The Bank of Japan yesterday cut overnight interest rates for the first time in three years before the release of key economic data tomorrow, triggering a sharp fall in the yen. At one point the US dollar strengthened to 138.15 yen, up almost 4.5 per cent from its New York close on Tuesday of 132.25 yen. It later fell to 136.65 yen in London afternoon trade. The Bank of Japan said it would try to boost the money supply by increasing liquidity in the market and that the overnight rate would be moved to 0.25 per cent, down from the 0.5 per cent level struck on September 8, 1995. 'The Bank of Japan decided it was appropriate to take this measure to ease monetary policy to ensure the economy does not worsen further and prevent the economy from falling into a deflationary spiral,' the bank said. Japan is set to unveil second-quarter gross domestic product figures tomorrow, forecast to show a 0.9 per cent contraction. Some analysts believe the rate cut was aimed at offsetting any further negative impact the figures could have on the yen. Bank of Japan governor Masaru Hayami denied the cut was part of a joint international action to reduce interest rates globally and insisted Japan took unilateral action. 'There have been no discussions with overseas authorities on this decision,' Mr Hayami said. 'We took the decision based purely on the present conditions of Japan.' Many analysts believe the cut in Japan will lead inevitably to a cut in the United States, Germany and Britain. Mr Hayami said the yen would be expected to weaken as a consequence of the reduction in the overnight rate, but he predicted the currency would eventually rebound. He said the action was taken to put an end to increasing concern over Japan's financial stability. 'Financial markets are vaguely worried about the financial system. The timing is right in terms of providing financial system stability,' Mr Hayami said. Strategists warned the cut might make it more difficult to strengthen the banking system and offload bad loans. Mr Hayami said the increasing concern over the financial system was a potentially more dangerous development for Japan. 'Bad-loan disposal is most important in stabilising the financial system. But an escalation of financial system concern would lead to an increase in bad loans,' he said. 'It's more important to vitalise the economy.' Foreign exchange analysts greeted the move with caution and most predicted the yen would rise again as the market refocused on a looming slowdown in the US. 'I would urge caution that this signals any new weakening of the yen,' said DKB International chief economist Gerard Lyons. 'There is every likelihood that we will see volatility return again. 'The yen will strengthen near-term, not because of the situation in Japan, but because of the problems in the US.' Since US Federal Reserve chairman Alan Greenspan said on Friday he no longer viewed inflation as the prime threat to the US economy, the market has become increasingly concerned the US is heading for a slowdown, which would lead to a cut in interest rates. Nomura Research International chief economist Bronwyn Curtis said the yen would probably weaken to a low of 140 yen, but would stabilise as US economic concerns reasserted themselves. Some analysts said the Bank of Japan move also showed the yen was no longer a priority for Tokyo. 'The new government has shown it is willing to sacrifice the recent strength of the yen in favour of an attempt to limit the economy's contraction,' JP Morgan global foreign strategist Avinash Persaud said. Mr Persaud said the yen would be underpinned by speculation of the rate cut in the US and continued Japanese repatriation of foreign-denominated assets ahead of the financial half-year at the end of the month. He said: 'Indeed it is possible that the dollar gives up a significant proportion of its immediate gains versus the yen, especially if investors view the Bank of Japan's move as confirmation that the Fed will soon make a similar move, particularly following the recent meeting of US Treasury Secretary [Robert] Rubin and Japanese Finance Minister [Kiichi] Miyazawa.'