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The Bank of Japan Goes Negative

Written by Geoffrey Pike
Posted February 5, 2016

Last week, the Bank of Japan (BOJ) made a surprise announcement that it would be implementing a negative interest rate. While other central banks have attempted going negative in various forms, this was a particularly notable announcement, as the Japanese central bank has been known to have a relatively tight monetary policy in the past.

It is just in the last few years that the BOJ has broken with its past history of tight money. The BOJ has been desperately trying to get positive price inflation to boost the economy, so it engaged in its own form of quantitative easing (money creation).

This wasn’t doing the trick, and the BOJ may actually be concerned about the continually increasing national debt. The debt-to-GDP ratio in Japan is a staggering 225%, which makes Greece look fiscally sound by comparison.

Since the BOJ’s easy money policy didn’t work as well as planned, and it is probably not thrilled with buying up even more government debt, it is trying a different methodology in implementing negative interest rates.

The whole idea of negative interest rates is a tough concept to grasp. After all, why would anyone turn their money over to someone else in order to get less of it back at a later date?

Actually, the concept does make some sense when you consider that it costs money for storage and services. Some banks charge a fee for checking accounts if the depositor does not have a large account or does not make consistent deposits. You are paying a fee to store your money and to have access to banking services such as writing checks and withdrawing money from an ATM. This is, in effect, a negative interest rate.

This is not the same situation as what we have with the Japanese central bank. The BOJ will not be charging any individuals a negative interest rate, although the new policy move could indirectly result in this.

The BOJ is implementing a negative interest rate on excess reserves held by banks. The banks are required to have a certain percentage of reserves based on deposits. They can lend out anything beyond the required reserves. But banks (in Japan and the U.S.) are not lending out the maximum they are allowed by law. It is these excess reserves where the BOJ will impose a negative interest rate. It is starting out at minus 0.1%, so it is barely below zero.

Keynesians Love Price Inflation

We live in a world of Keynesian economics. The central planners of the world believe that spending grows an economy. It is a Field of Dreams mentality — build it and they will come. The Keynesian mentality is that if you spend it, productivity will increase.

But consumer spending alone doesn’t grow an economy. Spending is the result of economic activity. In order to consume something, it must first be produced.

The central planners believe that we always need positive price inflation in order to have spending and thus growth. Price inflation (or lack of) can be correlated with economic activity, but low price inflation does not cause a bad economy. Low price inflation, or even price deflation, may occur due to fear as the result of economic downturns caused by artificial booms. But it was the prior easy money that is responsible for the artificial booms and subsequent busts.

There were many periods in 19th century America where there was mild price deflation. This was prior to central banking in the U.S. These were not depressionary times. Quite contrary, they were times of increasing productivity and increasing living standards. Real wages were going up, unlike today.

Therefore, the entire premise of the BOJ to create price inflation is wrong. In fact, the central planners are doing the exact opposite of what they should be doing, assuming that they actually do want to help the economy.

The policies of easy money and artificially low interest rates, coupled with increasing debt, only serve to misallocate resources and stifle production. It harms living standards.

The BOJ’s imposition of negative interest rates may “work” for a while. It is possible that it could lead to increased bank lending and bubble activity in certain sectors. But it will hurt productivity and ultimately lead to more pain and misery in the future.

The problem is that if this policy does appear to be working a few months down the road, will other central banks follow suit?

Will the Fed Copy?

There are already implications from the BOJ’s new policy. On the day of the announcement, stocks soared, including in U.S. markets. But the rally was short lived. The dollar also temporarily strengthened that day, and unsurprisingly, the yen weakened.

In Japan, the banks may try to pass on the costs to depositors by charging them. The 10-year yield on Japanese bonds is nearing zero. This means that the big money in Japan will be looking to other places for yield. As I mentioned in another article, Japanese investors may start investing outside of Japan.

The big question for Americans is whether the Fed will try to imitate the Bank of Japan at some point. It is actually being openly discussed at this point. While Fed officials are saying there are no immediate plans to impose negative interest rates, they are opening up the possibility.

The Fed just raised its key interest rate in December. It was expected to raise it four more times in 2016, but that is not looking likely at this point. The Fed raised its key rate by increasing the interest paid on reserves to banks, which includes excess reserves. In other words, the Fed’s move in December is the opposite of the move by the BOJ.

The Fed exploded the monetary base nearly five-fold from 2008 through 2014. Much of this money went into excess reserves. The Fed is paying these banks not to lend. This is primarily the reason we have not seen massive price inflation.

If the Fed ever wants to create higher price inflation, it can do so easily. It just has to impose a fee on excess reserves. On the margin, this will increase lending, which will effectively multiply the money supply through the fractional reserve lending process.

Another interesting story that just popped up on the heels of the BOJ’s announcement is that the stress tests given to U.S. banks will include a scenario of negative interest rates in 2016. While the Fed assures us that this is not a prediction, the scenario is how banks would handle the situation if the yield on three-month Treasury bills turned negative for several years.

The Fed probably wouldn’t be discussing this if it weren’t a real possibility. Sometimes the discussions actually get the public used to the idea.

I don’t think the Fed is going to follow the BOJ unless it is necessary in their eyes. We would have to see some kind of an economic downturn bigger than what we see right now. Otherwise, Fed officials are content to keep things as they are.


Investment Implications

In terms of the latest move coming out of Japan, there is not a lot to do. It is slightly bullish for the dollar. It is bearish for the yen, especially if Japanese investors look to trade their yen for dollars and other currencies.

The bigger implications in the U.S. are whether the Fed will follow. Despite the Fed “raising rates,” the U.S. 10-year yield is below 2%, well below where it was in December. In times of slow economic growth (or none at all), investors like government bonds, assuming price inflation stays low.

If the Fed reverses course at some point and starts dropping its key rate again, this will mean paying less interest on bank reserves. If it follows Japan, it will mean a fee imposed on excess reserves. On the margin, this means more lending. On the margin, this is inflationary.

It is interesting that despite the down stock market, gold has done well over the last few weeks. Gold does not typically do well in recessions, as we saw in 2008–09.

But if the Fed responds with negative interest rates, this will be bullish for gold. It will be an investment that people can turn to in the face of declining yields. Would you rather keep $1,200 in the bank and pay a fee to the bank every year to hold your money, or would you rather buy a gold coin or its electronic equivalent?

People will still need bank accounts for access to cash and to pay their bills. But at some point, it may not make sense to keep much more in an account than to meet basic expenses.

As the economy slumps and the Fed considers negative interest rates in its future, bonds and gold will likely outperform most stocks — unless you are ready to take a risk with some gold stocks.

Until next time,

Geoffrey Pike for Wealth Daily

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