Bank of Japan may signal ready to join G7 action

By Leika Kihara

TOKYO, Oct 7 (Reuters) - The Bank of Japan may signal on Tuesday whether it sees a need for further major central bank action on the global financial crisis, and there is speculation it could even cut a secondary interest rate to spur bank lending.

Speculation that the Group of Seven rich nations would agree on a coordinated response, including rate cuts, to the financial turmoil reached fever pitch on Monday and helped Wall Street erase some of its biggest intraday losses on record. [ID:nCRISIS]

The BOJ finishes a two-day policy review on Tuesday and is expected to keep interest rates on hold at 0.5 percent, with core inflation at a decade high.

But there is speculation in the bond market that it could cut the rate at which it lends to commercial banks, in the face of the crisis that has shaken lenders from New York to Hong Kong.

Bank failures in the United States and Europe are shattering confidence in Japan's export markets, accelerating an economic slump that already bears the hallmarks of a recession.

The crisis that began with U.S. mortgage defaults last year is washing up on Asian shores, pushing South Korea to call for emergency talks with Tokyo and Beijing, and forcing a policy easing from India. [ID:nPEK39057]

Japanese stocks plunged 5 percent at one point on Tuesday, taking the benchmark Nikkei share average .N225 to a five-year low as a stronger yen and global fears hit. Yields on 10-year government bonds JP10YTN=JBTC hit a six-month low.

China and Taiwan have cut rates to cushion their economies from the slowdown, and overnight swap contracts are pricing in a 40 percent chance the BOJ will follow this year. JPONIBOJ=TRDT

"Japan's economy may worsen further in the near future due mainly to external factors such as weakening exports," said Takahide Kiuchi, chief economist at Nomura Securities.

"I don't think the BOJ will cut rates easily, but speculation of such a move could heighten towards the end of this year."

The BOJ is expected to announce its rate decision between noon and 2 p.m. (0300-0500 GMT) followed by a news conference by Governor Masaaki Shirakawa, whose embargoed remarks will be available sometime after 4:15 p.m. (0715 GMT).

LOMBARD ACTION?

Speculation has grown among some bond market players that the BOJ might cut the 0.75 percent Lombard rate, at which banks can borrow directly from the central bank, although analysts play down the chances of this.

Such a move could ease money market strains as the Lombard rate sets a ceiling for call rates and other interbank rates.

Shirakawa's comments will be scrutinised for signs of any willingness to cut rates.

If the domestic economy were the only consideration, the BOJ would probably leave rates as they are until it has room to raise them, analysts said, with Japanese inflation running around decade highs at 2.4 percent.

A rate cut will do nothing to support crumbling export markets and will reduce the BOJ's room for manoeuvre if serious economic trouble surfaces at home as rates are already near zero.

But the BOJ has been working with other central banks in the industrialised world to keep the financial system stable and prod banks to lend to each other to thaw frozen money markets, and it may be asked to join any co-ordinated rate cut.

The joint central bank injection of extra funds, including U.S. dollars, into money markets to try to ease the global credit crunch has so far been largely ineffective, and bets are growing that rate cuts may be needed to jump-start interbank lending.

"We don't see an early BOJ rate cut as the main scenario for the moment," said Izuru Kato, chief economist at Totan Research.

"But if the crisis deepens, the chance of a rate cut cannot be ruled out."

RATE CUTS EXPECTED IN US, EUROPE

Analysts expect the European Central Bank to cut its benchmark rate to 4 percent this year. [ID:nL2441098]

It left rates on hold at 4.25 percent last week but warned of further risks to the European economy from the credit crisis.

The worsening outlook has also boosted prospects of a rate cut by the U.S. Federal Reserve, perhaps in coordination with other global central banks.

U.S. rate futures suggest the Fed may cut rates by a further 0.5 percentage points to 1.5 percent ahead of its next scheduled meeting at the end of the month, though a top policymaker said on Monday rate cuts were not the answer. [ID:nN06265978] FEDWATCH

Japan's economy shrank more than initially estimated in the second quarter to log its worst performance in seven years as exports and capital spending, the main drivers of growth, were hit by the global slowdown. (Editing by Rodney Joyce)