Following a meeting in November 2016, the Bank of Japan (BOJ) has decided to continue its previously established monetary policy of negative interest rates. The BOJ’s Negative Interest Rate Policy (NIRP) is part of of the larger set of economic policies commonly referred to as “Abenomics,” a mixture of economic strategies put forth by Prime Minister Shinzo Abe that are aimed at stimulating the Japanese economy. Along with negative interest rates, the Bank of Japan has also pursued Quantitative Easing (QE) to increase the money supply, and Abe introduced a 10.3 trillion yen fiscal stimulus bill in 2013. Created with the goal of revitalizing Japan’s economy, these policies are aimed at increasing spending in order to increase aggregate demand in Japan.

In January 2016, Japan made headlines when it announced that it would cut interest rates to -0.1%. This policy was only applied to new excess reserves that banks deposited at the Central Bank. At the time of the policy implementation, existing balances were allowed to have an interest rate of 0.1%. By the BOJ’s new policy, required reserves (the money that the bank is required to hold) will have 0% interest rate, and any reserves in excess of this will be subject to the -0.1% rate.

Faced with a weak economy and low consumer and business demand, the Bank of Japan has turned to this unconventional form of monetary policy in hopes of providing a much needed jolt to incentivize investment, since QE and Abe’s stimulus package have not done enough to increase consumption. Though it has only been less than a year since the policy’s implementation, results have not been as promising as predicted.

The use of negative interest rates is not exclusive to Japan; this form of monetary policy has been used in other areas of the world, most notably the Eurozone. In June 2014, the European Central Bank became the first major bank to adopt negative interest rates, with the monetary officials in Sweden, Switzerland, and Denmark following suit in the following months.

What are Negative Interest Rates?

Negative interest rates are highly unconventional and usually represent a last-ditch effort by central banks to spur economic growth. Central banks work as a bank for commercial banks, allowing them to borrow or lend money. With positive interest rates, commercial banks are paid to deposit money at the central bank, creating what are called “excess reserves.”  Banks are generally only required to hold a fraction of depositors’ balances as cash, which is determined by the central bank. Excess reserves are cash reserves held by the bank that are above this required amount. When interest rates fall below zero, they function as a deterrent to banks for holding excess reserves by forcing the banks to pay a fee on them.

The goal of establishing negative interest rates is to make it less attractive for banks to hold on to their excess reserves, pushing them to make more loans. This increases the money supply, leading to greater liquidity and greater aggregate demand. This will in turn push prices up and help to combat deflation.

Though many people would think that low prices are a cause for celebration, low prices and deflation are two of the most challenging problems facing Japan right now. During deflationary periods, consumers are less likely to spend money. When prices fall continuously, consumers adopt a “deflationary mindset”: consumers anticipate even lower prices in the future and refrain from spending money in the present so that they can have more buying power in the future. This leads to a decline in consumer spending, slowing down the economy. Negative interest rates are intended to encourage consumers to spend their money now, rather than later, so that consumer spending, which is a part of the calculation of GDP, will increase for the period. If the banks pass on these negative rates to depositors, one concern that banks must deal with is the threat that people will simply withdraw their money from the bank and prefer to hold cash.

At the same time, negative interest rates also lead to currency depreciation. When interest rates are high, they tend to attract foreign investors, leading to a greater demand for the currency. However, when interest rates are low, or in this case negative, foreign investors are turned away and domestic investors seek other places to invest their money. This leads to an excess supply of their currency in the market, which contributes to currency deprecation. This can be beneficial because a weaker currency can increase inflation and stimulate demand and corporate earnings. A weaker currency can also increase Japan’s competitiveness on the world market. When the yen depreciates, Japanese goods become “cheaper” relative to other goods in the world market. As a result, this effective decrease in price leads to an increase in demand for Japanese goods by other countries, which will increase Japanese exports and lead to growth in GDP.

How well have they worked?

Despite the theoretical model, negative interest rates have not been particularly effective. Contrary to expectation, the yen has been extremely resilient. At the beginning of 2016, the USD/JPY exchange sat at 120 yen to 1 USD, but that number has since gained over 10%, falling below 110 and reaching around 101 at its lowest points. 2016 has been a year of uncertainty, with events such as Brexit and Donald Trump’s election as the President of the United States. Because the yen functions as a safe-haven investment, investors have gravitated towards the yen this year, causing the currency to appreciate and leading to a decline in the value of net exports.

Japan has also seen little in the way of inflation, making its goal of achieving 2% inflation by the fiscal year 2017 seem like an unlikely target (current predictions are around 0.8%). Consumer prices have not been increasing and consumer spending is continuing to fall. The savings rate among Japanese consumers has always been high, historically, but consumers are even less willing to spend in an uncertain economy with small wage gains.

Though gains have been small, reports show that Japan’s economy grew faster than expected during the third quarter, with GDP expanding 2.2%. Net exports were able to increase by 1.9% this quarter, despite the strength of the yen, but domestic spending only rose by 0.1%. This highlights the increasing challenge that Japan faces with regards to lackluster consumption. Some economists also predict that this robust growth will not last, as exports might not be able to stand up to further strengthening of the yen.

In September, the Bank of Japan acknowledged the fact that it has fallen off schedule, but has shifted its target year back further, moving from fiscal year 2017 to fiscal year 2018. This timeline has not changed with the most recent meeting of the Bank of Japan. However, with the continuing stagnation of the Japanese economy, it is hard to say what will lie in Japan’s future.

Please reach out to Betty Liu at bettyliu@princeton.edu for any questions, comments, or concerns.

Written by thefinancier

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