The Bank of Japan (BOJ) will complete a two-day policy meeting on September 17th. This will be the first BOJ policy meeting since the DPJ election victory in August. The DPJ party came to power ousting the LDP party who ruled Japan for the last 50 years. The DPJ Party pledged to boost Japan's domestic growth and reduce reliance on exports. The first issue is whether the new government will respect BOJ independence? The new Japanese government is expected to respect the independence of BOJ but will likely increase pressure on the BOJ to support the economy and keep interest rates low. Japan's new PM Hatoyama plans to boost domestic demand by increased spending. This generates concern about rising Japanese debt. According to the OECD Japans debt may surge to 197.3% of GDP in 2009. Japans GDP debt ratio may limit the Japanese governments ability to spend to boost growth. Investors and the BOJ will be monitoring the new government's plans for debt issuance and to expand the current level of fiscal stimulus. Increased fiscal spending by the new Japanese government may encourage the BOJ to announce an earlier exit from its current bond purchase plan. This could emerge as the first test of the new government's respect of BOJ independence.

Extend bond purchases or signal exit strategy

One of the key questions concerning the September BOJ policy meeting is whether the BOJ will increase purchase of bonds or set a timeframe for an exit strategy from it bond purchases. The BOJ may be reluctant to continue to purchase bonds if the new government plans to boost growth dramatically increases the size of Japan's debt and Japan's economy continues to improve. At the August BOJ policy meeting the BOJ said that economic conditions in Japan have stopped worsening as exports improve. The BOJ expects the economy to recover and deflationary pressures to recede into fiscal year-end in March 2009. The DPJ see considerable downside risks to the Japanese economy and are concerned that rising unemployment will hurt domestic demand. Japan's recession ended in Q2 but the outlook for the recovery is uncertain. The Japanese economy grew by a less than expected 2.3% in Q2 and the unemployment rate rose to 5.7%. The unemployment rate is at its highest level since 1953. Machinery orders remain weak but have bounced off the lows and consumer spending and industrial production have improved. The trade will be looking to see whether the BOJ expresses concern about the risk of rising deficits and the impact of new government spending plans will have long bond yields. The BOJ noted in August that higher bond yields could hurt the recovery.

In July the BOJ extended liquidity measures through December

At the August policy meeting, the BOJ unanimously elected to hold overnight rates unchanged at 0.1% and maintained existing liquidity measures. At the July policy meeting the BOJ extended its liquidity measures that were due to expire in September through December. The BOJ has increased liquidity injections buying commercial paper and corporate bonds. The trade will be looking to see if the BOJ extends unconventional credit measures beyond December or if the BOJ is preparing an exit strategy from its liquidity measures. Dow Jones reports that BOJ board member Suda says that she is considering whether the BOJ should end liquidity measures as the global financial markets and the economy improve.

DPJ JPY intervention policy and deflation

In addition, the new Japanese government is signaling a change in JPY intervention policy. Japan's new Finance Minister Fujii says that he sees benefits of strengthening JPY and that he does not favor intervention to weaken JPY to help exporters. This is a major shift in Japan's FX intervention policy which in the past has encouraged weaker JPY to boost Japan's export competitiveness. JPY is trading at its highest level in seven months versus USD approaching 90.00. Stronger JPY will contribute to additional risk of deflation in Japan. The BOJ noted in the August policy meeting that the rate of decline in Japan's CPI has accelerated. Japan's August corporate goods prices declined by a record 8.5%. With deflationary pressures intensifying, the new Japanese government endorsing a stronger JPY and deficit spending likely to increase, the BOJ is expected to maintain current monetary policy and are unlikely to expand liquidity measures beyond December. The BOJ is expected to leave the current bond purchase level unchanged and hold rates at 0.1% through 2011. Focus will turn to the BOJ Policy Statement and the press conference following the meeting. The trade will be looking for any change in BOJ economic forecast or plans for an exit strategy from unconventional liquidity measures. The minutes for the September policy meeting will be released on September 25th.