Since it ended its zero-interest-rate policy in July 2006, the Bank of Japan has sought to normalize interest rates up to a level that matches the nation’s economic recovery. Recent increases in land prices also have given the BOJ cause to think that an interest-rate rise is necessary. But the central bank decided last week by an 8-1 vote to keep its key short-term interest rate steady at 0.5 percent in view of a possible worldwide credit crunch related to the brewing financial crisis caused by defaults in U.S. markets for high-risk, high-return subprime mortgages.

Because the BOJ must coordinate policy with the central banks of the United States and Europe to avert global credit contraction, its scenario for a higher interest rate has hit a snag, at least for the time being. The BOJ, for the first time in about six years, had raised the benchmark rate to 0.25 percent in July 2006 then doubled it to 0.5 percent in February 2007.

After the BOJ Policy Board’s decision Aug. 23, Gov. Toshihiko Fukui said the Japanese economic recovery has been solid and that the U.S. subprime mortgage crisis’s negative impact on the Japanese financial sector will be limited because its exposure to subprime-related securities is relatively small.

But it is impossible to rule out the effects the subprime mortgage crisis could have on the Japanese economy. To avert risks amid the market turmoil, investors have substantially unwound yen-carry trade (in which investors borrow yen at low interest rates, then convert it into dollars and other currencies to invest in higher-return assets abroad) and bought back the yen. While stock prices in Tokyo steeply fell, the yen appreciated rapidly. The strong yen will affect Japanese companies for which exports are the driving force of their performance.

The sluggish housing investment and the fall in stock prices may also apply downward pressures on the U.S. economy. Both in the U.S. and Japan, prolonged sluggishness in the stock markets can depress consumer spending. The current situation requires that the BOJ keep careful watch on both the financial markets and the real economy.

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