Japan’s Negative Rate Cut - Is It Enough?

Published on 01 Feb, 2016

Japan Investment Research

Image courtesy: Kalandrakas (www.jessleecuizon.com)

Bank of Japan has cut one of the interest rates on balances kept by banks with the central bank to negative 0.1 %, thus joining the league of European Central Bank and central banks of Switzerland, Sweden and Denmark in venturing to negative interest rate territory. The last few years have pulled perhaps the most surprises in monetary and fiscal policy. What started with an unconventional bond buying program and the zero interest rate policy (ZIRP) by the US Federal Reserve, was taken forward by the Bank of England (BoE), the European Central Bank (ECB) and now the Bank of Japan (BoJ) expanding its arsenal to negative interest rates.

The move appears to have caught market participants by surprise, a déjà vu when compared to the previous policy actions of stimulus expansion (October 2014) and first announcement of the monetary ‘bazooka’ (April 2013). However, a closer study of the timing of policy announcements reveals precedence of weakening macroeconomic indicators prompting policy action. Even in this instance of negative interest rate, Japan’s ‘core’ inflation fell to 0.8% in December 2015, slower than the 0.9% rate in November 2015.

While the Bank of Japan has already waded into uncharted territory of negative interest rate and has committed to pursue its course till the inflation target of 2% is achieved, we may get an early indication of further policy action based on deterioration of major macroeconomic indicators. Few more ‘surprises’ may include the government coming into play with fiscal measures, such as tax cuts to spur consumption instead of targeting to increase wages by means of sales tax increases.

Doing What ECB Did

The Bank of Japan (BoJ) has broken new ground by announcing a negative interest rate for part of the bank deposits with the central bank. This adds a third dimension to the Japanese central bank’s earlier strategy of quantitative and qualitative easing, and thus puts BoJ in the company of European Central Bank (ECB), Switzerland, Sweden and Denmark in terms of adopting negative interest rates. The most prominent of all is the ECB Governor Mario Draghi’s commitment to negative rates and willing to pursue this strategy to its end for reaching its inflation targets.

A quick read of the BoJ’s policy statement announcing the negative rates sounds like an echo of ECB in terms of the language used "The Bank will continue with...Negative Interest Rate...to achieve the...target of 2 percent, as long as it is necessary for maintaining that target...". In that sense the BoJ appears to be following in the footsteps of ECB.

BOJ Bank Balances

The estimated reserves to which negative rates will be applicable are approximately 10 trillion to 30 trillion yen initially as per media reports. Further, the rates will apply only to new reserves that financial institutions deposit at the central bank and are applicable from February 16, 2016 onwards. BoJ expects near term interest rates to fall and overall yield curve and real interest rates to be pressured downwards with further expectation that both consumption and investment will be stimulated. BoJ governor Harihuko Kuroda has repeated his ‘whatever it takes’ line to meet his inflation target and seems to be following up on his talk with unprecedented actions.

Where Is The Targeted Inflation?

The Shinzo Abe government came to power in December 2012 promising a change in Japan’s economic stagnation and unveiled the three ‘arrows’ of fiscal stimulus, monetary easing and structural reforms. Shortly afterwards, Bank of Japan governor Horuhiko Kuroda first introduced the ‘bazooka’ monetary stimulus in April 2013, which consisted of massive bond-buying program and a formal adoption of 2% target inflation. He further surprised by announcing extra stimulus in October 2014. Recently, there were expectations of no further expansion in stimulus post extra measures announced in December 2015, but nevertheless the BoJ surprised one and all with negative interest cuts. All the while during this ever-loosening monetary policy, inflation remained stubbornly below target.

Round-up BOJ's efforts

Round-up BOJ's efforts

Is The Negative Interest Rate Move Really Surprising?

Bank of Japan has undertaken several steps in the past three years that were deemed as unexpected. However, if we observe the timing of policy decisions, they have followed weakening macroeconomic data updates.

