What the End of Japan’s Negative Interest Rates Means

Summary

The Bank of Japan has raised interest rates for the first time in seventeen years, ending the negative interest rate regime and abandoning its yield curve control policy. This move could impact global finance as the Yen's role may change. The decision was anticipated and is symbolic, with Japan's central banking history marked by innovation. The shift towards higher rates comes as Japan nears its 2% inflation target due to wage inflation. However, the future pace of rate increases depends on various factors, including the ability of businesses and households to handle higher borrowing costs. The change may affect Japanese investors' foreign investments and the demand for US Treasuries and Euro bonds. Despite the end of negative rates, the Bank of Japan remains cautious and ready to intervene for financial stability.

Takeaways

• 📈 The Bank of Japan raised interest rates for the first time in seventeen years, ending the world's only remaining negative interest rate regime.
• 🚫 The bank also abandoned its yield curve control policy, which involved buying Japanese government bonds to keep long-term interest rates from rising.
• 🔄 Despite policy changes, the Bank of Japan will continue to buy bonds at the same pace for the time being.
• 🌐 Rising Japanese interest rates could have global repercussions due to the Yen's role in international finance, which might be changing.
• 💰 Negative interest rates meant that central banks required counterparties to pay to store their excess cash.
• 🎯 The new target for Japan's overnight interest rate is a range of about zero to 0.1 per cent, a small but symbolic move.
• 💹 Japan has a history of central banking innovations, including being the first to introduce zero interest rates in 1999 and pioneering quantitative easing.
• 📊 Achieving a 2% inflation target is getting within reach in Japan due to recent wage inflation.
• 💼 Higher incomes from wage growth are expected to lead to a virtuous spiral of domestic demand fueling inflation in Japan.
• 🌍 Japanese investors, having been big capital exporters, might reduce their foreign investments as domestic yields rise.
• 🛑 The change in interest rates could impact the demand for US Treasuries and Euro-denominated bonds if Japanese investments are repatriated.

Q & A

Why did Japan's central bank raise interest rates for the first time in seventeen years?

Japan's central bank raised interest rates to end the world's only remaining negative interest rate regime, marking a significant shift in its monetary policy.

What was the yield curve control policy abandoned by the Bank of Japan?

The yield curve control policy, in place since 2016, involved the Bank of Japan buying Japanese government bonds to prevent longer-term interest rates from rising, thereby controlling the shape of the yield curve.

What is the new range for Japan's overnight interest rate following the central bank's decision?

Following the decision, the Bank of Japan guided Japan's overnight interest rate to a range of about zero to 0.1 per cent, moving away from the previous benchmark rate of minus 0.1 per cent.

How has Japan's history with central banking innovations influenced global financial practices?

Japan has a history of introducing unconventional monetary policies, such as the first introduction of zero interest rates in 1999 and pioneering asset purchase programs like quantitative easing and yield curve control. These policies were widely adopted by central banks globally, especially after the global financial crisis.

What is the impact of Japan's interest rate changes on its international financial role?

The stability of the Yen and its low interest rates have given it a significant role in international finance. Changes in these rates could alter this role, as higher domestic yields might lead to reduced foreign investments by Japanese investors.

How have wage inflation and the Bank of Japan's policies contributed to Japan's 2% inflation target?

Recent wage inflation, driven by stronger than expected increases in base pay negotiated by Japan's largest federation of trade unions, has brought the 2% inflation target within reach. The Bank of Japan expects higher incomes to fuel domestic demand and inflation, achieving their long-held goal of stable inflation.

What is the significance of 'core-core inflation' in Japan's inflation measurement?

Core-core inflation, which excludes fresh food and energy prices, is closely watched by the Bank of Japan as a better gauge of trend inflation. It has been above the 2% target for over a year, but policymakers have been cautious, attributing some of this inflation to imported factors.

How have Japanese investors' preferences for foreign investments been shaped by domestic interest rates?

Decades of ultra-low interest rates in Japan have encouraged investors to seek higher yields abroad, leading to Japanese investors becoming among the largest capital exporters in the world, with significant holdings in US Treasuries and Euro bonds.

What is the potential impact of higher Japanese interest rates on global bond markets?

Higher Japanese interest rates could lead to a repatriation of funds from foreign investments back to Japan, impacting the demand for US Treasuries and Euro-denominated bonds. This could also make the carry trade strategy, which heavily relies on borrowing in Yen, less attractive.

How do Samurai bonds fit into Japan's financial landscape?

