Japan’s futile quest for inflation

In an attempt to stave off further deflation, the Bank of Japan (BOJ) set the country's first negative interest rate, cutting its effective policy rate from +0.1% to -0.1%. Long-term rates also plummeted with yields on Japanese 10-year government bonds turning negative for the first time ever and the news triggered volatility in global currency and equity markets, particularly in Asia.

Inflation and policy rate

While the move signaled the BOJ's intent to tackle deflation, it also highlighted how little ammunition it had left. It is already buying ¥80 trillion (£500 billion) in assets a year, putting nearly a third of Japan's massive bond market in its hands, and interest rates have remained persistently low. The BOJ's policy rate has been below 0.5% since 1995, during which time the average annual rate of inflation has been 0.1% (see chart). Despite easing on a huge scale, the monetary stimulus arrow of Abenomics has failed to hit its target, as Torgeir Høien, Portfolio Manager of SKAGEN Tellus, explains: "If the Bank of Japan had sought price stability, its policies would have been a success story but it is striving for inflation with an annual target of 2%. Despite the longevity of its zero interest policy and extent of its quantitative easing, the current growth rate in Japan's core Consumer Price Index is zero and so its twenty year effort to reflate the economy has to be judged a failure."

Unintended consequences

Furthermore, the market reaction to the BOJ's decision – which was carried by a slim majority of five board members to four – appears to have added rather than relieved pressure on the world's third largest economy. The inflation swap market is signaling inflation expectations of 0.36% for the next ten years, down from 0.57% before the announcement and even further short of the BOJ's 2% target. The FX market has reacted in a similarly unhelpful way. The BoJ probably expected the rate cut to weaken the Yen, thus boosting exports, GDP growth, employment and in turn inflation, but although it depreciated by 2% in the days following the announcement, a weaker dollar has seen the Yen strengthen and it is now 2% higher than before the BOJ action.

Marginal central bank deposit rates

The cut will take effect this week when the BOJ will start charging banks 0.1% for the privilege of parking deposits beyond those that are required by law. It has also said that it could reduce the deposit rate further in the months ahead, although it is unclear how much lower they could go. The BoJ is following several other central banks in adopting negative rates in an attempt to boost economic activity in the face of trouble from low oil prices, stalling international trade and slowing growth in nearby China. Last Thursday Sweden's Riksbank further cut its already negative interest rate to -0.5% from -0.35%, still someway short of Switzerland which has the lowest international marginal deposit rate of -0.75% (see chart).

Høien thinks the BOJ may well follow the trajectory of other central banks who have entered negative rate territory: "I don't believe the short-term market reaction to the BOJ's decision will influence its thinking. The policy rate might be cut again and I expect the effect of such a move would be a further fall in expected inflation and a stronger Yen. At some point – maybe after the BOJ has found the effective lower bound where banks begin to swap central bank deposits for notes – it will be forced to alter its modus operandi and completely overhaul its economic policies."

Accommodative financial conditions

The economic backdrop against which the BoJ will operate is mixed, but arguably improving. While the IMF recently cut its projections for global economic growth in 2016, citing a slowdown in emerging economies as the key factor, it maintained its forecast for Japan of 1% expansion this year, outlining that growth in Japan is "expected to firm in 2016, on the back of fiscal support, lower oil prices, accommodative financial conditions, and rising incomes." Although Japan's public debt is 2.4 times gross domestic product, a level far above peers and rising due to an ageing population, net of government assets the figure is around half that with a low annual interest coupon.

SKAGEN Tellus currently has two Japanese government bond holdings which together represent 8.8% of the portfolio, as Høien explains: "We previously avoided Japan due to its high sovereign debt level and the risk of inflation, which clearly hasn't materialised. Looking at the other two Abenomics arrows, we are optimistic that Japan might get its fiscal house in order – a primary balance of -4% would be sufficient to stabilise the debt-to-GDP ratio – and structural reforms could eventually begin to pay off."

Returning to the arrow which has been shot most aggressively, Høien believes that long-term the BoJ may change its monetary policy completely: "The most important Japanese monetary lesson since 1995 has been that while a policy rate close to zero causes price stability, it is very difficult to prove that this in turn has had a negative effect on economic growth, with GDP per capita expansion on a par with countries like France. Given this lack of negative causation, the most likely end-game is that the BoJ will scrap its inflation target altogether and instead peg the policy rate permanently at zero."

The BOJ is not alone with many other central banks around the world facing the same problem of low inflation, despite years of 'easy money'. It may be that the country which pioneered both zero interest rate policy and quantitative easing may end up once again exporting a radically new monetary policy framework to other nations. It is this possibility that makes it even more interesting to follow the actions of its central bank from here.