Japan Cuts Interest Rate to Zero in Bid to Boost Economy

(Oct. 5) -- Facing an economic downturn that threatens to get worse, the Bank of Japan today surprised markets by cutting the cost of borrowed money to rock bottom prices and announcing a plan to pump trillions of yen into the financial system.

It was the latest sign the world's major economies fear a stalled recovery could slip into a new recession, and It's a move the U.S. Federal Reserve could soon try to replicate.

The BOJ, central bank to the world's third-largest economy after the U.S. and China, said that its benchmark overnight lending rate would be kept at zero to 0.1 percent, and that it will "maintain the virtually zero interest rate policy" until it judges inflation and price stability to be at normal levels.

It noted that such a promise, along with plans to buy assets and supply loads of cash for banks to lend out, is an "extraordinary measure for a central bank."

Japanese interest rates have been low for some time, but deflation -- the spiraling tumble of prices that discourages consumers and businesses from spending -- plagued the country for years following its economic meltdown in the 1990s and looms as a threat there, far more than in the United States.

The BOJ said it will spend about 5 trillion yen ($60 billion) to buy a broad range of financial products that include government bonds, real estate trusts and the commercial paper used by companies to borrow short-term operating cash. The move is a bid to push lower longer-term interest rates and spread money around the rest of the Japanese economy. It will also maintain a 30 trillion yen pool of funds that banks can access and in turn lend to prospective borrowers.

The unanimous decision by the BOJ board follows a two-day meeting where its members struggled with an economic outlook that has sharply deteriorated since its last forecast in July. The bank has also come under pressure from the Japanese government, which like its counterpart in Washington has few options left to stimulate growth. And the decision comes at a time when the rising value of the yen has been hurting Japanese exports.

"Although Japan's economy still shows signs of a moderate recovery, the pace of recovery is slowing down partly due to the slowdown in overseas economies and the effects of the yen's appreciation on business sentiment," the BOJ said. "The pace of economic improvement is likely to slow for some time before returning to the moderate recovery path," mainly "due to the waning effects" of government efforts to boost demand.

Another source of concern is "heightened uncertainty" about the U.S. economy -- the second biggest buyer of Japanese goods after China -- and its downside risks to Japan's economy.

The decision may increase pressure on the Federal Reserve to take new measures to help the American economy.

The Fed, which has held its benchmark interest rate close to zero since the start of last year, said after its Sept. 21 meeting that a worsening economy -- and especially any deterioration of the ailing jobs market -- might prompt the U.S. central bank to consider a new program of buying Treasurys or other securities.

Speaking to a student town hall on Monday, Fed Chairman Ben Bernanke increased speculation about such a move by talking about the success of the Fed's roughly $1.7 trillion program of buying mortgage-backed securities and government bonds to fight the financial crisis.

"I do think the additional purchases, although we don't have the precise numbers for how big the effects are ... I do think they have the ability to ease financial conditions," Bernanke said.

The Fed doesn't meet again until November, and the one thing it has been clear about is that the most important economic indicator for its next decision will be unemployment.

That makes the September monthly payroll and employment report from the Labor Department, set for release Friday, the next big piece of the puzzle for economists trying to figure out what will happen next.