Samurai bonds are yen-denominated bonds issued by foreign entities in Japan, allowing non-Japanese governments and corporations to secure capital from Japanese investors. These bonds are issued at fixed interest rates and have been utilized by highly indebted African countries as a means to obtain funding at lower rates than in their home markets.

What are the structural challenges faced by Japan's economy?

Japan faces significant structural challenges including an aging population, low growth, and high public debt. The aging population, in particular, is expected to put extreme strain on the economy, welfare programs, and retirement plans, with the number of workers and retirees expected to be almost equal by 2050.

What is the Bank of Japan's stance on further interest rate changes?

The Bank of Japan has indicated that it is not embarking on a tightening cycle and is prepared to intervene to support financial stability if needed. The future pace of rate increases will depend on various factors, including the ability of businesses and households to handle higher borrowing costs and the sustainability of the 2% inflation target.

Outlines

00:00

📈 Japan's Interest Rate Shift and Global Implications

The Bank of Japan has raised interest rates for the first time in seventeen years, ending the negative interest rate policy. This move abandons the yield curve control policy established in 2016, which involved buying Japanese government bonds to prevent long-term interest rates from rising. Despite maintaining the current bond-buying pace, rising Japanese rates could affect global finance as the Yen's stability and low rates have been significant in international finance. The shift to a 0.1% target for overnight interest rates is more symbolic than substantial but indicates a move away from unconventional monetary policies introduced after the 1990s asset price bubble. Japan's central banking history is marked by innovations such as the first introduction of zero interest rates and quantitative easing, including asset purchase programs and yield curve control. The goal of 2% inflation seems within reach due to recent wage inflation, with the largest trade union federation negotiating a 3.7% increase in base pay, stronger than the previous year's gains. The Bank of Japan expects this to lead to a virtuous spiral of domestic demand fueling inflation. The decision was anticipated and well communicated, with core-core inflation already above the 2% target for over a year. The change might affect Japanese investors, who are significant capital exporters, owning trillions in US Treasuries and Euro bonds. A potential shift in domestic yields could impact their foreign investments.

05:06

🌐 Impact on Japanese Investment Abroad and Domestic Economy

Japanese banks and institutions, driven by ultra-low interest rates, have become significant foreign investors, owning over $2tn in foreign bonds. The yen's stability made it ideal for carry trades, where investors borrow in yen to invest in higher-yield countries. This investment style is risky due to currency fluctuations. With the potential rise in Japanese interest rates, investments abroad might be repatriated, affecting the demand for US Treasuries and Euro bonds. The unwinding of the yen carry trade has been occurring over the past two years as US Treasuries become more expensive for Japanese investors after hedging. Samurai bonds, yen-denominated bonds issued by foreign entities in Japan, have been utilized by indebted African countries, but an appreciation of the yen could increase the cost of servicing these loans. The developments in Japan's monetary policy are crucial for global markets, especially with Japan's debt reaching $8.6 trillion, or 255% of GDP, the highest in the developed world. The future pace of rate increases will depend on businesses' and households' ability to handle higher borrowing costs. Higher interest rates are expected to benefit Japanese banks and companies, but continued rate hikes could lead to losses for Japanese bond investors, similar to the US experience last year. The Financial Services Agency has warned regional banks to prepare for rapid interest rate fluctuations.

10:10

👵 Challenges and Future Outlook for Japan's Economy

Japanese bankers have limited experience in a rising interest rate environment. Despite Japan's share of global GDP falling from 9% in 1990 to under 4% today, some salaried workers benefited from deflation. However, the new inflationary environment has seen wages rise slower than retail prices, causing frustration. Japan has faced structural issues such as an aging population, low growth, and high public debt. The aging population is expected to put a strain on the economy and welfare programs, with Japan becoming a super-aged society by 2025. The country's high debt and the need for reforms to boost productivity and potential growth rate are critical. Without reforms, deflation could return. The Bank of Japan's optimism about wage growth and consumption is questioned, as real wages have fallen, and consumption growth is expected to follow only after households recover lost purchasing power. For now, a sharp increase in Japanese interest rates seems unlikely, with policymakers signaling a cautious approach and readiness to intervene for financial stability. The structural challenges persist, and the Bank of Japan has not signed a peace treaty with unconventional monetary policy but an armistice. The future trajectory of Japan's economy and its relationship with inflation and interest rates remains uncertain.

Keywords

💡Interest Rates

Interest rates are the cost of borrowing money or the return on investment for saving money, set by a country's central bank. In the video, Japan's central bank raised interest rates for the first time in seventeen years, ending the negative interest rate regime. This is significant as it suggests a shift in monetary policy and potential global economic repercussions due to the yen's role in international finance.

