3 February 2016

Japan’s negative interest rates threaten a currency war

By Mickey D. Levy

The Bank of Japan (BoJ) joins the European Central Bank and central banks of Sweden, Denmark and Switzerland to impose negative rates on excess commercial bank reserves. The BoJ’s announcement is in direct response to disappointing economic performance, worries about low inflation and weak bank lending.

The negative 10 basis point interest rate will augment the BoJ’s ongoing massive quantitative-qualitative easing (QQE). Under QQE, the BoJ is the dominant purchaser of Japanese Government Bonds as well as other financial assets.

While the negative rates will suppress the yen and thereby boost profits and the Nikkei, its impact on the economy will be relatively modest.  Nor will it have much impact on bank lending, which is rising modestly.

Japan’s ongoing economic struggles reflect dour expectations of the future that dampen household and business spending, and even more so misguided tax, regulatory and economic policies, including tight fiscal policy, and failure to address demographics and immigration, the biggest constraints on Japan’s long-run growth.  Pursuing turbo-charged monetary stimulus while imposing crippling tax hikes (the economy has not recovered from the spring 2014 VAT hike, and the government continues to aim for another VAT hike in 2017) is counterproductive.

Concerns about deflation in Japan are warranted, as on-and-off deflation since the early 1990s has generated a general expectation of malaise leading households and businesses to save rather than spend.  Recently, core inflation in Japan has been hovering around 0.8 percent, but the decline in energy prices has lowered inflation to zero.  The failure of wages to pick up, despite the government’s efforts, indicates that Prime Minister Abe’s goal of raising inflation and inflationary expectations are falling short.

Some of the government’s initiatives to improve economic performance are helping marginally. But generating healthy sustainable growth requires addressing head on the obvious economic inhibitors and lifting expectations of future potential growth.  More and more monetary stimulus in the face of other economic policies that constrain growth and dampen expectations about the future is not a viable solution.

While concerns about deflation in Japan may be warranted, they are not in the US or Europe. In both the US and Europe, core inflation is moderate and nominal GDP is growing comfortably faster than real potential growth—that is, aggregate demand for all goods and services is growing faster than productive capacity.  That virtually rules out the probability of deflation.  Most tellingly, there are no signs in the US or Europe that expectations of deflation are leading people to save rather than spend.  Rather, people are spending more in response to declining prices of select goods and services. Concerns about deflation—like those expressed by the US Federal Reserve, the European Central Bank and the Bank of England—are overstated.

China is Japan’s largest trading partner, and the yen’s depreciation in direct response to the BoJ’s policy change affects Japan’s terms of trade with China at a time when China’s unit labor costs have risen substantially and its exports are declining.

Will the BoJ’s policy move be perceived as a move to “front-run” China’s deliberations about its currency? While the BoJ’s move is a direct response to its domestic malaise, the weaker yen is a direct consequence.  Will it elicit a Chinese response?  Another announcement may jar financial markets, particularly if markets perceive China’s actions were a response to Japan.

Could these events initiate responses of other central banks? The probability of a currency war seems small, yet it remains very worrisome that leading global central banks have been extended well beyond their normal scope of monetary policy and the relationship between central banks and financial markets have become very unhealthy.

One guaranteed outcome of the BoJ’s actions: expect higher market volatility.

Mickey D. Levy, Chief Economist of the Americas and Asia for Berenberg Capital Markets, is a member of the Shadow Open Market Committee sponsored by the Manhattan Institute.