Quotes of the Day

During a two-day meeting later this week in a stately neo-baroque building in Tokyo, nine men may vote to end of one of the oddest periods in the history of central banking—and send one of the clearest signals yet that Japan's economy has finally emerged from 15 years of stagnation. Led by governor Toshihiko Fukui, the monetary-policy committee at the Bank of Japan (BOJ) will vote on whether to raise its overnight lending rate to 0.25% or leave it at zero, where it has been for more than five years. That shift would not just demonstrate that the BOJ believes the world's second largest economy is now on sound footing—it would also have a profound effect on global markets and both corporate and private borrowers.

The rate hike is by no means guaranteed—the BOJ could wait until its next meeting in August or beyond. But 32 out of 41 analysts and traders surveyed by Reuters last week said they expect an increase at this week's meeting. Yasunari Ueno, chief market economist at Mizuho Securities, says, "I put the possibility for a hike this week at 80% to 90%." If it doesn't happen, there's nonetheless a widespread belief that it will inevitably do so in the next few months—and that the first rise will likely be followed by more.

This conviction is an indication of just how far the Japanese economy has come. Following the stock and property collapses of the early '90s, most businesses and consumers drastically cut their spending and investments. With demand falling, prices dropped too, exacerbating businesses' unwillingness to invest in new ventures, and Japan found itself in a disastrous deflationary spiral. In desperation, the BOJ reduced interest rates to zero in 1999, but it had little impact for years because Japanese companies were hobbled by so many other problems, like bloated payrolls and debt-laden balance sheets. Under the reform agenda initiated by Prime Minister Junichiro Koizumi in 2001, however, Japanese industry began to modernize and streamline. Taking the helm of the BOJ in 2003 as Koizumi's handpicked favorite, Fukui led central-bank intervention into uncharted waters. His predecessor frequently claimed impotence, saying there was little a central bank could do to stoke an economy's fires once it had lowered rates to zero. But Fukui stepped up or initiated a series of unorthodox "quantitative easing" programs designed to flood the market with easy money. For example, he more than doubled the target for current-account deposits held by financial institutions and he ramped up the BOJ's purchases of corporate and government bonds. With increased deposits, banks had more money to put on the street; and the BOJ's shopping spree also put more money in circulation.

With the government and the central bank coordinating more closely, the economy slowly revived. It's now in full swing, enjoying one of its longest postwar expansions. GDP grew 3.2% in the last fiscal year and the Nikkei stock index is up 66% in three years. Spending is up, wages are up, even property prices are rising again, and unemployment is at an eight-year low. With conditions improving, Fukui has made no secret of his desire to end the anomalous zero-interest era, saying he favors acting early and in small steps. In March, the BOJ declared an end to its quantitative-easing campaign, and it has since tightened the money supply considerably, draining an astonishing $181 billion from the system in four months. Economic growth has risen steadily since March, while the consumer price index excluding fresh produce has gone up year-on-year for seven months straight, bolstering claims that deflation has at last ended.

Things are looking so rosy, in fact, that the BOJ has begun to fret that the biggest danger is that the economy will expand too rapidly. BOJ policy-board member Kiyohiko Nishimura has warned that low rates could promote "useless, excessive investment," and Fukui has vowed to raise rates "without delay" should investment become rampant. Those fears may be coming to pass. Last week's much-watched Tankan business-sentiment survey indicated that Japan's largest companies plan to increase investment at the quickest pace in 16 years. "The Tankan survey showed the economic climate is slightly overheated," says Takeo Okuhara, a bond strategist at Daiwa Institute of Research. "The current financial policy is so accommodative, it's better to pull back soon."

Yet Koizumi and his cabinet have voiced strong opposition to a rate hike, claiming that deflation has not been conclusively vanquished and that higher rates could dampen growth. Bitter memories remain of 2000, when the BOJ prematurely raised rates from 0% to 0.25%, plunging Japan back into recession; six months later, the BOJ was forced to drop rates back to zero. Still, Jesper Koll, chief Japan economist at Merrill Lynch, says fears of a replay of 2000 are misguided: "The Japanese economy is fundamentally different today, fundamentally stronger."

Although the BOJ is officially independent, its governors are subject to far more government influence than U.S. or European central bankers. Complicating matters is a scandal over Fukui's personal finances that could further weaken his ability to withstand political pressure. Fukui has been in the hot seat since revelations last month that he invested in a fund run by shareholder activist Yoshiaki Murakami, who recently admitted to insider trading. Although Fukui made the investment in 1999 when he was working in the private sector, and the BOJ had no regulations for incoming officers to put their assets in a blind trust, he has apologized for his bad judgment and vowed to give away his profits from the fund. Fending off calls to resign, he has needed the support of politicians in the ruling Liberal Democratic Party to keep his job. But Richard Jerram, an economist at Macquarie Securities in Tokyo, dismisses any speculation that Fukui's independence has been compromised. "The BOJ has been working for years to prove that it is immune to outside pressure," says Jerram, who argues that political interference might actually embolden Fukui to raise rates.

The end of 0% interest rates would have a significant impact on global money flows. For one thing, it could spell the end of the Japan "carry trade," the practice of large investors borrowing yen cheaply to invest in anything with higher yields—from U.S. treasuries to stocks to emu farms. The carry trade has been blamed for speculative excesses in global stock and commodity markets, not to mention exotic investments like Icelandic and New Zealand currencies. In June, financier George Soros blamed the recent dip in global markets on the BOJ's money-supply tightening since March, noting: "When the Japanese central bank reduced the excess liquidity, this situation had a global effect on currencies, bonds and stocks. It is a correction of the excess liquidity."

Carry-trade alarmists tend to focus on the fact that Japan's "free money" spigot is closing, but rarely mention that rates are likely, for now, to rise by a mere 0.25%. That's not free, but it's still pretty close to it. For the foreseeable future, Japan will remain the world's first stop for low-cost capital. "Even if Japan's rates were to rise to 1%, its differential with other asset classes around the world would still be pretty high," says Macquarie's Jerram. Besides, the BOJ has been signaling its intention to raise rates for months, giving major market players plenty of time to prepare. "The market has been incorporating these factors ahead of time," says Mizuho's Ueno.

Domestically, the rate rise would be a tiny boon for Japanese savers—the BOJ says a decade of ultra-low interest rates has cost households $1.3 billion in interest income. But the cost of loans for housing and credit cards would inch up, and stocks traditionally suffer when rates rise. Still, after so many years trapped in an economic twilight zone, the Japanese may find such worries almost a pleasure to contemplate. As Tatsushi Shikano, a senior economist at Mitsubishi UFJ Research and Consulting, says: "It's a sign that things are going back to normal."

• Jim Frederick | Tokyo
• As the economy lifts off, central bankers appear poised to end the country's easy-money era