On the backdrop of two decades of economic stagnation for Japan, shortly after taking over the charge of the Governor, in April 2013, Harihuko Kuroda announced measures to increase monetary base at an annual pace of JPY 60-70 trillion yen and inflation target of reaching 2% in 2 years.

Before the expansion of monetary stimulus in October 2014, BOJ’s preferred inflation gauge had slowed to lowest level in past 12 months to 1% (sharply down from 1.5% the previous month) and was at risk of further moving away from central bank’s target of 2%. In addition job creation had weakened for the first time in three years.

This time, the economy has been hit by global slowdown and the commodity meltdown. Oil prices have fallen to decade lows, thus lowering imports and putting Japan’s inflation target at risk. The central bank’s preferred rate of inflation (the ‘core’ inflation) fell to 0.8% in December 2015, slower than the 0.9% rate in November 2015.

Have These Measures Help Revive Japanese Growth And Inflation?

The very fact that the Bank of Japan has had to push its inflation target timeline further into the future and expand its toolkit by adopting increasingly bold and unprecedented measures answers the question for itself, even without looking at the economic indicators.

However, the BOJ still hopes to achieve its targets and appears to do its part (with the Government expected to play its part) in reviving economic growth and push up inflation. The near-term beneficiaries of these ultra-loose monetary policies appear to be the capital markets. The markets moved up substantially in both instances of monetary stimuli (first announcement and second expansion) over a period of time, aided by liquidity and expected earnings growth for Japanese companies due to weaker currency.

Japan Inflation v/s Interest rates

Japan Inflation v/s Interest rates

Did Extreme Policies Ever Work?

The verdict on ECB’s negative interest rate moves has been mixed. While the monetary stimulus and negative interest rates appear to have halted the slow decline and concern of Eurozone slipping into recession, the monetary actions have not resulted in inflation rising up to the levels targeted by the ECB either, albeit the ECB has had to deal with many more issues such as the Greek crisis and the implications in terms of pressure on Euro. The jury is still out on how long will it take for inflation to reach ECB’s target level of 2%. The ECB is more patient in terms of its expectations and believes the impact of inflation will be visible with certain lag. To its credit, the five-year, five-year forward break-even rate, which measures the outlook for inflation over the five-year period from 2020, recently increased to its five-month high of 1.83 % in December, 2015. At the same time, unemployment fell to its 10.7% in October, 2015, which was the lowest rate since January 2012. These developments would provide encouragement for BOJ to further pursue unconventional monetary policy including deeper interest rate cuts, though it would do well to observe how long is it taking for inflation in Eurozone to move up post the expansionary monetary policy and negative rate cuts adopted by ECB.

Expect More ‘Surprises’

The attempt to revive the economy and regain the ‘lost decades’ have prompted the Shinzo Abe government and BOJ governor Kuroda to undertake aggressive fiscal and monetary policies. The targets set to be achieved are steep and the resolve to achieve them is evident from the bold steps, including going ahead with policy measures in spite of a split verdict (5-4 in favour of expanded stimulus and negative interest rates) in BOJ board, which is in contrast to the strong culture of decision by consensus, prevalent in Japan.

A close watch on the macroeconomic indicators could flash early signs of an even further expanded monetary policy, as the BOJ goes where no Central banker has gone before. The expansion of monetary base has already outpaced that of US and appears set to further accelerate.

Japan v/s US monetary base

Japan v/s US monetary base

Given the rapidly expanded monetary base, there may be limits to how much more the BoJ can venture into uncharted territories of monetary policy, without impacting the currency. The weakened currency does benefit exports to a limited extent, but also creates grounds for competitive devaluation of peer currencies. Consequently, the ball may now very well be in the court of the Japanese government, which needs to act on the structural reforms which formed part of the three ‘arrows’.

In the past, when there were hint of recoveries (mid 90s and even the mid of last decade), the Japanese government has raised taxes (VAT) which crushed consumer spending and brought back the deflationary pressures. Conversely, a cut in cut in taxes could be adopted instead of the failed experiment of sales tax increase which further crimped consumption. The decision to venture in to negative interest rate territory has just underscored the same.