Bank of Japan ends zero rate policy

Bank of Japan Governor Toshihiko Fukui is due to give a news conference later. Picture / Reuters

TOKYO - The Bank of Japan raised interest rates for the first time in six years on Friday, lifting its key overnight rate by a quarter point from zero as it affirmed the end of a long era of deflation and stagnation.

The BOJ joined central banks in the United States and Europe that have already embarked on a credit-tightening cycle, although Japan's new rate remains minuscule and further increases are expected to be slow.

"Japan's economy continues to expand moderately, with domestic and external demand and also the corporate and household sectors well in balance," the BOJ said in a statement.

In such an environment, keeping rates at zero could have resulted in "large swings in economic activity and prices in the future," the central bank said.

It added, however, that "an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time."

BOJ board members voted unanimously for the rate rise.

Financial markets had expected the hike, though foreign exchange and bond traders were betting that cautiousness by the BOJ would keep the rate gap between Japan and other big countries wide for some time yet.

The yen slipped following the announcement after dropping to a two-week low earlier on Friday. The BOJ earlier supplied extra funds to the money market as overnight call money rates jumped in anticipation of a rate rise.

The Nikkei 225 stock average was steady after the decision. It had dropped by about 1 per cent ahead of the announcement as worries resurfaced about the impact of high oil prices on demand - another factor that could deter the BOJ from raising rates aggressively.

While risks such as financial market volatility and a slowdown in the U.S. economy remain, BOJ officials appear confident that Japan's economy is headed for a long recovery.

The economy grew at an annualised rate of 3.1 per cent in the January-March quarter, the fifth straight quarter of expansion.

Consumer prices have been rising for seven months, after more than seven years of deflation that had been blamed for crimping consumer spending and corporate investment.

The finance ministry is concerned that higher interest rates will raise the costs of funding the massive state debt, which is expected to rise to ¥775 trillion ($10.8 trillion) by next March, or some 150 per cent of gross domestic product.

Government officials also want to avert the nightmare of the BOJ's last rate rise in August 2000. That increase, also to 0.25 per cent from zero, coincided with the bursting of the dot-com bubble and was followed by an economic slump.

But with the BOJ seen committed to keeping future rate hikes slow, the government appears not to have exercised its right to ask the independent board to delay its decision - something it did when the BOJ proposed its ill-fated rate hike in 2000.

The BOJ paved the way for a rate rise in March when it scrapped its five-year-old "quantitative easing" policy of flooding the banking system with excess funds, reverting to a conventional policy of controlling short-term interest rates.

An overnight call rate of 0.25 per cent still pales in comparison with key rates in other big economies.

The U.S. Federal Reserve has raised rates 17 straight times since mid-2004 to 5.25 per cent, although it has signalled it may pause, while the European Central Bank has raised rates three times since December to 2.75 per cent and is expected to keep tightening policy.

- REUTERS