Bank of Japan Ends Era of Negative Rates: Over the course of last week, in a historic move, the Bank of Japan has abandoned its negative interest rate policy, which had been in place for over a decade, this signifies a significant shift towards a tighter monetary policy aimed at curbing inflation.
By raising borrowing costs (overnight interest rate target range set at 0% to 0.1%), the Bank of Japan (BoJ) hopes to discourage excessive borrowing and spending, ultimately slowing down inflation. This decision positions Japan as the last major economy to move away from negative interest rates. Before we delve deeper into the shift in Japan’s monetary policy it's better to explain what are interest rates and why the Bank of Japan put it in negative in the first place.
Interest rates 101
To put it in simple terms, interest rates are the cost of borrowing or the opportunity costs of savings. It refers to the return on investment for lending money, in a way it represents the percentage of the loan amount that is charged over a certain period of time, usually expressed annually.
When you borrow money, such as taking out a loan for a car or mortgage for a house, you agree to pay back the amount you borrowed plus an additional percentage, which is called an interest.
Similarly, when you save money in a bank account or invest in bonds or other financial instruments, you earn interest on your savings or investments (thus why it is called the opportunity cost of savings). It determines how much money you will earn overtime on top of your initial capital invested.
Interest rates generally can be influenced by various factors, including central bank policies, inflation, economic growth, and supply demand for credit. As the recent news, central banks like the Federal Reserve in the US and all around the world have been raising interest rates in controlling inflation. Due to external effects on the world market, like the war in Ukraine and disruption in the supply chain, countries are forced to raise interest rates as central banks aim to make borrowing more expensive and incentivise saving.
This reduces the amount of money circulating in the economy, slowing the price increase. Interest rates are one of the many important financial instruments in the economy, and there are many economic theories revolving around it, one of many includes the Liquidity Preference Curve; the theory that explains the demand and supply of money in the market influenced by interest rates.
Why negative?
The Bank of Japan first introduced the negative interest rate in 2016 to encourage borrowing and spending in the economy. When interest rates are negative, commercial banks are charged to keep the money in their reserves and are encouraged to liquidify their assets. It is intended to have banks lend money more to businesses and individuals rather than keeping it idle.
If you are still confused, see it like this. When the interest rates decline, the cost of borrowing and the opportunity cost of savings decreases. This means, that when the interest rates go down, it is cheaper to borrow and it is less ideal to save as the returns you get from your savings become less. Therefore when the interest rates become negative it is savings will have negative returns and borrowing becomes beneficial.
This encourages lending and spending, the BoJ was aiming to stimulate economic activity, boost investment, and fight against deflation. The case of deflation can discourage spending and investment because consumers and businesses may delay purchases in anticipation of lower prices in the future, leading to a slowdown of economic growth, or worse a recession (negative economic growth).
Negative interest rates also weaken the Yen, the national currency of Japan, making it more attractive to consumers as the exports from Japan are relatively cheaper than other countries. Although that is the case, the lower interest rates cause investors to seek higher returns elsewhere as the returns are less.
How did BoJ cause negative Interest Rate?
The BoJ’s negative interest policy involved large-scale purchases of government bonds. This method has significantly increased Japan’s government’s debt, raising concerns about long-term sustainability.
The expansion of Japan’s balance sheet due to the purchase of bonds raises concerns about the potential financial risks if the BoJ needs to unwind its position (selling bonds), which could cause market volatility. This comes to the topic of this article, the new Japanese policy to raise interest rates for the first time since 2016.
So what now?
Essentially the reason for this change is that the BoJ aims to combat inflation and promote a “virtuous cycle” where rising wages lead to higher prices and economic growth. Signs of a strengthening Japanese economy, including recent wage hikes, provided confidence for this shift as Kazuo Ueda, the BoJ governor is confident in Japan’s new economy.
Gradual Tightening with Continued Support: Although the BoJ is raising borrowing costs, it emphasises a gradual and cautious approach. They signalled that further interest rate hikes will be limited, as inflation expectations haven’t yet reached their target of 2%. Additionally, the BoJ will continue purchasing a substantial amount of Japanese government bonds each month.
This ongoing bond-buying program aims to maintain accommodative financial conditions and support the Japanese economy, particularly considering areas like sluggish household consumption. Essentially, the BoJ is attempting a delicate balancing act — addressing inflation concerns while preventing a sharp economic slowdown.
The impact of this policy is likely to trigger adjustments in global investment flows as the yen weakened slightly against the dollar, and the stock market reacted positively. In addition to the negative interest rates the BoJ also removed yield curve controls, another measure used to stimulate the economy. It is still early to tell but some BoJ board members opposed the move, arguing for a more cautious approach until inflation is more stable and wage-price cycles are stronger.
