``The BOJ thinks we're going to go back into deflation,'' said Richard Jerram, chief economist at Macquarie Securities Ltd. in Tokyo. ``You shouldn't have been raising rates until you were confident that you weren't going to go back into deflation.''

A zero-rate policy prevailed in Japan for five years until July 2006 as the bank tried to end the deflation that followed the bursting of the bubble economy in the early 1990s.

From March 2001 until March 2006, the bank combined zero rates with a so-called quantitative-easing policy of increasing money in the accounts held by commercial banks. That measure isn't likely to be repeated.

Quantitative Easing

Shirakawa said in a May interview that he'd be reluctant to return to the policy which ``had limited impact'' in resolving the problem of stagnant economic growth. ``There have been a variety of evaluations, but I personally consider it so.''

If the economy deteriorates and the central bank needs to provide extra funds, it may consider alternative means to those used under quantitative easing, said Takehiro Sato, chief Japan economist at Morgan Stanley in Tokyo.

The bank may need to expand the range of collateral it accepts from lenders in exchange for loans, step up government bond purchases from banks from the current 1.2 trillion yen ($12 billion) a month, and purchase commercial paper and corporate debt to improve companies' access to cash, Sato said.

Shirakawa said yesterday that the central bank is considering measures to help commercial banks reduce share holdings, including resuming buying stocks.

The Bank of Japan bought about 2 trillion yen in shares held by banks between 2002 and 2004 to protect lenders' capital from being depleted by slumping stock prices. The central bank started selling its stake two years ago, though it halted the sales this month as the stock market tumbled.

May Be Reluctant

The bank may be reluctant to go back to zero rates, warning in its policy outlook yesterday that ``from a longer-term perspective,'' keeping borrowing costs low for too long ``may lead to larger swings in economic and financial activity as well as in prices.''

Still, the global financial crisis will ``weigh on economic activity for some time to come,'' the bank said.

``This is an understatement -- the world economy is heading for the biggest recession since World War II,'' said Julian Jessop, chief international economist at Capital Economics in London. ``We expect the bank to cut rates all the way to zero percent again, most likely in January, and keep them there until 2010.''

To contact the reporter on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net.