Why the BOJ is convinced Japan rates must rise

By Leika Kihara - Analysis

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.