Investors are quickly shifting to factor in the risk that the Bank of Japan's next policy move may be to cut interest rates later this year as a US downturn could damage Japan enough to prompt a monetary policy response.
For investors, the threat of a US recession combined with a very tepid pace of Japanese growth is seen forcing the BOJ to consider changing a policy outlook that for almost two years has been centered on the long-term inflation threat of very low short-term rates.
Even as BOJ Governor Toshihiko Fukui and his deputy Toshiro Muto made clear on Thursday and Friday that the stance of gradually raising interest rates has not changed, market players are starting to believe the BOJ's hand will be forced.
Futures on the overnight call rate have swung sharply this week to show around a 20 per cent chance of a quarter-point rate cut.
At the start of this week, the futures reflected a 40 per cent chance of an increase in the rate, which stands at just 0.5 per cent.
Takehiro Sato, an economist at Morgan Stanley in Tokyo, said that while he is not forecasting a recession in Japan, the fact that the economy may nearly stall in the first half of 2008 warrants a shift in BOJ expectations.
"Under such circumstances, it is quite natural to see the market consensus shift from a rate hike to a rate cut," Sato said.
At one point on Friday the two-year yield on Japanese government bonds fell to 0.580 per cent -- a mere 8 basis points above the overnight rate target, suggesting any prospect of a rate increase had vanished.
But Sato, who is not yet forecasting a rate cut but sees the probability rising to 30-40 per cent, said a BOJ policy shift would depend on a new governor who is willing to shift away from the central bank's current framework.
That framework was designed by Fukui and his policy board after the BOJ scrapped its quantitative easing policy of flooding the banking system with cash in March 2006.
Ending quantitative easing laid the groundwork for the BOJ to raise rates from near zero, where they had been pinned almost continuously since 1995 to revive the economy from the collapse of the 1980s bubble in property and stock prices.
Fukui's term as governor expires in mid-March and he is expected to step aside, with Muto seen as the favoured successor.
Analysts believe Fukui wanted to see through a normalisation of Japan's monetary policy as the economy finally pulled out of its decade-long slump and bout of deflation.
But that process was derailed in August 2006 when benchmark revisions to consumer price data wiped away the return of inflation, and then again last year as the US subprime mortgage crisis mushroomed into a global credit crunch.
The BOJ first lifted rates to 0.25 per cent from zero in July 2006 and again to 0.5 per cent in February last year. Since then, the central bank has been on hold.
But the BOJ has stuck to its main scenario for normalising policy even with a lack of inflation -- that a self-reinforcing cycle of growth and rising incomes will eventually awaken price pressures.
Certainly the economic news out of Japan has been glum. Data on Friday showed bank lending slumped in December to its weakest in nearly two years, while the leading index of economic activity fell in November back near a decade-low hit two months earlier.
Worries the world's second-largest economy would follow the United States into recession have been slowly building, but they reached a climax on Thursday when investment bank Goldman Sachs said Japan was at a "danger level" of falling into a recession.
Yet other analysts said Japan's prospects are not so dire, and the fears about the US economy are clouding the fact that Japan's own slowdown may have already hit bottom last year.
Japanese growth rebounded in the third quarter from a contraction in the second quarter caused by a collapse in new construction. At that time a law was enacted to tighten building approvals after some builders were found to have skirted codes on earthquake safety. That slowed down building activity.
The surge in energy and commodity prices last year also hobbled small businesses, which employ the vast majority of Japanese workers.
"The pessimism about the Japanese economic outlook by some observers is overblown," said Kiichi Murashima, director of economic and market analysis at Nikko Citigroup.
One important bright spot for the economy is exports, which have posted steady growth because of robust demand from China, Asia and the Middle East.
Export growth has remained steady even as shipments to the United States started to fall towards the end of last year.
Murashima said he expects export growth of 5 percent this year compared with 8 per cent last year, helping underpin the economy so long as consumer spending does not retrench.
"As long as the upward trajectory in exports is maintained, the Japanese economy does not collapse or slow down," he said. (Reuters)
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