The Bank of Japan (BoJ) surprised financial markets on 28 January 2016 by announcing the imposition of negative interest rates. The investment community has been discussing the possibility of further monetary easing in Japan for a while, but few analysts reckoned with the announcement of such a decision at this policy meeting. Expectations, prior to the meeting, were generally centred on the possibility of a fine-tuning of the pace of quantitative easing.
The initial reaction of financial markets to the BoJ's decision was positive. The Japanese yen weakened and Japanese equities gained in choppy trading. European equities took sustenance from this trend.
Bond yields, which had been trending lower in Europe during the days before the meeting, extended their fall. Japanese 10-year bond yields fell to a record low of just 9 basis points (0.09%).
Interactive graph 1: Events in January 2016 suggest this will be the twenty-sixth year of falling sovereign bond yields in Japan. In the wake of the BoJ's decision, on 28/01/16, to impose negative interest rates, Japanese 10-year bond yields made a new historic low of 9 basis points.
Why has the Bank of Japan decided to move now to negative policy rates?
The BoJ tweaked its quantitative easing programme late last year, but another step had not been expected before March 2016. While the rate of inflation remains well below the BoJ’s 2% target, the publication of new growth and inflation projections in March and the BoJ’s signalling a desire to end deflation right before the spring wage negotiations had pointed to March as a more likely time for a change of policy. In our view, it is possible that the yen’s recent strength, driven by flows of liquidity seeking a safe haven amid Asia’s financial market turmoil, may have come into play as a trigger for BoJ action.
In their statement the BoJ said that a moderate recovery of the Japanese economy remains underway, but recent data on household spending, industrial production and foreign trade was weak. Core inflation had increased lately – at the national level to halfway the BoJ’s target – but this upward trend appears to have stalled recently. As justification for the rate cut, the BoJ pointed to volatility in international financial markets and in particular the uncertainty about the outlook for China’s economy. The Japanese central bank considers this move to be a pre-emptive strike aimed at preventing a deflationary mindset reasserting itself in relation to Japan’s economy.
Interactive graph 2: After depreciating versus the US dollar since 2012 the Japanese yen has been buoyed since the start of 2016 by flows of liquidity seeking a safe haven from the turmoil amid Asia's financial market turmoil. Part of the explanation for the BoJ's decision to impose negative interest rates may, in our view, be a desire to counter the yen's recent strength.
Is the BOJ’s decision to implement negative policy rates positive?
As mentioned above, the initial reaction of markets was to interpret this decision positively. We are more cautious. Firstly, this step shows that there is a limit to what be can achieved with quantitative easing (QE) and quantitative and qualitative (QQE) easing. Even in Japan, where the government runs a large deficit requiring heavy issuance of new bonds each year and the central bank has held an ever larger share of the government bond market. Increasing the pace of QE would have potentially reduced the time left before the BoJ will run out of government debt it can buy. The BoJ is already buying other assets, such as ETFs and J-REITs, but the size of its current buying programme and potential future purchases are much smaller than was the case for government debt. Purchasing equities outright on a massive scale with newly printed money would obviously be very controversial.
Secondly, the impact of this step will likely be limited. The BoJ is adopting a three-tier system. Positive interest rates will continue to apply to bank reserves built up so far under quantitative easing. Zero interest rates will apply to required bank reserves, some other reserves and on an adjustable amount of reserves depending on the macroeconomic situation. Negative rates will only apply to new reserves above those for which positive or zero interest rates are now applicable. Exhibit 1 below illustrates this three-tier system. The reason for this tiered system is that the cost for Japan's banking system of an across-the-board application of negative interest rates would be too high. Financial market are priced on marginal interest rates, not on averages, so lowering the marginal rate should have an impact, but we don’t think the level of interest rates was an impediment for the Japanese economy.
Exhibit 1: The Bank of Japan has adopted a three-tier system for paying interest on reserves held by banks at the Bank of Japan.
Source: Bank of Japan, policy statement published on 29/01/16.
What about the weaker yen? This should benefit corporate profits, but in recent years, yen depreciation has hardly led to any (extra) growth in real exports. It is outright negative for consumers, whose purchasing power has been undermined. And, while the move in the yen was significant on a daily basis, it only takes the valuation of the yen back into the range in which it traded for most of 2015.
It is clear that the BoJ’s announcement surprised financial markets. Only very recently, BoJ governor Kuroda had ruled out the possibility of negative rates. It may be that Kuroda wanted to enhance his reputation for policy surprises, but in our view this decision smacks of desperation. The majority in favour of this decision on the BoJ policy committee was slim, 5 members voting for it and 4 against.