💡Yield Curve Control

Yield curve control is a monetary policy tool where a central bank attempts to influence the shape of the yield curve by targeting specific interest rates across different maturities. In the video, the Bank of Japan abandoned this policy, which involved buying Japanese government bonds to keep longer-term interest rates from rising, a change that could impact global financial markets.

💡Quantitative Easing

Quantitative easing is a non-conventional monetary policy where a central bank creates new money to buy government bonds or other financial assets to stimulate the economy. The Bank of Japan pioneered this policy, which later became widely used globally, especially after the 2008 financial crisis.

💡Inflation Target

An inflation target is a specific level of inflation that a central bank aims to achieve to ensure price stability. In the video, the Bank of Japan has a long-standing goal of achieving a stable 2% inflation rate, which is now considered 'within sight' due to recent wage inflation.

💡Carry Trades

Carry trades involve borrowing in a currency with a low-interest rate to invest in assets that offer higher returns in another currency. The yen has been popular for carry trades due to its stability and low interest rates. Changes in Japanese interest rates could affect this strategy and global investment patterns.

💡Samurai Bonds

Samurai bonds are yen-denominated bonds issued by foreign entities in Japan, allowing non-Japanese governments and corporations to raise funds from Japanese investors. These bonds, often issued at lower rates than in their home markets, could be affected by changes in the Japanese interest rate environment.

💡Deflation

Deflation is a decrease in the general price level of goods and services in an economy, often leading to reduced economic output and consumption. Japan has experienced deflationary periods, which have influenced its monetary policy and economic strategies.

💡Aging Population

An aging population refers to a demographic shift where the median age of a country's population increases over time, leading to a higher proportion of elderly individuals. Japan faces significant challenges due to its rapidly aging population, which puts pressure on the economy, welfare programs, and retirement plans.

💡Structural Problems

Structural problems are deep-rooted issues within an economy or society that are not easily resolved and can hinder long-term growth and development. Japan is grappling with several structural problems, including an aging population, low growth, and high public debt.

💡Monetary Policy

Monetary policy refers to the actions taken by a central bank to influence the economy by adjusting interest rates, money supply, and other financial variables. The video discusses the Bank of Japan's shift from unconventional monetary policies, like negative interest rates and quantitative easing, towards more conventional policies.

Highlights

Japan’s central bank raised interest rates for the first time in seventeen years, ending the world’s only remaining negative interest rate regime.

The Bank of Japan abandoned its yield curve control policy, which involved buying Japanese government bonds to keep longer-term interest rates from rising.

Although bond buying continues at the same pace, any future rise in Japanese rates could have significant global repercussions due to the Yen's role in international finance.

Negative interest rates required counterparties to pay central banks to store their excess cash, a policy that has now been reversed.

The central bank's decision to guide Japan’s overnight interest rate to a range of about zero to 0.1 per cent is more symbolic than substantial, given the prior benchmark rate was minus 0.1 per cent.

Japan has a history of central banking innovations, including being the first to introduce zero interest rates in 1999 and pioneering quantitative easing and yield curve control policies.

The Bank of Japan's policies have included buying stock market funds and real estate linked securities, going beyond traditional quantitative easing measures.

Japan's 2% inflation target is now within reach due to recent wage inflation, with the country's largest trade union federation negotiating a significant increase in base pay.

The Bank of Japan expects higher incomes to lead to a virtuous spiral of domestic demand fueling inflation, achieving their long-held goal of stable 2% inflation.

The announcement of the interest rate change was widely expected and well telegraphed, resulting in no shock waves in the financial markets.

Japanese investors, encouraged by ultra-low interest rates, have become significant capital exporters, owning a substantial amount of US Treasuries and Euro bonds.

A rise in domestic yields in Japan might lead to a reduction in foreign investments, impacting the demand for US treasuries and Euro denominated bonds.

US bonds have become less attractive to Japanese investors due to the costs associated with hedging against foreign exchange risk.

Samurai bonds, yen denominated bonds issued by foreign entities in Japan, have been utilized by highly indebted African countries, potentially affecting their repayment costs if the yen appreciates.

Japan’s debt to GDP ratio is the highest in the developed world, and the future pace of rate increases will depend on various factors, including the ability of businesses and households to handle higher borrowing costs.

Higher interest rates are expected to benefit Japanese banks by boosting net interest margins, with shares in major financial institutions already reflecting this expectation.

Investors in Japanese bonds could face losses if rates continue to rise, similar to the experience of investors in US bonds during rapid rate increases.

