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Lessons from Europe for the BOJ

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Bank of Japan Gov. Haruhiko Kuroda attends a news conference at the BOJ headquarters on Dec.18, 2015.   © Reuters

The Bank of Japan on Jan. 29 became the latest central bank to set its deposit interest rate below zero, at -0.1%, following Denmark, Switzerland, the eurozone and Sweden, which all adopted negative rates in the past two years.

     The BoJ's move appears to have been forced on it by the failure of policies so far to get inflation back into positive territory. Japan has attempted a sustained fiscal stimulus, which left it with a 230% government debt to gross domestic product ratio, and a large scale quantitative easing program. Negative interest rates was a logical next step, as well as a possibility opened up by lessons learned from Europe.

     Before the 2008 financial crisis, zero was thought to be the floor to central bank rates. That the bound should be zero, or thereabouts, follows on from this: If the central bank offers you a negative deposit rate as an investment opportunity (or rather offers this to the bank that is acting on your behalf), in a modern economy, you always have the option of putting your money into cash, which pays a more healthy zero rate of interest.

     The floor is seemingly below zero -- though still perhaps not that far from it -- because putting money into cash is costly. It takes up physical space at some point, and has to be guarded and trucked about.

     The Bank of Japan back in 1998 became the first major central bank in the modern era to lower rates to what it thought was the zero bound. But economic activity and inflation failed to revive, raising the question of why the central bank waited so long to go negative. The reason is simply that, until a few years ago, the BoJ presumably shared the widespread view in central banking that negative rates would be damaging. But after watching the experience of European central banks that turned -- somewhat desperately -- to adopting negative rates, the BoJ learned that some of its fears were unfounded.

Three concerns

Before the European experiment with negative rates, Japan no doubt shared the three main concerns among central bankers about "going negative." The first was that cutting rates too far would weaken the balance sheets of retail banks. They saw that deposit rates were already pushed against their zero bound, and banks would have faced political difficulties in increasing non-interest rate charges on banking services. Yet, banks had tied themselves into loan rate contracts that were linked to the central bank rate. So rate cuts would have squeezed profit margins, leading to rates on new loans that were not shackled to the policy rate actually rising, tightening credit conditions just as policymakers were hoping to loosen them.

     A second concern was that very low or negative rates would cause an implosion of money markets, which oil the wheels of short term interbank lending, leaving the central bank as the only alternative for this kind of liquidity management.

     And third, there was a less well-articulated worry that zero or negative rates would at some point cause a rapid move into cash that could trigger a run on banks -- just what the authorities had been straining to avoid.

     None of these worries have been borne out by recent experiences. Five central banks have taken the plunge toward negative interest rates without prompting financial disruption or runs into cash. At the same time, many longer term interest rates embedded in government securities have fallen below zero, too. The BoJ's clear hope is that markets understand that negative rates will be sustained for as long as necessary, and that this will translate into a sustained fall in Japanese longer term interest rates, thereby boosting spending and inflation.

     In fact, it is hard to tell how effective a stimulus tool negative rates have been. The recent fall in longer term rates in European sovereign bonds may tell us as much about the worsening outlook for those European central banks that tried it as about the success of those central banks' signalling strategies.

     My guess is that the move will be stimulative, but not pivotal, in pushing inflation back up to target, and ultimately escaping the liquidity trap that Japan has been in for almost two decades now.

Size matters

Looking ahead, it is worth noting that the relatively small moves into negative rates tried in Europe do not amount to a crossing of the Rubicon where we might in the future see large negative numbers. I would guess that the Swiss -1% will prove to be the new lower bound.

     To eradicate the rates floor for central banks altogether would require a radical reform of monetary institutions that is unlikely to be on the agenda in the near future. One way of doing this would be to abolish cash altogether, so that if negative rates were applied to electronic money, investors would not have the option of zero interest cash.

     The idea has made it into the occasional central bank speech -- for example, in an address by the Bank of England's Chief Economist Andrew Haldane last September -- but it has been mainly as a thought experiment, not a serious policy proposition.

     For this reason, we are unlikely to see anything but marginally negative interest rates in Japan, as the BoJ will share the European consensus that abolishing cash would risk too much upheaval in the monetary status quo.

     Given that rates were anyway close to zero all along the Japanese yield curve, this latest move is not going to be a transformative moment in the Japanese recovery.

     For the U.S., U.K. and other Western central banks at the zero bound, this may mean that the burden of future stimulus, if it is needed, will fall on the fiscal authorities. For that to happen would require overcoming daunting political obstacles -- such as dysfunction in the U.S. Congress and the austerity branding of the U.K. Conservative Party.

     In Japan's case, the not-quite-but-near-zero bound leaves BoJ policymakers with precious few options. With the ratio of debt to gross domestic product already perilously high, the country's finance ministry will be nervous about pushing this ratio very much higher.

     A final possibility mooted is that the authorities could engage in large scale "helicopter drops" of money, amounting literally to sending cheques to private households. This is heretical for many central bankers and monetary economists, but the idea has been talked about openly by prominent economists and commentators, including Adair Turner, Eric Lonergan, Simon Wren Lewis and Ben Bernanke. Japan's monetary authorities have demonstrated willingness thus far to try whatever is necessary to revive growth, so I would not bet against them experimenting with helicopter drops -- if the inflation outlook does not brighten materially over the next year or two.

     Central bankers such as former Bank of England Governor Mervyn King used to jest before the crisis that successful monetary policy was "boring." It may be some time yet before monetary policy gets boring in Japan.

Tony Yates is professor of economics at the University of Birmingham and was previously senior advisor at the Bank of England's monetary policy directorate.

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