The Reversal of Japan’s Negative Interest Rate Policy

Introduction

On March 19th, the Bank of Japan (BOJ) made a significant policy shift, stating that with a 2% inflation target

now within reach, they would be phasing out a series of aggressive measures originally implemented to

combat the country’s persistent deflation. Since 2016, Japan’s central bank has maintained a short-term

interest rate target of minus 0.1% as part of an ultra-accommodative policy designed to support the economy,

going against the grain of the world’s leading central banks, which have increased interest rate rises over the

past two years in the face of soaring inflation. For the first time since 2007, the BOJ increased its target for

overnight loan interest rates, from between minus 0.1% and zero to between zero and 0.1% - becoming the

last central bank to scrap its negative-interest-rate policy. Additionally, the BOJ will halt its purchases of

exchange-traded funds and discontinue its yield-curve-control policy, which was designed to keep long-term

bond yields in check. Nevertheless, the Bank of Japan emphasized that its overall policy approach would

continue to be supportive: the termination of its most unorthodox strategies is not indicative of an impending

phase of monetary tightening.

Exhibit 1: Bank of Japan has ended its negative interest rate policy after eight years; source: Financial Times

Japan’s Overall Economic History

After World War II, Japan was in ruins, facing severe infrastructure damage and an economic downturn. However, Japan’s recovery and economic development in the decades following the war are known as “economic miracles." This transformation was driven by a combination of factors, including land reforms, industrial policy, labor practices, and foreign assistance, particularly from the United States throughout the Dodge Plan and later the Marshall Plan. The key to Japan's post-war economic miracle was a strategic approach that combined government-industry cooperation, the establishment of a dedicated and educated workforce, and significant investments in technology and manufacturing capabilities. The Japanese government, through entities such as the Ministry of International Trade and Industry (MITI), played a crucial role in guiding the economy, identifying strategic industries or developments, and facilitating the restructuring of the Japanese economy from a focus on light industries to heavy industries and technology.

The 1950s and 1960s saw Japan experiencing unprecedented economic growth, with an annual GDP growth

rate averaging around 10%. Companies like Sony, Toyota, and Honda became symbols of Japan’s economic

resurgence, competing internationally with their Western counterparts. However, this rapid economic growth

came with its challenges.

Japanese Asset Bubble and the Lost Decade

The Plaza Accord of 1985, which aimed to depreciate the US dollar, has significant implications for the Japanese economy in the coming decades. A decade before the agreement, a strong dollar boosted Japanese exports. This agreement almost doubled the value of the yen against the dollar and threatened to undermine Japanese exports due to their raised prices. The Japanese Ministry of Finance responded by lowering interest rates and flooding the economy with extra cash. Additionally, to support banks, the ministry decided to encourage lending not only to corporations but also to small and medium-sized companies. Having all this extra cash, the companies, rather than supporting their operations, decided to speculate in the real estate markets, allowed by little land regulation, low tax rates, and loopholes in tax law on capital gains from land. Thus, the land price in central Tokyo started rapidly accelerating: 10.4% in 1986, 57.5% in 1987, and 22.6% in 1988 (Cutts). Banks started lending against the inflated prices and giving out riskier credits, which again further fuelled the land speculation cycle.

Exhibit 2: Bubble Burst in Japan; source: National Institute of Graduate Policy Studies

With fear of the economy becoming overheated, the BOJ started hiking the interest rates in 1989, continuing with the raises as the real estate prices resisted up to 1991, even as the stock prices had suffered greatly. The bubble burst rate of business bankruptcies rose by 66%, and wages decreased massively. Financial institutions were ill-equipped to handle the aftermath of the bubble burst, contributing to the decade of stagnation that followed. From 1991 to 1999, output growth averaged 1%, compared to the previous decade’s 4% (Bayoumi, Collyns). This experience led to the questioning of traditional macroeconomic policies and made Japan try unorthodox tools. In 1999, it lowered interest rates to zero, but a premature increase the following year led to further deflationary pressures. Responding more aggressively, the BOJ introduced quantitative easing in 2001, marking the first use of such a policy by the post-war central bank, through the purchase of bonds with newly minted money. The Nikkei Index only reached the 20,000 points in 2015, which was only half of its high during the bubble in 1989.