Japan faces structural problems such as an ageing population, low growth, and high public debt, with the super-aged society of 2025 posing significant challenges for the economy and welfare programs.

The Bank of Japan's optimism regarding wage growth and consumption may be misplaced, with real wages having fallen and consumption growth only expected after households have recouped purchasing power lost to inflation.

A sharp increase in Japanese interest rates seems unlikely for the time being, with policymakers signaling a cautious approach and readiness to intervene for financial stability.

Transcripts

Japan’s central bank raised interest rates last week for the first time in seventeen

years, ending the world’s only remaining negative interest rate regime.

The Bank of Japan also abandoned its yield curve control policy which has been in place

since 2016, which saw it buying Japanese government bonds to keep longer term interest rates from

rising.

It has however maintained bond buying at the same pace for now.

If Japanese rates were to continue to rise, it could have global repercussions as the

Yen’s stability and low interest rates have given it a role in international finance that

might be about to change.

Negative interest rates are when central banks require their counterparties to pay to store

their excess cash at the institution.

Following a 7-2 vote last week, it was announced that the central bank would guide Japan’s

overnight interest rate to a range of about zero to 0.1 per cent.

Obviously, this is not a huge rate hike, the prior benchmark rate had been minus 0.1 per

cent.

It is maybe more important symbolically than anything else.

Japan has a long history of central banking innovations – or unconventional monetary

policies - which were introduced after the Japanese asset price bubble burst in the 1990’s.

While Japan was not the first country to introduce negative interest rates (that honor goes to

Sweden) it was the first country to introduce zero interest rates in 1999.

The bank of Japan also pioneered asset purchase programs – known as quantitative easing

along with the yield curve control policy, both of which became widely used by central

banks around the world in the wake of the global financial crisis.

The Bank of Japan went a bit further than other central banks buying up stock market

funds and real estate linked securities in what it referred to as qualitative easing.

The negative interest policy which has just ended involved applying different interest

rates to different tiers of bank reserves in order to prevent the banks from hoarding

cash.

Achieving the 2% inflation target is finally getting within reach in Japan due to recent

wage inflation.

Japan’s largest federation of trade unions recently negotiated a weighted average 3.7%

increase in base pay.

This was stronger than last year’s wage gains, which were the steepest in thirty years.

The Bank of Japan has said that they expect higher incomes to lead to a virtuous spiral

with domestic demand fueling inflation.

They say that their long-held goal of stable 2% inflation is finally “within sight”.

There were no shock waves associated with the announcement as the decision was widely

expected and well telegraphed.

“Core-core inflation - which excludes fresh food and energy prices - and is closely watched

by the BOJ as a better gauge of trend inflation has been above the 2% target for more than

a year, but policymakers took it easy believing that some of this inflation was largely imported

from overseas.

The low-return environment in Japan has pushed Japanese investors into being amongst the

biggest capital exporters in the world: they own over a trillion dollars of US Treasuries

and half a trillion Euro bonds.

Now that domestic yields in Japan might be on the rise, will they stop investing as much

abroad?

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Japanese banks and institutions have over the years become big foreign investors.

Decades of ultra-low interest rates encouraged yield-seeking Japanese investors to keep their

savings overseas, particularly in foreign bonds.

Commerzbank estimates that Japanese investors own more than $2tn in foreign bonds and international

investments are estimated to be around four trillion dollars in total.

Low interest rates combined with the yen’s stability made it the currency of choice for

carry trades, where an investor borrows in Yen to fund investments in other countries

where interest rates and expected returns are much higher.

This style of investment can (of course) be quite risky.

Big currency moves can wipe out returns and force investors to unwind their trades.

For this reason, the Yen usually rallies during times of market stress, as investors exit

these trades and repatriate their money to Japan.

Japan is the largest foreign holder of US government debt and in a world of higher Japanese

interest rates money that has been invested abroad could be brought back to Japan, impacting

the demand for US treasuries and Euro denominated bonds.

US bonds have already become less attractive to Japanese investors, as when they buy Treasuries,

they usually don’t want to run the foreign exchange risk and thus hedge it out.

After hedging US Treasuries are the most expensive, they’ve been in decades for Japanese investors,

and for this reason this trade has been unwinding over the last two years.

John Authers at Bloomberg points out that since the beginning of 2020, a carry trade

of borrowing in yen and investing in the Mexican peso, where rates are above 11% has made a

far bigger profit than an investment in the S&P 500.

Samurai bonds are yen denominated bonds issued by foreign entities in Japan, allowing non-Japanese

governments and corporations to secure capital from Japanese investors – often at lower

rates than they would get in their home markets.

