Japan's Negative Rates: Implications On Federal Reserve Policy

by: Tom Yuz

Summary

The article contends the reasoning behind the Bank of Japan's latest move to send rates into negative territory, as well as the mechanism by which it will be accomplished.

Analysis is conducted on the Bank of Japan's effects on the Federal Reserve's hiking cycle, revealing implications about domestic policy.

The various implications associated with the BOJ's move on stock markets from the S&P 500 to the NIKKEI Index is explored.

Adding a surprising rout to global markets, the Bank of Japan (BOJ) has officially taken interest rates into negative territory. With a narrow 5-4 vote, BOJ Governor Haruhiko Kuroda will now be charging an interest rate of -0.1% for excess reserves retained at the central bank by domestic banks and financial institutions. While global analysts have rushed to consider the implications of such a move, it is first necessary to elucidate what negative interest rates mean in the first place.

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As shown above, the majority of central banks worldwide have adopted zero-bound target interest rates. Normally, commercial banks would earn these interest rates by depositing excess reserves with a central bank instead of putting it into circulation via loans to consumers and businesses. In the case of Japan, however, these banks actually have to pay the BOJ for keeping their money there.

The reasoning behind such a move is defended by Governor Kuroda himself, who cites falling oil prices, market instability, and weakness in China as evidence for a need to increase stimulus in Japan. By keeping target rates negative, the BOJ is effectively forcing banks to lend their money rather than deposit excess cash at a central bank. In other words, the BOJ is yet again injecting money into the Japanese economy. Considering Japan's historic difficulties fighting deflation, negative interest rates are a means of boosting consumer spending and corporate investment to increase aggregate demand and consequently increase inflation.

In fact, the formal report that the BOJ released on twitter (in a very professional manner) cites that the negative interest rates are predominantly for achieving "the price stability of 2 percent" inflation "at the earliest possible time." Now one of the more granular aspects of the change in monetary policy is that it applies only selectively to reserves at the BOJ.

Though the above graph (courtesy of Marketwatch) is crucial to understanding the fundamentals of the BOJ's tiered system. Notably, the rate on existing reserves (i.e. reserves currently at the BOJ before the policy) remains 0.1%. Even more so, any reserves created when banks sell Japanese government bonds (NYSEARCA:JGBS) to the BOJ will continue to receive the 0.1% rate; this is protecting previous stimulus measures, as the BOJ gives money to banks when it buys bonds and hence adds the amount of loanable money to the economy. On the other hand, commercial bank assets over and in excess of these exceptions will now be forced to pay the negative rate.

Yet the most fascinating aspect of the BOJ's move is not on its effects on Japan (which are still significant). Instead, following the BOJ's interest rate changes, markets now give a 56% chance for the Federal Reserve hiking just one time in 2016. This is huge news considering markets previously expected 2 hikes in 2016, the Fed initially expected 4 hikes in 2016, and that these drastic changes are caused not by domestic data but by external events.

An explanation of how the Fed's Hiking Cycle is affected by the BOJ's own policies is evident when considering what is expected to happen to the dollar versus other currencies. As U.S. monetary policy further diverges from stances in Japan and the eurozone, the dollar will continue to strengthen appreciably. Even more so, the very fact that the dollar is now strengthen increases the yield on American assets and securities; this will create even more demand for the dollar as foreign investors seek higher rates of return in the United States-and thus the dollar will strengthen even more.

The strengthening of the greenback will further dampen inflation due to the now lower costs of imports. Considering inflation has not reached the Fed's 2 percent target since 2012, and recognizing that the Fed was highly conscious of inflation in the January minutes, it is unlikely that the Fed will follow through with its 4 hike plan in 2016. The equilibrium Fed Funds Rate (read more about that here) priced into the futures market has fallen to about 0.55 percent, down from 0.63 percent a week ago and below the 0.62 percent level that would have implied an interest rate hike in 2016.

With that news now in mind, the markets have "already begun to celebrate":

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Business Insider Australia

In summary, the BOJ's decision to send official interest rates into negative territory imply massive financial stimulus for Japan. However, the move has also reduced the change that there will be any hikes by the Federal Reserve in 2016, further corroborating a global move toward accommodative policy. As a result, markets have begun to react optimistically, although the tumultuous beginning to the year is still impressed in the market's memory. Now all eyes will be on the Federal Reserve in its next official meeting. Whether or not the central bank policy across the other side of the world will truly deter the aggressive plans of Federal Reserve members in Washington remains to be seen.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.