(3.3) FAQ: The Why and What For of BOJ’s Negative Interest Rates

The Bank of Japan surprised investors last week by introducing negative interest rates.  At the World Economic Forum in Davos a couple weeks ago, BOJ Governor Kuroda appeared to deny that such a move was under consideration.  The market's focus, like ours, was on the pace by which it was expanding its balance sheet (JPY80 trillion a year).    The FAQ format may be the most effective way to explain what the BOJ did, why and the implications for investors.

At the conclusion of its two-day meeting, on January 29, the BOJ decided by a 5-4 vote to introduce a three-tiered reserve system that includes a negative rate for some reserves.

There are currently about JPY250 trillion held by the BOJ.  The first tier, called the Basic Balance, is the existing level of reserves at the central bank (average current balance last year).  The Basic Balance accounts for the vast majority of reserves, accounting roughly for JPY210 trillion and will continue to earn 10 bp annualized.  The second tier is called the Macro Add-on Balance.  This includes required (as opposed to excess reserves), and funds borrowed from BOJ under a number of its existing lending programs.  There will not be interest earned or paid on the Macro Add-on Balance, which accounts for about JPY9 trillion of reserves.  It is only the third tier (Policy-Rate Balance) that will be charged 10 bp by the BOJ.   It will include new excess reserves created by the BOJ asset purchase program; it calls Qualitative and Quantitative Easing (QQE).   The BOJ projects Policy-Rate Balance to amount to JPY10-JPY30 trillion.

Several central banks have now adopted some form of negative rates.  They include the European Central Bank, the Swiss National Bank, the Danish National Bank, and Sweden's Riksbank.  Outside of the ECB, the others have a tiered reserve system.  The BOJ's version seems to apply negative rates to the smallest subset of reserves.  There had been rumors in November that the ECB could adopt a tiered approach in December.  While this did not materialize, it could in March.

A few hours before the BOJ meeting concluded, several economic reports were released that showed Japan's economy may have contracted again in Q4.  Headline inflation slowed to 0.2% year-over-year in December.  This is less than the pace seen in 2014, when allowances are made for the sales tax hike in April of that year.   Even excluding food and energy, the core rate slowed to 0.8% year-over-year from 0.9%.  Financial conditions had deteriorated.  Japanese stocks had fallen around 20% since early December.  Japanese interest rates had stopped falling despite the ongoing BOJ purchases.  The yen had appreciated roughly 7% on a trade-weighted basis since early December.   The BOJ took some operational measures in December to help facilitate the continued large-scale asset purchases, though the IMF and others have expressed concern of the approaching limits to the bond purchases.

BOJ officials should be pleased with the initial response.  Yields fell as did the yen.  Stocks rose.  Japan's yield curve is now negative through nine years.  In comparison, the German curve is negative through seven years.  Switzerland pays a negative yield through 15-year maturities.  The BOJ's move spurred global bonds and stocks to rally.  It may have encouraged some participants to grow even more suspicious of the Fed's ability to hike rates again.  Specifically, the December Fed funds futures contract implies about a 33% chance that the Fed does not even hike rates once this year.

The BOJ said that the purpose of its rate cut was to drive down the cost of borrowing to boost consumption and investment by households and businesses to boost inflation.  It is also aimed at persuading banks to deploy their funds to achieve better returns.  This is to boost lending.  We suspect that Japanese banks will first try to minimize the funds in the Policy-Rate Balance, and may try to pass some cost on to customers.   Japanese banks may also try to boost lending not just to domestic parties but internationally as well.

 Although we were as surprised as everyone else by the BOJ's move, we think it can be understood in its domestic context.  The economy was struggling to grow even by the subdued 0.5% pace considered trend growth by the BOJ.  Without the stronger growth, a given the lackluster wage increases despite full employment, the inflation target is elusive.  The BOJ pushed out its achievement of its target another six months to the start of FY17.   Japan's exports fell 8% year-over-year in December.  It was the third consecutive month of declines and the largest since September 2012.

 If Japan did fire a shot in the currency wars, surely Japan's trading partners would vigorously respond and call it out.  This is what its G7 partners did in the early days of Prime Minister Abe's government in early 2013. .  At that time, many G7 officials thought Japan was crossing a line in its attempt to talk the yen down.  However, the criticism Japan faces is it may be relying too much on monetary policy and not enough on structural reforms (the original third arrow of Abenomics)    Manipulating currencies is a zero sum exercise.  It allows, at most, one country to take the aggregate demand from a trading partner.  It can lead to a downward spiral, the beggar-thy-neighbor approach that leads to mutual ruin.  Manipulating interest rates needs not be zero-sum.  It can help spur demand.  It trading partners could also respond by easing monetary policy; thus boosting demand further.   Bernanke argued against claims the US was engaged in a currency war because on a trade-weighted basis the US dollar has been appreciating for four year and net exports are a drag on growth.  We reject claims that the BOJ reacted to ideas that China is engaged in a currency war.  Instead, we see the PBOC spending hundreds of billions of dollars to resist the downward pressure on its currency and fend off a speculative attack by leveraged asset managers.  We note that Chinese exports are also weaker on a year-over-year basis.  On the BIS trade-weighted measure, the yuan remains near the recent record high set in July of last year.

Some observers had argued that the prospects of Fed tightening would have stayed the hand of other central banks.  It did not.  ECB President Draghi strongly hinted of additional action in March, after pushing the deposit rate deeper into negative territory in December.  Clearly, the Fed's action did not deter the BOJ.     The mere fact that other central banks are responding to their mandates does not directly impact the Fed.  However, the channel of transmission could be the exchange rate.  Fed officials have cited the dollar as a headwind for exports and import prices.  It regards the dollar's appreciation as a transitory phenomenon.  That suggests what concerns monetary officials in not the level of the dollar but the pace of its movement.    For trade-weighted considerations, we note that the euro has been largely confined to a two-cent range since early December.  The Canadian dollar has appreciated about 5% against the dollar and the Mexican peso has appreciated by about 2.5% since January 20-21.  The yuan is flat over the last couple of weeks.  The slow growth (0.7% annualized in Q4) and the recent turbulence in the market may be more important considerations for the Fed than BOJ action.  That said, while we doubt that the Fed will deliver four hikes this year as the December FOMC meeting implied, but at the same time, we think the market is exaggerating in the other direction by not fully discounting a single hike.