While Japan has hinted for months it was considering ending its zero interest-rate policy, the Bank of Japan’s announcement in mid-July that it raised interest rates for the first time in six years was still quite significant.

The increase to 0.25 percent was the country’s first since August 2000. However, that proved to be little more than a false alarm, as the stock market collapse in the U.S. sent rates back to zero soon afterwards. This time, however, the BOJ said it is committed to a tightening cycle, which would be Japan’s first since 1989.

The BOJ had long hesitated to raise rates, citing deflation and economic stagnation. However, the BOJ said in a statement that keeping the zero interest-rate policy could have caused disruptive swings in the economy.

The BOJ also said it would be very cautious about raising rates again, keeping them low “for some time,” and had no intention of raising them again at the next BOJ meeting Aug. 10.

While the markets had been expecting the price move, they still reacted negatively to the news. The night before the July 14 rate hike, the Nikkei 225 closed at 15,097.95. By the close July 19, it was down to 14,500.26 — almost a 4-percent drop. As of July 31, it stood at 15,456.81.

Perhaps more surprising was the immediate decline in the yen. While rising interest rates are generally bullish for a nation’s currency, the yen dropped almost 2 percent in the two days after the announcement, although it did bounce back shortly thereafter. As of late July, it was at 114.55, a 1.3 percent appreciation in the yen from the announcement date and almost 3 percent from the July 19 low.

However, Brian Dolan, director of research at Forex.com, says the yen’s decline was not totally unexpected.

“You have to put the move in context,” he says. “The BOJ had essentially been preparing the markets for many months for the eventual end of the zero interest-rate policy. The main thing the market was focusing on was guidance for future rate hikes.”

Dolan says that since the BOJ announced it would be very careful about further increases, the 25 basis-point hike was not enough to spark great buying in the yen, especially because it still faces substantial yield disadvantages.

Blake Morrow, forex product manager at GlobalTec Solutions, says that because there was practically no buying of the yen right after the announcement, sellers figured it was safe to get back in.

“Also, I think some of the currency pairs, such as the dollar/yen, euro/yen, and pound/yen were breaking some technical levels, and that just accelerated the move,” Morrow says.

Additionally, says Joseph Trevisani, chief market analyst of FX Solutions, carry trades — selling a low yielding currency vs. buying a high-yield one — were not as prevalent in the days and weeks leading up to the announcement. After the announcement, when it became clear that the Japanese interest rate would remain low, the carry trades resumed.

Although Dolan doesn’t believe the rate hike will have that big of an immediate impact on the Japanese economy, he does believe it is a noteworthy move.

“In the sense it represents a turning point in global interest rate levels, it is significant for the six-month outlook,” he says. “The Japanese economy is strong, and inflation is at a risk of becoming more of an issue than it has been in nearly a generation. But I don’t think that’s sufficient to derail the Japanese economy.”

While Morrow agrees the near-term implications are minimal, he thinks it’s important to keep a close eye on what Japan does in the next several months.

“If Japan continues to raise interest rates at a measured pace, Japanese investors could potentially start massively selling their U.S. assets,” Morrow says. “That could push the U.S. dollar much lower than current levels and potentially disrupt the global economy.” As for where the yen is headed, Trevisani believes Japan will not necessarily have the biggest say in the matter. “The longer-term outlook in the dollar/yen depends more on the strength or weakness of the dollar than on intrinsic Japanese factors,” he says. “Although if there is dramatic change in the Japanese economy, that could become an element.

“The U.S. dollar is continually buffeted by external events — the price of oil, political instability in the Middle East, potential and real terrorism, the health of the U.S. economy, and the Fed interest-rate policy,” Trevisani adds. “These factors will have more impact on the dollar and hence on the yen in the near future than any likely combination of bilateral U.S./Japanese developments.”

At year-end, Morrow expects the dollar/yen to be around 1.12, while Dolan thinks more rate increases toward the end of the year and in early 2007 will strengthen the yen. “I think you’ll see some dollar weakness, and that will send the rate down to the 1.10-1.12 area,” he says. “As that side of the equation leads to yen appreciation, I think were looking at something in the 105-108 area.”

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