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Bank of Japan joins the sub-zero club

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In Brief

On 29 January 2016, the Bank of Japan (BoJ) announced its monetary policy for the new year: quantitative and qualitative monetary easing with a negative interest rate. The policy came as a surprise to money markets. The Nikkei index went up by over 800 points in two days and the yen depreciated sharply against the US dollar.


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Though the BoJ is not the first central bank to adopt a negative interest rate target, negative interest rate strategies remain unfamiliar territory to macroeconomists.

Following the 1970s oil shock, many central banks began to utilise short-term interest rates with the aim of building stable inflationary expectations. The theory went as follows: if a central bank’s commitment to hitting a certain stable inflation target was seen as credible, households and firms could adjust wage and investment expectations according to that inflation target.

If inflation exceeded the central bank’s target, then households and firms would anticipate that the central bank might increase interest rates. They would defer consumption and investment, lowering inflation and economic output. Conversely, if inflation was lower than the target, then consumption and investment would rise as households and firms would anticipate a cut to interest rates.

The 2007-08 global financial crisis brought about the end of monetary policy based on stable inflationary expectations. As Lehman Brothers collapsed in September 2008, the central banks of most developed economies, such as the United States, lowered interest rates approaching the zero lower bound — thought to be the lower limit of short-term interest rates.

With conventional monetary policy exhausted, central bankers turned to ‘unconventional monetary policy’, so named because it makes use of economic tools other than setting the short-term interest rate, including quantitative easing (QE). QE involves the central bank influencing long-term interest rates by purchasing long-term financial assets, such as government bonds, held by investors in global financial markets. Typically, the central bank funds QE purchases with digitally printed money.

As central bankers deployed unconventional monetary policy in an effort to provide liquidity in failing financial markets, the BoJ faced a special challenge. It had already been using unconventional monetary policy like QE since the early 2000s. To borrow a medical analogy, while many central bankers began administering morphine to ease the pain of the global financial crisis, the BoJ had to alleviate the pain of a patient already on morphine. How could the BoJ achieve this? The only way was to up the dose.

As part of the government’s Abenomics policy, BoJ Governor Haruhiko Kuroda undertook bold and aggressive unconventional monetary policy measures. Kuroda was determined to hit an annual inflation rate of 2 per cent per annum, even going so far as to increase the money base by 80 trillion yen (about US$739 billion) per year. The BoJ’s recently announced negative interest rate policy is simply an extension of its unconventional monetary policy program — an expansion of liquidity so great that it suppresses short-term rates below zero.

This policy is more nuanced than it sounds. For starters, the BoJ will only apply an interest rate of –0.1 per cent per annum to ‘Policy-Rate Balances’ held by large financial institutions at the BoJ. When the policy was announced, the sum total of these balances amounted to approximately 10 trillion yen (US$92 billion).

Other balances held by these large financial institutions will continue to attract an interest rate of either 0.0 or 0.1 per cent per annum. As the total amount of current account balances held at the BoJ add up to approximately 260 trillion yen (US$2.4 trillion), a rate of –0.1 per cent per annum on a 10 trillion yen balance is not expected to have a significant detrimental impact.

Yet the BoJ anticipates that Policy-Rate Balances will rise over time, increasing the exposure of financial institutions to the negative interest rate. To counter this, they will allow financial institutions to transfer current account balances out of the Policy-Rate Balance. The result is that the BoJ’s negative interest rate will only apply to approximately 10 trillion yen plus a certain mark-up — which the BoJ has yet to announce — going forward.

The aim is to encourage large financial institutions that hold current accounts with the BoJ to take funds out of the short-term money market and facilitate investment and loans. The BoJ hopes that the real rate of interest — the opportunity cost of consumption in the present — will fall, spurring consumption, investment and output. A far more tangible effect of the new policy is further currency depreciation as the BoJ continues to flood international bond markets with yen. This should assist Japanese export growth, one of Abe’s key goals.

But there are still questions about the BoJ’s aggressive unconventional monetary policy. Given Japan’s ageing and diminishing population, would a higher yen, favouring consumption, be a wise policy going into the future? Will households and firms believe the BoJ’s 2 per cent inflation target?

The BoJ strategy presumes that there is underutilised capacity in the economy, the use of which can be stimulated by monetary expansion — a gap between potential and actual output. But what if the BoJ is looking to fill an output gap that does not exist? If this turns out to be true, then the BoJ’s gamble with negative interest rates and aggressive monetary stimulus will not pay off. Real growth will remain flat and the hundreds of trillions worth of printed yen issued by the BoJ could lead to inflation well above the 2 per cent target.

Unconventional monetary policy is often used to treat the symptoms of an ailing economy while the underlying diagnosis remains uncertain. Though the logic behind these policies can be enticing, the BoJ’s reliance on certain assumptions — such as the output gap — raises valid concerns.

Few can say what lies ahead for Japan’s economy, but its next few years will be full of lessons for industrialised economies around the world.

David Murakami is a Parliamentary Fellow in the National Diet of Japan.

One response to “Bank of Japan joins the sub-zero club”

  1. I believe that the Yen actually appreciated in value shortly after Kuroda announced the negative interest rate policy. Perhaps investors realized that this policy would only affect a very small amount of the market, as the author pointed out.

    I agree that the BOJ and the ECB are in uncharted waters when it comes to these policies of negative interest rates. Thus, no one can predict with much confidence how this will play itself out in the months to come.

    Apparently, Kuroda just announced that there is more he can do. What he seems to fail to note, as well as the author of this piece, is that Abe has actually done little or nothing about applying fiscal stimuli or structural reforms to the Japanese economy. The country admittedly is facing very complex and difficult demographic and social challenges. It might be that even persistent and powerful fiscal stimuli and/or structural reform might not be enough.

    But Kuroda is letting Abe off the hook all too easily….as is Draghi in Europe. I believe that both need to force the elected leaders of their countries to take concerted action before they do any more with these experimental monetary policies.

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