Loose Money and Short Term Interest Rates

The Bank of Japan, the nation's Central Bank, announced that it will end its loose money policy followed in recent years to bolster the struggling Japanese economy. Rather, the Bank will use increased interest rates to guide the future of the now-healthy Japanese economy. The main message in the announcement: a declaration of victory over an extended stretch of Japanese stagnation that started in the early 1990s.

According to a Reuters report, Toshihiko Fukui, the governor of the Bank of Japan, said, "The Japanese economy is improving steadily, with prices having turned positive and expected to stay positive. This trend is strengthening."

Analysts interpret the Central Bank's decision as a first step toward an eventual rise in Japanese short-term interest rates from near zero. The move also seemed to reflect the bank's confidence that deflation was under control. The question remains: How smoothly they can pull back from making the easy money available?

"These are uncharted waters for a central bank," said dean of Columbia University Business School R. Glenn Hubbard. "Exiting with minimal disruptions will be a difficult exercise." Hubbard also served as Chief Economic Advisor to President George W. Bush in the beginning of Bush's first term.

By tightening credit, the Japanese Central Bank will end one of the biggest and longest financial free rides in modern history. The loose money policy has had the unintended side effect of turning Japan into a huge pot of basically free money for the rest of the world. With an overnight call rate of about 0.001 percent, global investors--from retirees to megabanks--have borrowed cheaply in Japan to invest elsewhere, while Japanese investors were buying foreign stocks and bonds in search of higher returns.

The fear now is that this flow of funds could reverse as interest rates begin to rise and Japanese investors could start selling their foreign stocks and bonds and return to domestic investments. "There is a risk of people overreacting," said Richard Jerran, a Tokyo-based economist for Macquarie Securities. "The five-year free ride comes to and end, or at least that's the fear. Chief economist at the research arm of Tokyo-based Mizuho Financial, Atsushi Nakajima, agrees, saying "It probably won't happen, but there's always the possibility of unexpected consequences,"