The grisly month of January, 2016 in the global financial markets has ended on a somewhat brighter note. Risk assets bottomed on 20 January, and since then they have recovered almost half of the losses incurred earlier in the month. Nevertheless, global equities still fell by over 5 per cent in the month as a whole.
The partial recovery has been triggered by a series of policy adjustments in China, the oil market, and the major central banks, all of whom have shifted in a more dovish direction in recent days.
The latest to act is the Bank of Japan (BoJ), which introduced a new flavour of monetary easing on Friday. They have given it a snappy title: “Quantitative and qualitative monetary easing (QQE) with a negative interest rate”. Roughly translated, they are still throwing the monetary kitchen sink at the economy, and have hinted that they might even increase the scale of the stimulus later in the year.
Some analysts have described the latest surprise announcement as “a very big regime change”. Compared to what has come before, that is probably an overstatement. On the Richter scale of unconventional monetary policy changes, it is not as significant as the two great Kuroda bazookas in April 2013 and October 2014, both of which had profound market consequences.
But it does introduce a new “tiered” approach to the implementation of negative interest rates that might allow much greater cuts into negative territory than previously envisaged by the major central banks, notably the ECB (which seemed to consider, and then reject, a similar course of action in December).
The BoJ’s official reason for acting this month was a familiar one. The downside risks from global events were deemed to have increased, and the attainment of its 2 per cent inflation objective was delayed by about 6 months into the first half of fiscal 2017. Mr Kuroda mentioned several times that he was concerned that Japan’s “deflationary mindset” should be defeated, once and for all. Furthermore, the BoJ is clearly worried about the consumption tax increase scheduled for April 2017, which is likely to reduce GDP growth by about nearly 1 percentage point.
The key to the new arrangement is that negative policy rates will be paid on only a small part of the commercial banks’ holdings of liquid assets at the BoJ. When monetary policy is operating in a conventional framework, the central bank usually changes the interest paid on the entirety of the bank’s holdings of reserve assets, or at least those required under regulatory reserve requirements. The market then adjusts all money market rates accordingly.
The BoJ’s new arrangements (apparently modeled on innovations by the Swiss National Bank and some smaller European central banks), apply the negative rate of -0.1 per cent to only a small fraction of the banks’ liquid asset holdings at the central bank. The vast bulk of their holdings (the “basic balance” accumulated during previous rounds of QE) will continue to earn interest at +0.1 per cent. Reserve requirements above that level (the “macro add-on” balance) will earn interest at zero. Anything on top of that level (the “policy rate” balance) will be paid -0.1 per cent.
Why has the BoJ resorted to such a complicated new mechanism? The reason is that commercial banks are unlikely to cut the rates paid on household and corporate bank deposits below zero, so bank profits would be reduced if policy rates are cut into negative territory on all the banks’ reserve assets. The BoJ is determined not to undermine the profitability of the financial system, so it is effectively paying a subsidy to the banks by keeping a positive interest rate on the majority of their current account at the central bank.
This means that the full effects of lower interest rates will not be felt by the whole economy, because the rates paid on household and corporate bank deposits will remain positive. As a result, the expansionary effects of the monetary stimulus will be limited, compared to a “plain vanilla” cut in all policy rates.
But the BoJ says that this new mechanism will succeed in reducing money market rates into negative territory, because these rates are determined by the policy rate paid on marginal increases in bank assets, not on the entire aggregate of these assets accumulated in the past. They presumably expect this to impact the foreign exchange and bond markets.
The markets seem to agree. Money market rates, and even bond yields, adjusted in line with the negative policy rate on Friday. It will be interesting to see whether this persists over the longer term. If it does, then the major central banks may have found a new weapon that allows them to cut interest rates deeper into negative territory without damaging the profits of the financial sector.
The BoJ also introduced a clever new idea to break the zero lower bound. In the past, there have been fears that negative interest rates could be avoided if the banks shifted their reserve holdings into physical cash, on which the interest rate is of course always zero. Ultimately, that is the fundamental reason why interest rates cannot drop much below zero in an economy.
But, under the new BoJ plan, any shift by banks into cash will be penalised by increasing the scale of the reserves at the central bank that will be charged the negative rate. So the problem of a drain into cash as policy rates dive into increasingly negative territory is mitigated.
Overall, then, the BoJ may have found a third weapon to add to its monetary armoury, following the “quantitative” increase in its balance sheet via purchases of government bonds, and the “qualitative” aspect, via purchases of private sector assets. The statement of the Policy Board hinted that nominal rates could be cut towards the levels reached in Switzerland (-0.75 per cent), Sweden (-1.1%) and Denmark (-0.65 per cent). If this can be achieved, it could reduce rates across the yield curve by at least another 50 basis points, and it could pave the way for the ECB to follow suit.
Each time that the markets suspect that the central banks have run out of monetary options, their research departments reach even further into the unconventional locker. Perhaps successive flavours of monetary easing have become progressively less effective. But they have not run out of monetary ammunition yet.
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