Beginning of the Negative Interest Rate Policy

The approach to monetary policy shifted dramatically with Kuroda Haruhiko’s appointment as governor of the BOJ in 2013. Kuroda launched an extensive monetary easing programme, pledging to deploy a “bazooka” of stimulus measures. This initiative set a 2% inflation target and involved “quantitative and qualitative easing," including significant purchases of government bonds and the use of forward guidance to promise continued loose policy. In 2016, the BOJ introduced a negative key overnight interest rate of -0.1%, effectively charging commercial banks for deposits, and then began to implement yield-curve control in order to restrain longer-term interest rates. Before putting in place the negative interest rate policy (NIRP), the bank’s efforts were foundering. Its main tool was an extensive bond-buying program, similar to policies adopted by the FED and the ECB. This strategy is intended to pump money into the nation’s financial veins, with the expectation that it will then circulate throughout the broader economy. It worked for a while but after the effects faded, prices were falling again and the BOJ needed to introduce a new tool – the NIRP.

The Negative Interest Rate Policy: How Does It Work?

Under negative interest rate policies, depositors effectively pay to store their money, which flips traditional.

economic principles on their heads. Typically, it’s the banks who find themselves in the role of depositors

when they park their excess funds with central banking institutions such as the Bank of Japan, and they usually earn a modest interest rate for their deposits. However, when negative interest rates are in place, this dynamic changes: central banks apply a charge to these holdings. This mechanism is designed to incentivize commercial banks to redirect their capital towards more active financial engagement, funnelling money into the hands of consumers and businesses by extending loans. The intention behind negative interest rates is to create a domino effect in the economy by reducing loan costs broadly, thereby fostering an environment that is conducive to economic expansion.

Effectiveness of NIRP

The effectiveness of negative interest rates and expansive monetary policy has been subject to debate around the world. In the context of Japan, these may have had a stabilising effect, particularly when used together with the BOJ’s aggressive asset-buying programme, which likely helped avert a more intense deflationary spiral. However, the true shift in Japan’s price dynamics did not materialise until the country, like many others, faced the disruptive supply shocks brought on by the COVID-19a pandemic, coupled with the economic repercussions stemming from Russia’s military actions in Ukraine. These global events led to pronounced increases in the costs of imports, such as energy, materials, and food. These surges in import costs were significant enough to push Japanese inflation beyond the BOJ's target threshold of 2%.

By putting in place a negative interest rate policy, the BOJ was trying to elevate consumer prices, which have been on a downward trajectory for much of the past 20 years. Decreasing consumer prices are detrimental to corporate earnings, leading to constraints on salary increases and inhibiting investment in new initiatives by companies.The BOJ’s commitment to a negative interest rate policy, even as it became the last of the global central banking institutions to do so, had significant and complex repercussions. This enduring policy stance began to impinge on the profitability margins of domestic banks. Furthermore, as central banks in other parts of the world started to escalate interest rates in response to inflationary pressures, the comparative draw of the yen diminished, leading to its depreciation. This scenario has resulted in a challenging economic environment for consumers, who face the double whammy of a weakened national currency and salaries that do not rise commensurately with the accelerating costs of living. Such a squeeze on household budgets presents both immediate and long-term challenges for the Japanese economy, as consumer spending power is a critical driver of economic health and vitality.

