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Bank of Japan Rate Cut Leaves Markets Thinking of More



The Bank of Japan (BoJ) surprised markets overnight by announcing it would charge negative interest rates on a proportion of new excess reserves deposited by banks. The object is to reduce the incentive for banks to park funds at the BoJ, since they would now be paying the central bank to hold their funds, thereby boosting bank lending to the economy and supporting inflation and growth. "What's important is to show people that the BoJ is strongly committed to achieving 2 percent inflation and that it will do whatever it takes to achieve it," said Governor Haruhiko Kuroda after the decision. The 5-4 vote came on the heels of disappointing data on household spending and industrial production.

Global financial markets rallied and the yen depreciated on the news. The Nikkei stock index average rose 2.8 percent, the yield on Japan's 10-year note fell to a record low of 0.09 percent, and the yen dropped 1.7 percent against the dollar. Part of the reason for the large moves was that the decision came as an almost complete surprise. The vast majority of analysts had predicted no change in BoJ policies, and only one out of 42 had anticipated this move after the governor had appeared to rule it out, most recently last week.

The rally also reflects the signal that the BoJ is prepared to move more aggressively to revive moribund Japanese inflation and activity. After some initial success from more aggressive monetary policies, the headline inflation rate is back at around zero. Even if fresh food and energy costs, which have been falling, are excluded, inflation is under 1 percent—well below the BoJ's target of 2 percent. Industrial production has fallen over the last year, putting further question marks on the recovery. The use of the phrase "whatever it takes" by Governor Kuroda is particularly notable, as it repeats the mantra used by European Central Bank President Mario Draghi when the ECB shifted toward a more consistently aggressive policy stance.

While negative interest rates are not new, they do constitute a new policy for the BoJ. Negative rates have become normal in Europe. The ECB has had negative rates for a year-and-a-half and Switzerland, Sweden, and Denmark have also used them. The Japanese plan, however, comes with a twist. While some reserves earn negative rates, another portion earns positive rates. This makes the system more flexible than those in Europe, if also a bit more complicated.

The BoJ also has some leeway with the new instrument. The deposit rate was cut to –0.1 percent, still much higher than the equivalent ECB rate. The markets are likely assuming that, absent better news in the future, the BoJ can further stimulate the economy. But there are limits to how low they can go. The most pertinent being that banks seems to be unwilling to charge negative deposit rates given customers always have the option to stow cash under the mattress.

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