Bank of Japan Raises Key Rate for the First Time in Six Years

The days of interest-free money in Japan are over.

Defying warnings from some politicians and economists, Japan’s central bank Friday raised a key short-term interest rate for the first time in six years, to 0.25% from virtually zero. The historic policy shift reflects Japan’s emergence from a long slump in which extraordinarily low rates were used to prop up a stagnant economy and troubled banking system.

The expected move by the Bank of Japan holds implications not only for the world’s second-largest economy but also for global markets.

The immediate effect is likely to be small -- affecting primarily speculative investors such as hedge funds that enjoyed access to cheap loans. But rising interest rates could spur Japanese banks to change their investment practices, including cutting back on purchases of U.S. Treasury bonds, thus influencing America’s interest rates as well, said Hiromichi Shirakawa, a former staffer at the Bank of Japan and now chief economist at Credit Suisse Securities in Tokyo.

“As financing costs increase, banks will be forced to change their behavior,” he said.

Some analysts and government leaders had argued that it was too early to end the zero-interest-rate policy. They worry about a possible repeat of a mistake made in 2000, when interest rates were last raised and the economy shriveled amid declining prices and massive job losses.

But many others praised the central bank’s action as an independent and prudent step given the changes in Japan’s financial picture. In recent months, the Japanese economy has been growing at a healthy pace, unemployment has fallen and business confidence has risen. Prices also have begun to tick higher, boosted by rising energy costs.

“BOJ’s action was very good,” said Kenji Yumoto, chief economist at the Japan Research Institute in Tokyo. He predicted that the central bank would nudge up the overnight bank-to-bank lending rate again in November.

Toshihiko Fukui, the Bank of Japan’s governor, took pains to reassure people that the central bank would be cautious about any future rate hikes. Fukui, who has been under duress from a scandal involving his personal investments, said the bank had no intention of following the kind of rate-hike campaign of the U.S. Federal Reserve, which has raised rates 17 straight times in the last two years to 5.25%.

The Bank of Japan doesn’t want to dampen the nascent recovery, but like central banks around the world, it also must guard against inflation and an overflow of money that could lead to asset bubbles. Policymakers failed to see such a trend in Japan in the late 1980s, triggering a cycle of economic malaise.

Nobuo Yamaguchi, chairman of Japan’s Chamber of Commerce and Industry, on Friday urged policymakers to exercise care, saying the economic recovery had not yet reached many smaller businesses and citing widening risks of high oil prices.

Prime Minister Junichiro Koizumi reiterated Friday that he did not think Japan had emerged from its ordeal with deflation, and other analysts pointed out that Japanese consumer confidence remained weak.

Tim Condon, chief Asia economist in Singapore for financial firm ING, said he believed that the Bank of Japan was sensitive to these issues and would act accordingly. “They’ve had some pretty powerful learning experiences,” he said.