In recent years, highly indebted African countries like Kenya, Egypt and Rwanda have issued Samurai

bonds.

This debt has mostly been issued at fixed interest rates which means that the change

in interest rate should not affect the borrowers, but if the yen were to appreciate against

their currencies, it would be more expensive to pay back these loans.

For these reasons, developments in Japan matter for global markets.

Japan’s debt reached $8.6 trillion dollars at the end of last year.

At 255 percent of GDP that is more than twice the debt to GDP ratio of the United States

and is the highest in the developed world.

The future pace of rate increases will depend on a number of factors such as whether businesses

and households can handle higher borrowing costs than they have become accustomed to.

Servicing Japan’s massive government debt is already a struggle which will become more

difficult once negative interest rates and yield-curve control have been abandoned.

For Japanese banks, higher interest rates can be expected to boost net interest margins,

and the FT points out that Japanese banks have performed very well over the last year

in expectation of this interest rate hike with shares in Mitsubishi UFJ Financial Group

up more than 80 per cent in the last year.

Large Japanese companies have 49 per cent cash on their balance sheets as a proportion

of net assets, according to the same article and higher interest rates would help these

companies too.

Should rates continue higher, investors in Japanese bonds could face losses not unlike

what we saw when US rates rose rapidly last year.

According to the Wall Street Journal, Japan’s Financial Services Agency warned regional

banks in mid-July that they should be ready to respond flexibly to rapid interest-rate

fluctuations.

Very few Japanese bankers have any experience in a rising interest rate environment.

Japan’s share of global GDP in Purchasing Price Parity terms fell from 9% in 1990 to

under 4% today and while deflation slowly made Japan relatively poorer, it actually

worked out well for certain salaried workers who made a steady income while prices fell

around 1 percent per year.

In the new inflationary environment wages have been rising slower than retail prices,

frustrating these Japanese workers.

The past 30 years have seen many false dawns in Japan.

The Economist points out that while price inflation is still above 2%, it is already

falling.

They argue that for the trend to continue, Japan needs reforms that raise productivity

and boost the potential growth rate, otherwise deflation could return.

Japan is faced with some big structural problems – an ageing population, low growth and high

public debt.

While all developed countries are aging, none are doing so as fast as Japan.

Around the turn of the century the phrase Japan’s 2025 problem was coined.

It referred to how by 2025, all six and a half million of Japan’s baby boom generation

would be 75 or older.

Japan in 2025 would become a super-aged society the likes of which has not been seen before.

Based on current projections, by 2050 there will be almost the same number of workers

in Japan as retirees.

The elderly in Japan vote for, and get old-age benefits, and many young Japanese people don’t

vote - aware that their numbers are not sufficient to counterweight the votes of the elderly

population.

In a country with high debt the high number of elderly people can be expected to put extreme

strain on the economy, welfare programs and retirement plans

My friend Manoj at Talking Heads Macro argues that the Bank of Japan’s optimism that wage

negotiations would deliver stronger nominal (and real) wage growth leading to consumption

growth might be wrong.

He argues that Japan’s real wages have fallen over the last two years and that consumption

growth will only come after households have recouped the purchasing power they lost due

to inflation.

He says that households will need several quarters of wages outstripping prices before

the wage level catches up with the price level.

Only then will they feel that their wages can be used for broad-based consumption…

that time is not now.

For the time being, a sharp increase in Japanese interest rates seems unlikely.

Japanese policymakers have been careful to signal they are not embarking on a tightening

cycle and that the central bank is prepared to intervene to support financial stability

if needed.

Wages are still quite weak in Japan and further wage growth would be needed for inflation

to remain on target.

The BOJ referred to extremely high uncertainty in their outlook meaning that they just don’t

know if they are on track with inflation or not.

A lot will depend on what happens if the US federal reserve starts cutting rates as the

difference between Japanese interest rates and US interest rates is quite wide at present.

If the Fed started cutting rates, narrowing that gap, the yen could start to rise as Japanese

rates become relatively more attractive.

This would make imports cheaper, putting downward pressure on prices.

All of Japan’s big structural challenges remain the same, and to quote Robin Harding

from The FT “it is not clear if there is any stable equilibrium where Japan chugs along

with consistently positive interest rates and inflation at its 2 per cent target.

The Bank of Japan has signed an armistice with unconventional monetary policy, not a

peace treaty”.

If you enjoyed today’s video, you should watch the one on how Japan’s economic miracle

turned into three lost decades next.

Don’t forget to check out our sponsor Opera using the link in the video description.

Have a great day and talk to you again soon.

Bye.