Is the Unconventional Effective?

The Downside to the Negative Interest Rate

Monetary policy in Japan is approaching a delicate stage. This is the first impression arising from the Bank of Japan’s Policy Board meeting of July 28–29. While market participants hoping for further easing were left dissatisfied, the meeting presented an opportunity to rethink the real nature of monetary policy.

Nearly three years have passed since Governor Kuroda Haruhiko of the Bank of Japan instituted monetary easing of a “different dimension,” firing the so-called Kuroda bazooka, and about six months since the adoption of a negative interest rate. How effective have these policies been? While the depreciation of the yen did lead to higher stock prices, an inflation rate of 2%, which initial plans assumed would have already been achieved, is still a distant goal.

Governor Kuroda explains the failure to achieve the inflation target by the unexpected decline of crude oil prices. Many private-sector economists, however, argue that the 2% target was never a realistic goal. Some even question the effectiveness of quantitative and qualitative easing, where the BOJ supplies massive quantities of liquidity through the purchase of Japanese government bonds (JGBs).

Monetary easing of a different dimension does garner some support among economists for what is assumed to be its real aim of inducing the depreciation of the yen. A majority of economists, however, have an unfavorable view of the negative interest rate policy that began in February 2016. In theory, this policy is meant to reduce the real interest rate, and the BOJ has presented a scenario where banks would use the funds returned to their balance sheets from their current accounts with the BOJ to lend to companies. But neither of these effects has materialized. Rather, the real economy is seeing disruptions and the proliferation of irregular financial transactions.

Expanding Foreign Currency Supply

In the report of the Policy Board meeting released on July 29, the board described no plans to adopt a more negative interest rate or expand quantitative easing. In short, the Policy Board simply affirmed the status quo. While the report was viewed as sidestepping the expectations of market participants, a development mostly overlooked by the news media was the doubling of the supply of foreign currencies to financial institutions (from $12 billion to $24 billion). Despite the lack of attention, this measure has great significance for Japan.

With the advent of a negative interest rate, Japanese banks have experienced a significant increase in their cost of raising dollar funds. Most Japanese banks acquire dollars through cross currency swaps that exchange yen for them. These banks must now pay a substantial premium over the base rate for dollar swaps. Specifically, the current cost of a five-year yen-dollar swap is the base rate plus 100 basis points (1%). This has removed the attractiveness of investing in US Treasuries, and Japanese banks are being driven to make credit investments recorded as risk assets on their balance sheets. Not only are their earnings worsening, but their future credit risk is growing—an extremely worrisome situation.

Expanding the supply of foreign currencies to financial institutions will ameliorate this situation. At his regular press conference held in May, Governor Kuroda rebutted the criticism of the negative interest rate that was then building in the financial industry by saying that monetary policies are not executed to satisfy financial institutions. This is an accurate statement, but only if two conditions are met. First, there must be reasonable expectations that the financial system will be stable going forward. Second, based on the stable management of financial institutions, monetary policies must propagate to the real economy through the financial activities of the private sector.

Unfortunately, neither of these conditions are currently satisfied. As the BOJ repeatedly lowered interest rates, expectations that rates would be even lower in the future became entrenched, the supply and demand for funds by companies was not stimulated, and banks disregarded credit risk to lend recklessly. Moreover, monetary policies squeezed the earnings of banks and weakened their financial functioning. The recent expansion of the supply of foreign currencies to financial institutions means that the BOJ has finally developed a means for addressing these two problems, even if only in part.

Needed: A Sober Review of Monetary Policies

In preparation for the Policy Board meeting of September, the BOJ will undertake a comprehensive review of the effects of quantitative and qualitative easing and the negative interest rate. This is also a welcome development. The addition of a negative interest rate to a monetary policy of quantitative easing through the purchase of JGBs has a flattened the yield curve in Japan by an unprecedented degree in global terms. Not only that, the negative yield curve now extends all the way out to bonds with 15-year maturity. This situation is so unusual that it deserves to be called pathological.

Observers with a political leaning ignore this unusual situation and maintain that the BOJ should engage in further quantitative easing and should adopt a more negative interest rate. Observers focused on the economy, however, are increasingly fearful about additional easing that would further flatten the yield curve. These observers assert that the BOJ should undertake a sober review of the effects of its monetary policies to date. It is reasonable to think that the International Monetary Fund shares this perspective. An annual report of the IMF Executive Board’s Article IV consultation with Japan released on August 2 stated that a looser monetary policy over a longer period of time could increase potential risks.

Also worth mentioning is the effect of a visit to Japan by Ben Bernanke, former chairman of the Federal Reserve Board, who arrived immediately before the July 28–29 BOJ Policy Board meeting. Bernanke’s meetings with Prime Minister Abe Shinzō and BOJ Governor Kuroda were quickly followed by the public discussion of “helicopter money,” where the BOJ would directly underwrite the budget deficit. This intensifying debate lacked the careful consideration needed due to its sudden appearance. So as to examine this issue in a more befitting manner, the BOJ should perform a comprehensive review of the effects of its past monetary policies. The Japanese central bank is no doubt well aware of this need.

Toward More Multifaceted, Rational Policies

The best scenario under current circumstances is to undertake this review to develop options for steepening the yield curve while maintaining a loose monetary policy. An increase of the interest rate for JGBs with long maturities will give rise to losses for the holders of such bonds. If this increase occurs now, however, the JGB holders will still have the financial strength to withstand losses. Once interest rates rise, new investments will begin to yield a return of some sort. The management of pension assets will improve, future uncertainties will ease, and household consumption will improve. Should the interest rate for long-dated JGBs increase, companies’ expectation for lower rates will dissipate, which can be expected to stimulate the supply and demand for funds.

Currently, Japan’s economy is being managed exclusively through a political mechanism that repeatedly warns of a crisis. Can a transition be made to management centered on an economic mechanism where financial functions perform as intended? Unless this transition can be achieved, it will not be possible to develop an exit strategy for Japan’s monetary easing of a different dimension. The BOJ is being put to the test regarding the development of a truly meaningful policy mix.