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Japan's Experiment With Rates of Less Than Zero

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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By now, financial markets have absorbed the news that the Bank of Japan has decided to implement negative interest rates. In doing so, the BOJ follows Europe, which sent rates slightly below zero in 2014. Presumably, the new target of -0.1 percent will be achieved through more purchases of assets such as exchange traded funds and real estate investment trusts, as well as the usual government bonds.

There are two interesting and important questions here. The first is “Why is Japan doing this?” The second is “How low can rates go?”
QuickTake Negative Interest Rates

Let’s talk about the second question first. There’s real uncertainty about how far below zero a central bank can push nominal interest rates using standard techniques like asset purchases. If holding your money in a bank account or government bond causes its value to steadily shrink, you can just withdraw your money and put it in cash, hide it under your pillow or bury it in the back yard. I can almost guarantee you that somewhere in Japan, someone is doing this right now.

One solution is simply to put a tax on paper cash. This is the solution being promoted by University of Michigan economist Miles Kimball, who has been going around the world evangelizing for electronic money for years now. The University of Chicago’s John Cochrane is skeptical, pointing out other ways that savers could avoid losing money to negative rates. But most of these techniques rely on prepaying bills, which could be penalized more under an electronic money system.

Now it's true that -0.1 percent isn't very much below zero, so there won’t be a huge flight to cash just yet. But if the BOJ decides to send rates deeper into negative territory, expect to see something like Kimball’s electronic money system.

Let’s think about why the BOJ made this move right now. One reason might be that since the spring of 2015, Japan’s core inflation rate has tumbled back to about zero. If the BOJ takes its official 2 percent inflation target seriously, it might be implementing negative rates in order to hit the target. But if this were the main motivation, it’s coming a bit late, since inflation collapsed almost a year ago.

A more likely explanation is that the BOJ is trying to cancel out some negative demand shocks. One big such shock is the China slowdown, which is already hurting Japan’s trade in a big way.

A second hit to demand will come if the government decides to raise taxes again. A higher tax on consumption imposed in 2014 raised revenues and put Japan on a sounder long-term fiscal footing, though it probably hurt the economy temporarily. One or two more similar tax hikes might put Japan on the path to long-term fiscal sustainability. So adopting negative rates might be how the BOJ hopes to cancel out the hit to demand from these future taxes increases.

A third reason for negative interest rates also involves fiscal issues. The lower rates go, the more cheaply the government can refinance its debt. Once all debt is refinanced at negative rates, the government’s interest payments vanish, allowing it to apply more taxes toward its spending commitments to the elderly. If the government can exercise fiscal restraint and resist the urge to splurge, then negative rates will act as a stealthy form of debt monetization.

All of these challenges might eventually call for very negative rates. So it makes sense for the BOJ to test the waters now, by sending rates a little bit below zero. This will give the central bank an idea of how easy it is to push rates below zero with standard techniques, which will help inform it about when it might need to implement a Kimball-style electronic money system. In part, negative rates are an experiment.

So what are the risks of negative rates? The obvious one is that at some point Japanese savers -- most of which are corporations at this point, since household savings have collapsed -- might start moving their money out of the country. Capital flight would necessitate a rapid reversal of interest rates, and might even spur hyperinflation -- a run on the Japanese currency itself.

But this danger is remote. And other dangers -- financial instability, for example -- are not even certain to exist. So far, low interest rates don’t seem to have done much harm to advanced economies, so it’s doubtful that slightly negative rates will be any different. If rates go very negative, though, things could abruptly change. The world’s central banks are, after all, in uncharted territory here.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net