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From Cautious to Bold, Can the Bank of Japan Deliver?

Tuesday, 22 Jan 2013 | 2:36 AM ET
Bank of Japan headquarters in Tokyo, Japan.
Tomohiro Ohsumi | Bloomberg | Getty Images
Bank of Japan headquarters in Tokyo, Japan.

The Bank of Japan (BOJ) entered a new era on Tuesday, unveiling an aggressive monetary policy aimed at pushing Japan's economy out of a slump. But the question is whether the central bank, with a reputation of being cautious, can now deliver?

The BOJ doubled its inflation target to 2 percent and made an open-ended commitment to asset purchases from next year, surprising financial markets that had anticipated an incremental rise in the BOJ's $1.1 trillion asset-buying and lending program.

Until Tuesday, the central bank had pledged to pump $1.1 trillion into markets via its asset-buying and lending program by the end of this year, but had made no commitment on whether to maintain the balance beyond 2014.

(Read More: Is the 'Abe Trade' in Danger of Unwinding?)

The latest announcement, made at the end of a two-day policy meeting, follows intense pressure on the central bank by Japan's new government to take bolder action to push the economy out of recession.

"There have been many times in the past that the BOJ has sought to untangle Japan from deflation and it has failed to do so, so this time around we are looking to see what is different," said Mizuho Corporate Bank's market economist Vishnu Varathan.

In a sign of some uncertainty among investors about the impact of the BOJ's latest measures, Japanese markets were volatile following the announcement, with the benchmark Nikkei stock index down giving up initial gains and moving into negative territory.

"There is some uncertainty about the effectiveness (of the policy measures) and we are in unchartered territory," said Tim Condon, head of research, Asia, ING Financial Markets,. "It takes time for markets to get their head around a new policy framework."

Indeed, a degree of caution was justified given the BOJ's reputation of responding slowly, analysts said. The open-ended program will not start until next year and central bankers were divided on the new 2 percent inflation target, with two of the central bank's nine policymakers voting against the move.

"If they (the BOJ) succeed it is in the realm of a real game changer for Japan," Andrew Pease, global head of investment strategy at Russell Investments in Sydney told CNBC's "Capital Connection." "But having watched the Japanese economy for the past 15 years, you have to have a degree of skepticism about the degree of follow through there will be from this type of policy action."

Japan's economy, the world's third largest, has contracted for two quarters in a row, pushed into a recession by weak global demand for its exports. Deflation meanwhile has dogged the economy for 20 years and the central bank has in the past shown reluctance to aggressively ramp up asset purchases in the way the U.S. Federal Reserve has done to kick start economic growth.

It May Be Different This Time

For ING's Condon, the big difference in Tuesday's BOJ announcement was the commitment to open-ended asset purchases.

"They have their work cut out in the sense that BOJ has had go-stop policies for many years, which has eroded their credibility and their ability to deliver more inflation," he said. "This policy is different, I think it will have the desired effect because it is open-ended and they intend to keep that until they achieve their target."

Kevin Gibson, CIO, Japanese equities at Eastspring Investments offered another reason to be hopeful.

"Why would it work now when it hasn't worked in the past? Ultimately the credit cycle is in a very different place now than it was before, i.e. banks are in the position to lend….I think they weren't in a position to do so because they ultimately didn't have the balance sheets to support them," he told CNBC.

Buy Stocks, Sell Yen?

Japan's yen has weakened 13 percent over the past three months, while the Nikkei stock index has surged about 25 percent on hopes for bold action by the central bank.

Analysts told CNBC that they continued to favor bets that the yen would weaken and Japanese equities would strengthen in the wake of the BOJ policy measures.

"The moves announced today are substantial, although the market was already pricing in a substantial good news flow," Rob Aspin, head of equity investment strategy, Standard Chartered Bank said. "We are positive on the market in Japan. The key thing here is that we continue to be short the yen and long the underlying equity market."

Mizuho's Varathan said he looked for further gains in the Nikkei over the next three-to-six months, with recent stimulus measures announced by the government likely to lend some support.

Earlier this month, Japan unveiled a $117 billion economic stimulus package to revive the economy.

(Read More: Japan Unveils Stimulus – Don't Get Too Excited Yet)

The mere fact that Japan was now acting to reflate its economy meant that the sell yen, buy Japanese equities trade that has dominated markets in recent weeks remained intact, said ING's Condon.

"In my judgment, and theory tells us also, reflation trades perform and in Japan that means dollar/yen moving higher and stocks moving higher too," he said. "Our forecast is dollar/yen at 95 by year-end and that number could be an underestimate."

The yen stood at 89.20 per dollar in late Asia trade on Tuesday, while the Nikkei stood at 10,711.

(Read More: Further Yen Weakness Unlikely: Japan's 'Mr Yen')