On February 16, the Bank of Japan (BOJ), the country’s central bank, implemented a negative interest rate policy for the first time in its history, in accordance with a decision made during its monetary policy meeting on January 29. This monetary easing, which imposes a minus 0.1 percent interest rate on a portion of the new reserve accounts held by private financial institutions at the central bank, is the third major action conducted by the governor of the bank, Haruhiko Kuroda, who took the position in 2013. Kuroda’s first two major actions as governor were significant increases in government bond purchases.
Ominously though, this is the first time his actions have failed to lead markets in the desired direction, one which is favorable for the Japanese economy. As a result of the negative interest rate, Japanese government bond yields decreased but the stock market declined, and despite a fleeting initial depreciation, the Japanese yen has sharply appreciated. Even though these market reactions were mainly caused by the rise in uncertainty regarding the outlook of the global economy, at the same time, it illustrates the simple fact that without desirable conditions in the global economy and markets, it’s difficult for Kuroda to make the bank’s monetary easing policy bring about the intended positive effects on the markets. Of course, this should be obvious, but expectations may have been different in Kuroda’s case since he has always acted as if he could control the markets—especially, in terms of weakening the yen.
The role of the weakening yen
Kuroda has stated that the bank’s monetary policy is aimed at overcoming deflation and stimulating domestic demand by changing expectations of markets and economic entities, and influencing longer-term interest rates and risk asset prices. Although it remains unstated, the weakening of the yen was likely a key factor in the bank’s policy. The bank would never admit this, however, because it wants to avoid being criticized internationally for implementing what could be perceived as a beggar-thy-neighbor policy. Kuroda brought about the weaker yen through quantitative and qualitative monetary easing (QQE), which included massive purchases of Japanese government bonds. The bank started QQE in April 2013 and expanded it in October 2014.
The depreciation of the yen has also played an important role in the performance of Abenomics, the policy package Japanese Prime Minister Shinzo Abe has advocated for overcoming a long-lasting economic slump with mild but stubborn deflation. First of all, it has sharply increased profits for Japanese exporters. Secondly, it has led to soaring stock market prices. Finally, it has resulted in the increase of corporate profits and therefore has increased the amount of corporate tax income for the Japanese government.
Furthermore, the weaker yen contributed significantly to the climb of consumer prices toward the 2 percent inflation target under Abenomics. Although slipping oil prices began to affect the consumer price index (CPI), the bank insists that the underlying trend in inflation is still improving because the CPI—excluding energy and fresh food—has been rising by around 1 percent on a year-on-year basis.
The bank basically intended for the negative interest rate policy to maintain the weaker yen trend, because when global markets have been risk averse, the yen has attracted a great deal of money as a safe haven. Many major central banks have adopted unconventional monetary policy in order to be more economically competitive, and in Europe, a negative interest policy was introduced in the eurozone, Switzerland, Sweden, and Denmark. However, the BOJ is the first to adopt negative interest rates after a massive government bond-purchasing program.
Negative interest vs QQE
So why did the BOJ adopt a negative interest rate instead of expanding QQE? First and foremost, it may reflect the bank’s shift from short-term to longer-term strategy to reach its 2 percent inflation target by adding a new measure that has more potential for expansion than the purchase of government bonds. In fact, it has become harder to reach the inflation target because of the plunge in oil prices. When the bank started QQE in April 2013, it declared its plans to reach its target in two years. Now, almost three years later, the actual inflation rate still hovers around 0 percent, and the bank’s newest prediction indicates that target realization has been delayed until the middle of 2017, taking about four years to achieve. However, there is consensus among market economists that Japan cannot reach 2 percent inflation even by the beginning of 2018.
One major problem is that the massive purchase of government bonds was presumably designed as a relatively short-term program. Many market participants and some economists believe that QQE is close to its limit because the amount of trade-able bonds has declined in secondary markets. Some of them think that one more expansion of the bond-purchasing program may be the final shot for additional quantitative easing. While Kuroda has repeatedly insisted, sometimes nervously, that there are no limits to the bond-purchasing program, it’s undeniable that the negative interest rate was implemented in order to prolong the life of QQE.
Despite the introduction of the negative interest rate, the upward pressure on the yen has continued. The fear of shrinking profit margins for financial institutions has eclipsed the expectation of positive effects from cutting the interest rate down below 0 percent. This fear led to a severe plunge in stock values in the banking sector, and therefore made investors more risk averse. So it ended up promoting the appreciation of the yen as a safe asset.
Moreover, in spite of the fact that the bank’s decision led to the yield of Japanese governments bonds decreasing, the gap between U.S. and Japanese government bond yields, which greatly affects the value of the yen against the dollar, tightened and incurred upward pressure to the yen, rather than widening and bringing down the pressure on the yen, as the Bank of Japan had expected. This was because the value of U.S. Treasury bond yields dropped more sharply than Japanese bond yields, mainly due to concerns over the current market expectations for the sustainability of U.S. economic growth and new perceptions of a slower pace for additional interest rate hikes by the Federal Reserve.
Finding an engine for inflation
Even though global markets seem to have calmed down now, their vulnerability still lingers. This situation provides Kuroda with a dilemma. He has said that if necessary, the bank would reduce the interest rate further into the negative range. However, it’s not clear whether Kuroda’s confidence in controlling the market is realistic considering its current vulnerability.
Nevertheless, Kuroda will keep pursuing his 2 percent inflation target. And here is the genuine problem. Unfortunately, without weakening the yen, it’s hard to find a promising and credible engine to reach 2 percent inflation in the Japanese economy. That’s not all. Kuroda needs to recognize that inflationary pressure brought about by the weakening yen is unlikely to stimulate domestic demand and could instead bring down consumer confidence.
In spite of remarkable increases in corporate profit, mainly driven by the weaker yen, fixed investment by businesses has increased at a very slow pace. Moreover, wages in nominal base have not kept up with the momentum of the underlying inflation, and the benefits of dropping oil prices, including the increase in household purchasing power, have not been effectively transferred to the economy as a whole.
As a result, the weakening yen has hardly activated the next engine: domestic demand. Many individuals do not recognize that inflation is beneficial for them because of the weakness of wage growth. As time goes by, will the weaker yen simply lead the Japanese economy to the next step, where strong domestic demand holds back the Japanese economy from decline? Or, as Kuroda’s predecessor at the bank had emphasized, should structural reform be the central policy instead of monetary policy, even though structural reform takes much longer to bring about secure results?
The International Monetary Fund has recommended that advanced economies avoid relying on monetary policy excessively, and if there is fiscal space, near-term fiscal policy would help to achieve a more balanced recovery. In Japan, over-reliance on monetary policy is an obvious fact. However, given the huge amount of public debt and the unavoidable decline of the population, is further financial stimulus desirable and feasible?
There are no easy answers to these questions. But at least the BOJ should transform its policy in order to fit a longer fight against deflation, including reducing the amount of bonds purchased in the near future. On the Abe administration’s side, structural reform, including revitalizing labor markets, should focus on establishing sustainable wage growth without relying on the effect of the weakening yen or simply requesting that companies increase wages. These difficulties illustrate how serious the struggle ahead will be for the Bank of Japan and Abenomics.