Japan Trims Short-Term Interest Rates

Japan’s central bank late Wednesday unexpectedly cut its short-term interest rates, which are already at rock bottom, in an attempt to stabilize the nation’s fragile financial system and halt the rapid slide of the world’s second-largest economy.

The Bank of Japan, in a statement released Wednesday night, said it took the action “to prevent the economy from falling into a deflationary spiral,” which some analysts read as an extraordinary admission of the danger faced by the Japanese economy.

Japan’s economy is in recession, stalled by falling consumer demand, business investment and prices. The economy is deteriorating rapidly, experts say, because the ailing Japanese banking system is unable to lend fresh capital to businesses. Financial analysts said the cut in interest rates will do little to reignite the economy because interest rates are so low and are not the cause of the credit crunch.

The bank reduced its target rate for overnight loans between banks to 0.25%, from slightly under 0.5%. By comparison, the U.S. federal funds rate is 5.5%.

At a news conference, Bank of Japan Governor Masaru Hayami said the rate cut was needed because of rising concerns about Japan’s financial system and economy.

“Economic activity has already sunk to considerably lower levels, and the recent financial market moves and increasing corporate failures threaten to worsen corporate and household confidence further,” the bank said in its statement.

The timing of the cut surprised analysts here. “This is not anything anybody was expecting,” said Robert Alan Feldman, a Tokyo-based economist with Morgan Stanley Dean Witter.

Interest rates are at historic lows, but that has not eased a credit crunch caused by the fact that banks have made hundreds of billions of dollars worth of loans that are not being repaid. Because banks are not generating profits, they are running out of cash to lend.

Furthermore, the bank’s cut in its overnight lending rate will not reduce corporate borrowing rates immediately, said Yasuhiko Shikubo, an economist with Industrial Bank of Japan. “It’s possible banks might lower lending rates for corporations. But even if corporations are able to pay slightly less interest, I don’t think that will really stimulate corporate capital investment,” he said. Corporations have cut back on investment because of falling prices and profits, not high interest rates.

Yasunari Ueno, chief economist at Fuji Securities, speculated that the central bank action “was largely intended as a psychological boost.”

Other analysts said the move appeared mainly aimed at helping the wobbly banking sector. But Brian Waterhouse, a banking analyst with HSBC Securities, said the cut would only reduce bank borrowing costs by a little.

Japan’s economy slipped into recession earlier this year and remains burdened by a fragile banking system, prompting the central bank’s policy to consider emergency policy steps to cope with possible downside risks.

Economists said the move reflected Bank of Japan fears that the nation’s feuding politicians would not be able to move ahead quickly with a vital banking sector cleanup, along with the judgment that stimulus steps already in the pipeline would have little effect on the flagging economy.

“Until now they said they would wait for the impact of the economic stimulus to come through, but clearly that has disappeared into the wind,” said Susumu Kato, chief economist of Barclays Capital.

“As seen in the U.S.-Japan finance ministers’ meeting [last week], they are under pressure to speed up their cleanup of the financial sector, and given the political situation, this was the only step they could take,” Kato said.

U.S. Treasury Secretary Robert Rubin urged Finance Minister Kiichi Miyazawa at a meeting in San Francisco to take fast and aggressive steps to stimulate Japan’s economy and fix its banking sector.

On Wednesday, the ruling Liberal Democratic Party offered the opposition a compromise proposal on key banking bills in an effort to break a logjam on steps to clear the nation’s mountains of bad loans.

A top member of the main opposition Democratic Party told reporters there were some praiseworthy elements in the LDP proposal but added that the two sides are still far apart.