Bank of Japan prepares to raise interest rates after five years at near-zero

Japan's central bank yesterday paved the way for an interest-rate rise after having kept rates in effect at zero for nearly five years. The Bank of Japan decided to end its ultra-loose monetary policy amid growing confidence that the country was winning the battle against deflation.

Investors welcomed the decision after days of uncertainty over whether the Bank of Japan would defy pressure from cautious government officials to keep the policy in place for at least another month, amid fears that a premature rise in interest rates would stifle economic recovery.

Yesterday the Nikkei 225 index gained 409.42 points or 2.6% to close at 16,036.91 as investors took heart from the bank's confidence.

Toshihiko Fukui, the head of the central bank, said that the transition to a more conventional interest rate regime would be slow. "Interest rates will stay at zero for some time, then stay extremely low and go through an adjustment period," Mr Fukui said at the end of the bank's two-day policy board meeting. "It's up to the economy how much and when."

The bank has been pumping trillions of yen in surplus funds into commercial bank accounts since March 2001, when it lowered interest rates to 0.1%, in a policy known as quantitative easing. It acted after consumer prices fell for two successive years and threatened to throw an already shaky economy into greater turmoil.

The bank will now gradually reduce the amount of cash it feeds into the banking system from the current 30 trillion yen (£147bn) to a legally required reserve level of 6 trillion yen over the next three to six months.

"If inflationary pressures are subdued, it's possible that we may continue with an accommodative policy," Mr Fukui said.

The bank had said any decision on interest rates would depend on a sustained rise in consumer prices. In January the core consumer price index rose 0.5% from a year earlier, the biggest jump in eight years. It followed rises of 0.1% the previous two months.

Combined with economic growth of 5.5% in the fourth quarter, the increase in prices made it difficult to resist tightening monetary policy.

In the run-up to the meeting, senior politicians had warned the bank, which is nominally independent, against acting prematurely, fearing that an eventual rise in interest rates could increase government borrowing costs and frustrate attempts to rein in Japan's public debt, which stands at 150% of the country's gross domestic product.

Mr Fukui denied that the bank had acted against the government's wishes. "We have absolutely no feeling that we acted against political opposition," he said. "We were in agreement."

Junichiro Koizumi, the prime minister, who this week warned the bank against ending quantitative easing too soon, said he respected yesterday's decision. But with an eye on possible rate rises, he added: "I hope the Bank of Japan will cooperate with the government to let the economy emerge from deflation and take a normal monetary policy in that direction."

The government's top spokesman, Shinzo Abe, attempted to play down the significance of the move."I understand the so-called zero interest rate policy will continue for the time being," he said.

But Heizo Takenaka, the internal affairs minister and a former economy minister, criticised the bank for acting too soon. "It used its authority to make the decision even though deflation remains a problem," Mr Takenaka, a key figure behind Japan's fiscal reforms, told reporters last night. "I hope the bank is prepared to take responsibility for its actions."

Financial analysts said that any significant rise in interest rates would depend on further increases in consumer prices in the coming months.