Bank of Japan Governor Toshihiko Fukui said on Friday the pace of growth was slowing, as markets started pondering the risk of a Japanese rate cut.
The downbeat outlook for the Japanese economy came after comments from Federal Reserve Chairman Ben Bernanke reinforced expectations for aggressive U.S. rate cuts and as some analysts have said Japan is at risk of following the United States into a recession.
Bernanke's comments prompted market watchers to predict a big U.S. rate cut this month, and even in Japan, where BOJ rates are at a very low 0.5 percent, markets are now pricing in a small chance of a rate cut.
Adding to the bleak view, data on Friday showed annual growth in Japanese bank lending at its slowest in almost two years.
"Uncertainty is heightening in the global economy, including downside risks for the U.S. economy," Fukui told the Japanese parliament. "We need to clearly keep in mind these factors as risks for Japan's economy. "There are downside risks stemming from the domestic economy, but more risks exist in overseas economies and financial markets."
Fukui said the Japanese economy's moderate growth trend was intact and he expected a recovery in the housing sector, which has contracted sharply since tighter regulations were introduced.
He said the central bank still intends to raise rates, not cut them. "Japan's economy is expanding moderately as a trend, although the pace of growth seems to be slowing mainly due to the drop in housing investment," Fukui told parliament."
Some private sector economists are more downbeat. Goldman Sachs warned on Thursday that Japan's tepid economy was in danger of following the United States into recession this year.
Goldman's Japan economists said in a note to clients that the probability of a recession in the world's second-largest economy was 50 percent, forecasting slow growth in the first half of the year as emerging market economies cool.
The banking data showed growth in Japanese loans by major lenders in December slowed to 0.1 percent from a year earlier, the smallest rise in nearly two years.
Analysts said that reflected companies' growing cautiousness in light of an uncertain economic outlook.
"Lending by city banks fell sharply, which can be partly explained as a reaction to strong growth in December the previous year," said Takeshi Minami, chief economist at Norinchukin
Research Institute. "But it might also reflect shrinking demand for funds by smaller firms, whose business activity is slowing."
Futures contracts based on the BOJ's main policy tool, the overnight call rate, are now pricing in a small chance of a rate cut late this year.
That would be a sharp turnaround, as the central bank has been working to restore Japanese rates to more normal levels.
A rate cut could raise the question of whether the BOJ would have to return to quantitative easing, a policy it followed for five years of virtually force-feeding banks with cash to try to
kick-start the economy.
The swap contract for the BOJ's December meeting is implying nearly a 20 percent chance of a rate cut, data from interdealer broker Meitan Tradition showed.
In addition, the yield of two-year Japanese government bonds fell 3.5 basis points on Friday to 0.600 percent, just 10 basis points above the overnight call rate target, showing the market was moving towards the possibility of a cut.
"Gradually, people are seeing a chance of a rate cut this year," says Hitomi Kimura, fixed income strategist at JPMorgan Securities. "Bernanke is also pretty much leaning towards a further rate cut. We have two central bank officials that have become more dovish."
Annual growth in Japanese bank lending has slowed since peaking at 2.0 percent in July 2006 when the central bank started raising rates after holding them at zero for years.
Lending by city banks fell 1.7 percent, the biggest drop since January 2006, but lending was still growing moderately because of demand from individuals, a BOJ official said.
Excluding special factors such as loan write-offs, the loan balance rose 0.8 percent from the same month a year earlier.