The Bank of Japan said Thursday it is abandoning its easy money policy of zero interest rates that has helped pull the country's economy out of a decade-long slump.
However, the central bank plans to move slowly so it doesn't alarm global markets, which had grown nervous in recent weeks over rumours of a policy shift.
"Interest rates will stay at zero for some time, then stay extremely low and go through an adjustment period," Bank of Japan governor Toshihiko Fukui told a new conference. "It's up to the economy how much and when."
During the past five years, the Bank of Japan's zero-interest policy has poured money into the economy by allowing the government to borrow for free and bolster the reserves of commercial banks. They, in turn, could lend money out relatively cheaply.
The policy appears to be paying off with growing corporate profits, rising consumer spending and the overall economy expanding at a 5.5 per cent pace in the fourth quarter.
But there were growing concerns that a continuation of the easy money policy would cause inflationary pressures to build and and possibly create bubbles in property and stock markets..
Expectations of a change mounted over the past week after data showed core consumer prices had risen on an annual basis for three months in a row.
Stock market investors responded positively to the decision, lifting the Nikkei 225 index by 2.6 per cent.
Fukui said the excess liquidity in the financial system will stay unchanged at about 30 trillion yen or $225 billion US for March, and reducing it to normal levels will take "a few months."
The announcement eased fears on international markets, particularly in the U.S., that a tighter money policy would suddenly dry up the investment flow from Japan and contribute to higher U.S. interest rates.
However, Sal Guatieri, a senior economist at BMO Financial Group, cautioned that any withdrawal of liquidity from Japanese markets could have a significant impact on North American bond markets.
The current yield on 10-year Government of Japan bonds is about 1.5 per cent, Guatieri noted, compared with rates of about 4.2 per cent in Canada and 4.75 per cent in the U.S.
A rise in Japanese bond prices could make our bonds relatively less attractive and prompt a significant outflow of Asian investment money back home.