Bank of Japan Feels the Heat to Act

Two weeks ago the European Central Bank took the stand to show how it would end the euro zone debt crisis and last week the Federal Reserve delivered aggressive steps to revive the U.S. economy. Now it’s the Bank of Japan’s (BOJ) turn to take the central bank podium.

Japenese yen
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Japenese yen

The BOJ concludes a two-day policy meeting on Wednesday and talk that it could deliver monetary easing of its own has grown sharply in the face of a strong yen, which threatens to derail a recovery in the Japanese economy.

Economists say that although the BOJ is more likely to act at its October meeting when it unveils its latest forecasts for growth and inflation, the outcome of this week’s meeting is a close call.

“Whether the BOJ takes additional easing measures at its policy meeting is becoming an increasingly close call. We believe it is quite likely to do so at either the upcoming meeting or one of its two meetings in October, but it is difficult to tell when (at which of these three meetings) it will decide to do so,” Masayuki Kichikawa, Chief Japan Economist at Bank of America Merrill Lynch said in a note.

“Pressure on the BoJ to ease further is rising given: (1) the slowing pace of the economic recovery, (2) the possibility of yen appreciation, and (3) potential political pressure,” he said.

The yen , which was trading at 78.70 per dollar on Tuesday, hit a seven-month high last week after the Fed’s decision to deliver a third bout of quantitative easing triggered broad-based dollar weakness. The Fed said it would buy $40 billion of mortgage debt a month and continue asset purchases until it sees significant improvements in the jobs market.

The yen’s sharp move, which took it to within 3 percent of a last year’s record high against the dollar, appears to have set off an alarm bell in Tokyo – the BOJ was reported to have “checked” rates in forex markets last week, often a precursor to official central bank intervention, while Finance Minister Jun Azumi said on Friday Japan would take decisive action to curb excessive strength in the yen if necessary.

Yen Headache

The likelihood of official currency intervention, which would involve the BOJ selling yen in the forex markets on behalf of the finance ministry, is high, analysts say. But they add that to significantly weaken the yen, the BOJ needs to follow the Fed in delivering its own monetary stimulus or asset purchases as only this would encourage heavy yen selling, in the way the dollar was sold after the Fed’s action last week.

The U.S. central bank has significantly expanded its balance sheets after two rounds of monetary easing; its monetary base – the total amount of banknotes and coins in circulation and current accounts deposited at the Fed – stood at $2.65 trillion at the end of August. In contrast, Japan’s monetary base stood at about 121 trillion yen ($1.54 trillion) at the end of last month.

“The world we’re operating in at the moment is one of relative balance sheet size and from a central bank perspective, the BOJ is very much losing that battle – with the Fed doing what it’s doing and the ECB doing what it’s doing, Japan is definitely under a lot of pressure,” Jonathan Cavenagh, Senior Currency Strategist at Westpac Bank, told CNBC’s "Capital Connection" on Monday.

“This Bank of Japan meeting is going to be an interesting one, but I think it is going to be a bit too early for any action,” said Cavenagh.

Any monetary easing is likely to come in the form of an expansion of the BOJ’s 70 trillion yen ($904 billion) asset-purchasing and loan program by 5 to 10 trillion yen, with asset purchases focused on government bonds, analysts said.

The Bank of Japan may have other reasons to act sooner rather than later. Data shows the outlook for Japan’s economy, the world’s third largest, is bleaker than it was a month ago.

On Friday, the Japanese government cut its assessment of the economy for a second month in a row and warned that growth is slowing. Exports hurt by the strong yen, fell 8.1 percent in July, the biggest slump in six months, while industrial output fell unexpectedly in July.

“For the BoJ, which had assumed steady economic recovery as its main scenario, the delayed economic rebound in China and other parts of Asia is probably becoming an unexpected development,” said Kichikawa at Bank of America Merrill Lynch.

Despite the pressure to act, the BOJ would err on the side of caution this week, Junko Nishioka, Chief Japan Economist at Royal Bank of Scotland in Tokyo said.

“I still think it’s too early for the BOJ to ease and I think it will keep its monetary stance on hold this week,” she told CNBC Asia’s "Squawk Box".

- By CNBC's Dhara Ranasinghe