The First Rate Hike in 17 Years

After a 7-to-2 vote in favour of raising the interest rates, the governor of the BOJ commented that this policy had fulfilled its purpose, citing the steadily rising wages and prices and maintaining that the 2% goal of annual inflation “had come into sight.” According to the IMF, negative interest rates boost the economy the same way conventional monetary policy does: pulling down the interest rates means less costly borrowing and spending, which means more demand and rising inflation. Some debate the effectiveness of the policy, but where did BOJ get the confidence? At the beginning of the policy implementation, the effects were not that evident; negative interest rates did not affect the Japanese yen, as other central banks had also utilised the negative interest rates. Nevertheless, because of the disruption of supply chains triggered by the global pandemic and the war in Ukraine, the Federal Reserve raised rates, with the ECB ending its negative interest rate policy in July 2022. The differences between the regions’ rates and the negative interest rates incentivized investors to move their money from the yen to the euro and dollar, driving down the yen. The persistently low valuation of the yen has amplified the cost of imports further, exerting inflationary pressures in areas that directly affect the consumer, notably energy, basic materials, and foodstuffs. Following that, the Japanese importers passed down the increased prices to consumers. With the government data showing a 2.85% year over-y increase in consumer prices in February and a 2.2% increase in January, this exceeded the target of 2%, convincing the BOJ to end the policy. However, many still debate that the policy alone could not have effected such a change, as minus 0.1% was not different enough from zero. The second reason for the first hike in interest rates in 17 years can be attributed to the unprecedented increase in wages. In Japan, real wages have stagnated since the 1990s. Nevertheless, with the inflationary pressures stemming from the war in Ukraine and government pressures to increase wages, this year’s shunto (wage negotiations in Japan) is setting a milestone.As workers demand to increase wages to match the increasing inflation, the unions negotiate with companies for wage raises. The increase in living costs, matched with ongoing labour shortages in Japan, has given the trade unions the ability to negotiate the highest wage increase since 1992. Nippon Steel gave its workers’ 11.8% rise in wages, ANA 5.6% (the highest since 1991), and Honda 5.6% as well (the highest since 1989). Morgan Stanley estimates that the final round increase will be around 4.8%, which is significantly higher than the inflation rate. In Japan, a country with strong deflationary pressures, this expected significant wage increase could signal steady consumption growth and perhaps a more positive outlook after this daring step from the Bank of Japan.

Outlook for the Future

Two of the nine members of the BOJ’s board thought that the increase in interest rates was too rushed, believing that the economic recovery was still too fragile for that change. So did the Prime Minister, Fumio Kishida, who thought that it was too early to celebrate the “end of deflation.” Despite the return of positive interest rates, the BOJ’s governor has signalled that borrowing costs will not increase sharply, indicating that there are no future rate hikes to be expected. There, indeed, is a reason for caution. With China struggling in its recovery, the BOJ has warned that the Japanese economy will be subject to downward pressures stemming from the slowdown in the recovery of overseas economies. Additionally, a big test is coming up for the Japanese economy. The expected interest rate decrease from the Fed will appreciate the Japanese yen, slowing the external inflationary pressures, leaving the success of the rate hike to the possible wage increases and following consumption increases. After eight years of a negative interest rate policy with ambiguous results, a question has to be asked: what other tools does Japan have? Fiscal policy may play a crucial role in fueling confidence in growth. This may include reforming the tax system to accommodate fresh economic activity or fiscal packages. Japan is planning to use a fiscal package in November, which will help the confidence of the Japanese economy as it moves from the stagnation of the last three decades to nominal growth. Additionally, with expected human capital reskilling in Japan, the growth of the GDP may accelerate. Addressing employment issues, such as wages and pensions, has been crucial in reversing the negative interest rate policy and will remain so in the future. The path ahead remains uncertain, and even though the experiment has come to an end, it is certain that the policymakers will keep the negative interest rates in the toolbox in case of future shocks.

Conclusion

The effectiveness of the negative interest rate policy, or NIRP, designed to combat deflation and stimulate growth after the burst of the asset bubbles in the 1990s has been debated. While it may in part have eased the deflationary pressures, the decision to end the NIRP has been influenced by the disruption of supply chains due to the global pandemic and geopolitical crises. The decision to raise interest rates for the first time in seventeen years has been led by the recent milestone in the increase of wages and consumer prices. Still, there are concerns about the fragility of the growth as Japan takes a step towards policy normalization. Even though negative interest rates have come to an end, their legacy calls for adaptive strategies for the future.

References

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