Why the BOJ is convinced Japan rates must rise

TOKYO (Reuters) - Global market turmoil, tame domestic inflation and soft economic data seem to offer all the ingredients for a central bank to hold off raising interest rates. But not for the Bank of Japan.

While rhetoric from other governors of major central banks has become cautious in the face of global market gyrations resulting from the U.S. subprime mortgage crisis, the Bank of Japan's Toshihiko Fukui has maintained that policy must tighten.

Market uncertainty was enough to keep rates on hold in August at just 0.5 percent, but Fukui quickly underlined his determination to push rates higher to avoid what he called painful market adjustments.

"Domestic economic conditions are in line with BOJ forecasts so once financial markets restore calm, the bank will go ahead and raise rates," said Hideo Kumano, chief economist at Dai-ichi Life Research Institute.

"The BOJ seems to be sticking to its stance of raising rates about once every half year," which means the next rate rise could come in October followed by another one early next year, he said.

Many economists expect rates to rise to 0.75 percent by the end of this year and to 1.0 percent before Fukui's term expires in March.

Swap contracts on the overnight call rate show investors see a 20 percent chance of a BOJ rate hike in September and a near 40 percent chance of a hike in October.

DETERMINED

So why is the Bank of Japan so determined to push interest rates higher?

One reason is the still-vivid memory of Japan's bubble economy of the late 1980s and early 1990s that led to a slump and nearly a decade of deflation. The BOJ has repeatedly said it needs to act pre-emptively at the first sign of an overheating economy.

Policy makers worry that keeping rates low for too long will exacerbate economic swings, even if politicians fret that raising rates will tip the economy back into recession -- just as the BOJ was accused of doing in 2000.

So far, the economy is showing more signs of slowing down than overheating.

Growth was an anemic 0.1 percent in April-June, with tame personal spending seen capping growth the following quarter. Weak capital spending figures on Monday raised expectations the April-June growth figures could be revised down next week.

Core consumer prices have fallen for six straight months, reflecting tame wage growth as Japan's baby-boom generation retire to be replaced by cheaper workers fresh from university.

But the Bank of Japan is trying to look ahead and some figures do point to inflation.

While core consumer prices have eased for some months, wholesale prices are on the rise and could feed into consumer prices. They were 2.1 percent higher in July than a year earlier.

Backing that scenario, some consumer food prices -- including mayonnaise, hamburgers and orange juice -- are creeping higher in a sign that companies are finally able to pass on higher costs to consumers.

The jobless rate is at a nine-year low of 3.6 percent, which could eventually generate more momentum for wage growth and consumption, economists say.

Asset prices are also creeping higher, particularly property prices in big cities. Land prices in Tokyo jumped 17 percent last year in the biggest increase by far since Japan's bubble years, government data on August 1 showed.

CARRY TRADE

Another factor is concern that the Bank of Japan's current rate -- the lowest among the Group of Seven major nations -- is fuelling global imbalances as investors borrow cheap yen to fund higher, risky yields.

The yen surged 11 percent against the dollar between mid June and mid August, partly as concerns about a global credit squeeze prompted investors to reverse these so-called carry trades.

"We cannot say our country's low interest rate policy had nothing to do with subprime problems and the resulting sharp swings of the yen," Atsushi Mizuno, a BOJ hawk, told business leaders in central Japan last Thursday.

"The underlying financial market turmoil was evidence that maintaining interest rates at levels deviating from fundamentals could destabilize financial markets," said Mizuno, the sole BOJ board member to vote for a rate rise in July and August.

He is yet to convince the rest of the BOJ's nine-member board that interest rates should be brought closer to neutral levels, which neither stimulate nor curtail growth, which analysts see as around 1.5 percent to 2.0 percent.

"The BOJ has repeatedly said that if deflation seems out of sight, it needs to raise rates from abnormally low levels," said Yasuhiro Onakado, chief economist at Daiwa SB Investments.

"Unless there is severe damage to the economy, it's hard to justify changing this explanation. Holding off a rate hike too long could even put the bank's credibility under question."