Bank of Japan Holds Rates; Cautious on Crisis, Economy

The Bank of Japan played up the risk of global market turmoil and grew more cautious about economic recovery at home as it left interest rates on hold on Tuesday as markets had expected.

Markets will scrutinize Governor Masaaki Shirakawa's news conference later in the day for anything that will look like a response to the U.S. call for a coordinated global response to the financial crisis that is threatening banks around the world.

The BOJ maintained its overall assessment, saying the world's second largest economy was "sluggish". But it changed the wording of the statement to say the economy would remain sluggish as "the slowdown in overseas economies become more evident."

"As for risk factors, strains in global financial markets have intensified in the wake of failures and rescues of U.S. and European financial institutions," the BOJ said after announcing that rates would stay at 0.5 percent.

It added the phrase "in the longer run" to describe the likelihood of Japan's economy returning to sustainable growth with price stability, suggesting that it is becoming more cautious about the timing of Japan's economic recovery.

"With the change in rhetoric, the BOJ apparently emphasized the stronger risk of a prolonged recession in Japan as the financial market turmoil is now posing greater downside risks for overseas economies and exports from Japan," said Susumu Kato, chief economist at Calyon Securities.

"Given growing downside risks at home and abroad, we cannot rule out the possibility of monetary policy action by the Bank of Japan, especially in a scenario where U.S. and European monetary authorities have to lower interest rates."

Speculation that the Group of Seven rich nations would agree on a coordinated response, including rate cuts, to the financial turmoil reached fever pitch on Monday and helped Wall Street erase some of its biggest intraday losses on record.

Bank failures in the United States and Europe are shattering confidence in Japan's export markets, accelerating an economic slump that already bears the hallmarks of a recession.

Japan's economy shrank more than initially estimated in the second quarter to log its worst performance in seven years as exports and capital spending, the main drivers of growth, were hit by the global slowdown.

In the face of the crisis that has shaken lenders from New York to Hong Kong, there had been speculation the BOJ could cut a secondary interest rate to spur bank lending. But the BOJ did not move the rate on Tuesday, either.

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Just before the BOJ's rate decision, Australia's central bank stunned investors with its biggest interest rate cut in 16 years, a dramatic attempt to insulate banks, households and firms from a meltdown in global financial markets.

Overnight swap contracts are pricing a one-third chance of a BOJ rate cut by the end of the year.

Japanese stocks plunged 5 percent at one point on Tuesday, taking the benchmark Nikkei 225 Average to a five-year low as a stronger yen and global fears hit. Yields on 10-year government bonds hit a six-month low.

Copyright 2008 Reuters. Click for restrictions.