Japan ends era of negative interest rates. A chief economist explains

The Bank of Japan raised interest rates this month, ending the country’s historic era of negative interest rates.

In a 7-2 majority vote, Japan’s central bank decided to increase short-term interest rates to 0-0.1%. The decision increased rates from the previously held minus 0.1% and marked the first rate hike in Japan in 17 years.

Negative interest rates are used by central banks as a monetary policy to stimulate economic growth and combat deflation. The policy results in charges being imposed on commercial banks and financial institutions for holding large reserves. In turn, banks were encouraged to spend and lend money into the economy, rather than save.

In 2014, while confronting deflationary pressures, the European Central Bank became the first major central bank to implement negative interest rates. In subsequent years, multiple other central banks, including Japan’s in 2016, followed suit and lowered interest rates below zero. With its decision this month, Japan became the last country in the world to end a policy of negative interest rates.

The Japanese economy, which has faced deflationary pressures such as wage stagnation, has seen indications of healthy inflation in recent months. In a statement announcing the policy change, the Bank of Japan (BOJ) said that the economy has “recovered moderately” and that it is “highly likely that wages will continue to increase steadily.” The central bank, which also abandoned yield curve control (YCC), did not indicate whether or not more rate hikes can be expected.

In the following questions-and-answer, Seisaku Kameda, the Executive Economist at the Sompo Institute Plus, details the rationale behind negative interest rates and examines the policy’s impact.

“The action was taken to strengthen quantitative and qualitative easing (QQE) against negative shocks expected from China’s slowdown at that time. The negative interest policy in Japan, however, was only an extraordinary form of large-scale monetary easing that has continued for many years. The history of ultra-low interest rates is much longer and dates back to the late 1990s.

“BOJ decided to implement a zero interest rate policy in 1999. Since then, short-term policy rates have been extremely low, whether it was zero, near-zero or slightly negative. An exception was a short period from 2006 to 2008, when policy rates were low but positive, namely 0.25 to 0.5%. The rates went back to near-zero levels again after the Global Financial Crisis.

“The saga of ultra-low interest rates in Japan reflects the fact that the Japanese economy suffered from secular stagnation and also from mild but persistent deflation for the past 20 years.

“The problem was deeply structural: (i) the burst of the bubble economy and its scarring effect in 1990s, (ii) rapid decrease and ageing of population that no advanced economies had experienced, and (iii) emerging China and the following increases in cheap imports, have all combined and exerted tremendously negative pressures onto Japan’s economic growth and inflation.

“Under the new environment, small non-manufacturing companies kept their businesses by cutting costs, for example by hiring more non-regular workers. This strategy was successful in maintaining the ‘status quo’ of the domestic economy for a while, but it was a fatal mistake for future growth, as innovations to create new business and values were disturbed, and the economy was trapped with a low-wage, low-price equilibrium. This situation has not changed, until just recently.”

“The main driver of this fundamental policy change was, obviously, strong results of the annual spring-time wage negotiations, revealed just a few days before the policy meeting.

“According to the initial press release by JTUC-RENGO, one of the major labour union confederations, the average base wage rate has risen by 3.7%, accelerated from 2.3% last spring that was already historically high. This wage growth has also exceeded current inflation rates: Japan’s CPI this February recorded an increase of 2.8% year-to-year.

“Based on these wage results and related anecdotal information obtained through the network of local branches, BOJ confirmed the virtuous cycle between wages and prices, an indispensable condition for achieving its 2% price stability target.

“BOJ also stated that QQE with YCC and the negative interest rate policy ‘have fulfilled their roles’. We should note, however, that skyrocketing wage growth this year and last year has been brought about by changes in the external environment, rather than by aggressive monetary easing.

“Global inflation and pent-up consumer demand in the aftermath of Covid-19 pandemic has led to cost-push inflation even in Japan, which in turn pushed up nominal wages, along with effects of strong calls for higher wages from the government and major industrial associations. Monetary policy including negative interest rates played a supporting role, but was not sufficient by itself to create the current wage-price momentum.”

“Although this policy change has a symbolic meaning as a near-exit step of aggressive monetary easing, its direct impacts on financial markets and the Japanese economy are considered to be small.

“BOJ emphasised that ‘accommodative financial conditions will be maintained for the time being’ in its policy statement. This phrase, with the decision of continuing QE, is generally taken by market participants as a sign that a move for the next interest rate hike will not come very soon.

“Given a very small rise in short-term policy rates and virtually no move in long-term rates, the immediate impact upon the economy will naturally be negligible as well. On the other hand, we should bear in mind that this very accommodative policy stance could be reversed unexpectedly, depending on incoming data, especially data on wages and service inflation.

“Extremely strong results in this spring wage negotiations were more than enough for BOJ to exit from negative interest rates. At the same time, however, they could materialise upside risks of higher inflation in service sectors, earlier than BOJ currently anticipates. Unexpected change of policy stance in the near future might then become an adverse factor to financial markets and the economy.

“Lastly, although we are observing a dramatic change in Japan, so far, the change is mainly in progress in nominal terms; wages and inflation. Deflation in the past was probably one of the reasons for secular stagnation of the Japanese economy, but it is not a single absolute reason. In Japan, rapid ageing of population will continue, and innovations, such as digital investment and its wider use, still lag behind other advanced economies. Japan’s problem in real terms remains.”