(This essay was published in Hong Kong Economic Journal on 11 February 2016.)
On 29 January the Bank of Japan (BoJ) surprised investors and economists by pushing a key interest rate into negative territory. This was its latest attempt to reflate the country’s price level and rekindle economic growth, and it came just days after BOJ Governor Haruhiko Kuroda told the World Economic Forum in Davos, Switzerland that the central bank had no plans to adopt negative interest rates.
The BoJ is the latest central bank to enact negative rates The European Central bank and the central banks of Switzerland, Denmark and Sweden have also done so.
Japan’s move looks like a desperate attempt to encourage banks to lend to businesses instead of hoarding cash, and rekindle the flagging economy, rather than a program meant to make a real difference.
Only a small proportion of reserves is affected since the minus-0.1% interest rate applies only to subsequent increases in the bank’s excess reserves. This ensures that on average, more than two-thirds of reserves will continue to earn 0.1% interest while a sizable remainder will still earn 0% over the coming year.
The Privilege of Quantitative Easing
Nonetheless, there is a real worry that the BoJ is running up against serious limits in its quantitative-easing strategies and that it fears further expansion of its 80 trillion yen ($666 billion) a year program of purchasing government bonds would be difficult to execute.
Negative interest rates underscore questions about the effectiveness of quantitative easing alone to target inflation in Japan. Even so, the BoJ will continue to remain under pressure to ease rates further if the economy continues to slide. It is likely to push rates further into negative territory rather than ramp up asset purchases.
All of this will weigh on Japanese government bond yields. Maturities out to eight years are now in negative territory. If interest rates move further into negative territory (even if they do not affect all reserves held at the BoJ) then banks could move their deposit rates below zero in response, which will leave life insurers, pension funds and even individuals with no incentive to sell Japanese government bonds to the BoJ.
The central bank will then approach a situation where it cannot stop buying bonds—to do so would defund a government that has no other major buyers of its paper than the BoJ—and where it cannot find enough bonds to buy, other than the new issuance of the government.
This is a predicament the US has been able to avoid so far with its quantitative easing. Because of the deep market for US government bonds and the dollar’s status as the world’s dominant reserve currency, the Fed does not have to worry about asset purchases running up against limits.
At the end of the day the effectiveness of quantitative easing rests on an American privilege to issue debt in the world’s dominant reserve currency that people are willing to hold. Japan does not possess the same privilege. Even Europe does not have the privilege given its lack of a central fiscal authority for issuing pubic debt.
The Limitations of Monetary Policy Alone
Over in Europe, Stanley Fischer (now vice chairman of the Fed) found the introduction of negative interest rates there since 2012 surprisingly successful. But this is because its central banks had a shorter-term objective of influencing exchange rates rather than longer-term aims of rekindling economic growth or reflating prices.
The broader economic circumstances also need to be taken into account when one considers the effectiveness of government policy measures. The world today is in a massive debt driven balance sheet recession. Balance sheets are highly inflated, with mismatches of asset and liability term structures causing an enormous amount of uncertainty.
Consider how differently a person with a net worth of $1 million and no debt liabilities will behave compared to someone with the same net worth but a debt liability of $100 million. Of course the debt-ridden person will feel a lot less secure and be far more cautious. Boosting economic growth and reflating prices depends on the willingness of businesses to invest and households to spend – a willingness that ultimately depends on confidence in the future.
The most important lesson of the Great Depression, according to Milton Friedman, is that central banks must not tighten liquidity and credit if there is the threat of imminent loss of market confidence and deflationary pressure; otherwise they risk pushing the economy into a depression. The quantitative easing policies of the US have avoided this since 2008, but it is now obvious that monetary policy alone cannot rekindle economic growth and reflate the economy.
Negative interest rates, like quantitative easing, are just another unconventional monetary policy. There is no empirical evidence that they alone are able to rekindle growth and reflate prices, especially when uncertainty still abounds. Unemployment is down and labor markets are tight in the US, but inflation has still stubbornly failed to reach the targeted 2% level.