End of an Era for Japan's Negative Interest Rates
Author: Colin Chow, Research Executive
Editor: Tavisha Jain, Research Director
On 18 March 2024, The Bank of Japan (BoJ) announced a significant policy shift, marking its first interest rate hike in 17 years and ending eight years of negative interest rates. Since 2016, the BoJ embarked on a negative interest rate policy to prevent the further appreciation of the Yen (JPY) from damaging its export-driven economy and combating its deflationary spiral. To achieve a sustained negative interest rate level, the BoJ massively increased the money supply via the purchase of long-term Japanese government bonds (JGB): from 98 trillion JPY in April 2013 to 324 trillion JPY in June 2016.
When interest rates are negative, this signals to foreign investors that they earn lower returns on their investments, which will lead to diminished demand for the domestic currency (the JPY, on this occasion); thus, devaluing the JPY. Conversely, a negative interest rate would incentivize domestic consumption (by ‘paying consumers to borrow’), and signal to foreign trading partners cheaper exports. The impacts of the negative rate policy were evident, contributing to lifting Japan out of a deflationary spiral (in late 2016) caused by deflated energy prices and supply chain disruptions from a domestic earthquake.
Over the past two years, the Japanese economy has dramatically changed from its previously deflated state, with the CPI inflation rate surpassing the 2% target set in 2013 for the first time in almost a decade. While emerging from prolonged deflation, exacerbated by COVID-19, marks a significant achievement, the economy faced stagflation caused by challenges such as declining real wages, higher prices due to cost-push inflation, and subdued domestic consumption.
However, following the largest pay hike in 33 years by major firms, along with the consideration that inflation has remained above the Bank of Japan's (BoJ) 2% target for over a year, the BoJ was prompted to conclude its unconventional monetary policy. The BoJ’s changes in monetary framework included:
Discontinuing the negative interest rate policy.
Setting the uncollateralized overnight call rate to remain at around 0 to 0.1%.
Gradually phasing out its purchases of commercial paper and corporate bonds, with the aim of stopping this practice in about a year.
(Bank of Japan, 2024)
Whilst the BoJ remains cautious, indicating future rate hikes will be moderate and maintaining a commitment to accommodative financial condition, the policy shift may result in the unwinding of the JPY carry trades, potentially hurting Japan’s export-driven sectors.
The yen carry trade involves borrowing Japanese yen at low-interest rates to invest in assets with higher returns in other currencies. As interest rates in Japan rise, the carry trade becomes less attractive due to increased cost of borrowing. This dynamic can lead to a large-scale unwinding of carry trades, where investors sell off foreign assets and convert the proceeds back to yen, thereby increasing demand for the yen and potentially causing its appreciation. Additionally, artificially low interest rates in Japan have pushed investors to seek better returns abroad given near-zero returns at home. Higher domestic interest rates could make Japanese bonds and other financial instruments more attractive, encouraging the repatriation of Japanese capital. This influx of capital could strengthen the yen and increase liquidity in domestic markets but may also reduce the availability of Japanese capital in global markets.
Nevertheless, it is not projected that the recent increment in interest rates will have any large effect on investment flows. As per analysts, an increase in rates by 10 or 20 (0.1 or 0.2%) basis points will have a minimal impact on flows, with visible repatriation only occurring at a 50 (0.5%) basis point rise. This is not expected to occur any time soon, with Nomura expecting the BoJ to raise overnight rates to 0.25% by October (Ranganathan, 2024). The BoJ has reinforced this, citing “nimble responses” (Tan, 2024) in the form of increased Japan government bond (JGB) purchases and fixed-rate purchases of JGBs, among other things, should there occur a rapid rise in long-term interest rates.
It is thus expected that the BoJ observes caution when further raising interest rates, to minimize volatility in its currency and economy. Nevertheless, should there be some increase in upside risk to the price outlook, a policy change would be on the cards, as per the BoJ’s governor Ueda.
Attached to this essay are two supplementary readings by Haksar & Kopp (2020) and Claeys (2021), both of which serve to further clarify and elaborate upon the efficacy of negative rate policy on a more general level.
Further Readings
Haksar, V., Kopp, E. (2020, March). How Can Interest Rates be Negative? International Monetary Fund. Finance and Development, March 2020. https://www.imf.org/en/Publications/fandd/issues/2020/03/what-are-negative-interest-rates-basics
Claeys, G. (2021). What Are the Effects of the ECB’s Negative Interest Rate Policy? European Parliament. Policy Department for Economic, Scientific and Quality of Life Policies. Monetary Dialogue Papers, June 2021.
References
Bank of Japan. (2024, March 19). Changes in the Monetary Policy Framework. Press Release. https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2024/k240319a.pdf
Ranganathan, V. (2024, March 18). The BoJ won’t sway Japan’s trillions of investment abroad. Reuters. https://www.reuters.com/markets/asia/boj-wont-sway-japans-trillions-investment-abroad-2024-03-18/
Tan, C. (2024, March 18). Bank of Japan ends the world’s only negative rates regime in a historic move, abandons yield curve control. CNBC. https://www.cnbc.com/2024/03/19/bank-of-japan-boj-march-2024-policy-decision-mpm-meeting.html
Yoshino, N., Taghizadeh-Hesary, F., Miyamoto, H. (2017). The Effectiveness of Japan’s Negative Interest Rate Policy. Asian Development Bank Institute. Jan 2017, no. 652.