Buoyant Japan to raise rates

The bank of Japan is poised to increase interest rates on Friday for the first time in six years, finally drawing a line under the 'lost decade' of deflation and recession in the world's second-largest economy.

Tokyo has effectively been handing out free money since 2000, with its key overnight interest rate firmly set to zero to fight a vicious cycle of falling prices and wages. But with confidence - and prices - rising, and the economy expected to grow at 3 per cent this year, BoJ governor Toshihiko Fukui wants to move interest rates towards more normal levels.

'It will send a strong signal that the recovery is now here to stay,' said Robert Ward of the Economist Intelligence Unit. 'There's a sense of an opening of the purse-strings: corporate restructuring has finished; the economy looks better; people are feeling more confident.'

Analysts said a strong reading in the regular Tankan business survey last week set the seal on a rise in borrowing costs. 'It's the right thing to do,' said Kevin Grice of American Express. 'The recovery has been going for a significant period of time, and it's very broad-based.'

He predicted a quarter-point rate rise this week, followed by another quarter every three months for at least the next year. 'Neutral rates in Japan would be 2-4 per cent, so they've got a long way to go.' Unlike the UK, where homeowners carrying a heavy debt burden tend to tighten their belts when rates go up, higher borrowing costs can actually stimulate spending in Japan, where many consumers are sitting on a large pile of savings.

However, politicians who remember the downturn that followed the BoJ's last decision to raise rates, in August 2000, have warned Fukui not to rush into a decision. Just five months after that last rate rise, the BoJ had not only reversed it, but been forced to introduce a more radical policy of 'quantitative easing' to pump extra cash into the economy, which it abandoned only in March this year. 'They will definitely not want to repeat the fiasco of 2000,' said Ward.

Finance minister Sadakazu Tanigaki said this weekend that the BoJ should take into account the damage to market confidence from last week's controversial missile tests by Japan's neighbour, North Korea, before pushing up rates. 'The BoJ needs to examine what impact the missile launches had on the market and what impact they will have in the future when deciding policy,' he said.

Tokyo's avowed intention to start tightening the monetary screws was one reason for the wave of market turbulence that wiped billions of pounds off equity prices across the world in May and June. Foreign investors had been borrowing for free in Japan, and pouring the cash into high-yielding assets in developing markets - the so-called 'yen carry-trade'. Emerging market assets plunged last month as investors hurriedly unwound these bets in the expectation of higher borrowing costs.

Although next week's move has been well signposted by Fukui and his colleagues, analysts fear positive interest rates could cause another market wobble. Graham Turner, of GFC Economics, warned that if the markets react badly to this week's decision, the BoJ may have to put its foot back on the brakes. 'The BoJ has to listen to what asset prices are telling it,' he said.

Fukui's position has been undermined in recent weeks by revelations that he had invested around £50,000 of his own cash in a fund run by a man now being investigated for insider trading. However, Prime Minister Junichiro Koizumi has expressed his confidence in the governor, who is now expected to stay on.