Bank of Japan acts to end its era of zero interest rates

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Japan raised interest rates for the first time in almost six years yesterday, ending its era of zero rates and delivering final confirmation that the world's second largest economy had ended a decade of stagnation.

The decision by the Bank of Japan (BoJ) to raise its lending rate to 0.25 per cent means the country has joined the United States and the eurozone in a synchronised global tightening of monetary policy. The Tokyo stock market fell almost 1.7 per cent, although analysts said this was a reaction to record oil prices rather than the rate rise, which had been well signalled.

The BoJ said it had taken its action against a background of "steady improvements" in economic activity but hinted it was not the first of many increases. "The Bank will adjust the level of the policy interest rate gradually in the light of developments in economic activity and prices if they follow the projection presented in the outlook report," its statement said.

"In this process, an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time."

Analysts said the BoJ would continue to raise borrowing costs gradually as the economy expanded, although with inflation forecast to run at 1 per cent, real rates looked set to remain negative - stimulating the economy - for some time to come.

Stephen Kirchner, at Action Economics, said: "We see scope for follow-up tightenings in the fourth quarter of 2006 and the first quarter of 2007, but this will still leave Japan's real official interest rate in negative territory well into 2007."

But Julian Jessop, chief international economist at Capital Economics, said the markets were too complacent about the risk of steeper rate rises. "The chances that rates ultimately rise to 3 per cent or so, which no one seems to expect, are much higher than the chances it lifts rates just one or two more times and then goes back on hold as many still suggest," he said.

At a news conference, Governor Toshihiko Fukui repeated that he intended to stay in his job despite a public outcry over his links to an equity fund whose manager has been indicted for insider trading. "I have caused a fuss and made some people worried," he said, but added that he wanted to keep fulfilling his responsibilities.

Japan is now enjoying its second-longest period of growth in the post-war period. The economy grew at an annualised rate of 3.1 per cent in the first quarter.

Yesterday's rate rise was the end of a prolonged bout of shadow boxing between government ministers, who believed a rate rise would dent the recovery, and the BoJ, which wanted to raise rates to demonstrate its independence and show it was able to take pre-emptive action. But in recent weeks the government has been split. Sadakazu Tanigaki, the finance minister, and Shinzo Abe, the chief cabinet secretary, had urged the BoJ to stick to the zero interest rates right up to this week. But Kaoru Yosano, the economics minister, defended the bank's right to decide the timing of policy moves.

Stephen Lewis, chief economist at Insinger de Beaufort: "There can be no surprise the BoJ chose to pay little attention to this tangled web of political motivations when it decided to put an end to zero rates."

The Prime Minister, Junichiro Koizumi, who must step down in September, said the nation's economy had not yet emerged from deflation but that such a situation was close.