Column by Andreas Lipkow – Japan

Interest rate and money market policy in Japan has been a major issue in the global economic landscape for decades. In recent years, Japan has pursued an unprecedented monetary policy strategy based on extremely low interest rates and unconventional measures. This policy has both short-term and long-term effects on the Japanese economy and will continue to have profound consequences in the future. Last but not least, many institutional investors take out loans in yen and invest them in higher-interest investments in Europe and the USA. Reversals of these so-called carry trades due to an appreciating yen have had far-reaching consequences for the international financial markets. A small foretaste of this was already given at the beginning of August after the unexpected interest rate action by the Bank of Japan.

The low interest rate policy and its origins

Japan has struggled with economic stagnation and severe deflation since the 1990s. This period, often referred to as the “Lost Decade,” began after the bursting of the real estate and stock market bubble in the late 1980s. To stimulate the economy and combat deflation, the Bank of Japan (BoJ) implemented a series of monetary easing measures in the decades that followed, including cutting key interest rates to near zero.

In the 2000s, the BoJ introduced quantitative easing measures to increase the money supply and encourage lending. These measures were further intensified, especially after the global financial crisis of 2008. Other central banks, such as the ECB and the US Fed, followed this trend and a global devaluation race among the leading currencies began.

In 2016, the BoJ went a step further and introduced a negative interest rate policy (NIRP) where commercial banks have to pay penalty interest for holding excess reserves at the central bank. The aim of this measure was to motivate banks to give out loans instead of parking money at the central bank. In addition, yields on the bond markets in Japan were controlled via the so-called Yield Curve Control Program (YCC). By making targeted purchases of Japanese government bonds across different maturities, the Bank of Japan created an artificial and controllable yield level in Japan.

Japan had maintained an extremely loose monetary policy for years and used it to support the Japanese economy to a limited extent. It was only when significant increases in inflation and the resulting negative effects on consumption, not only in Japan, that the central bank in Japan moved away from this monetary policy. The unconventional measures to control interest rates and money markets had achieved the goal of bringing inflation to the desired level of 2% and stimulating economic growth, and now a dynamic trend in inflation trends appeared to be emerging.

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Despite these aggressive monetary policy measures, the Japanese economy faces further challenges, some of which have been exacerbated by the previous low interest rate policy.

Japan has one of the fastest aging populations in the world. This is leading to a decline in the labor force and lower domestic demand, which is slowing economic growth. While low interest rates have supported lending and investment in the short term, in the long term it will be difficult to solve the structural problems of the aging population through monetary policy alone.

The persistently low and negative interest rates have led to asset bubbles in some assets. In particular, noticeable valuation asymmetries had already formed in the real estate and stock markets. The long-term maintenance of this interest rate policy led to a massive overvaluation of assets and ultimately to a sharp correction in the financial markets in Japan. A small foretaste of this could already be seen at the beginning of August, when the Nikkei Index corrected from 39,100 to 31,450 points.

The negative interest rate policy has had a significant impact on the profitability of Japanese banks in recent years. Low interest rates have reduced the interest margins of financial institutions, making the banks' business more difficult and more vulnerable to systematic risks. In the long term, this would have led to a politically undesirable consolidation in the banking sector and further restricted lending in Japan.

The BoJ's intensive efforts to achieve the 2% inflation target had become more pronounced over the course of the current trading year. Similar to other western industrialized nations, the resource-poor country imported inflation through the import of raw materials. The Japanese economy was already beginning to suffer from the increased prices and there was a risk that the economy could slide into a “liquidity trap” in which monetary policy had lost its effectiveness in the medium term.

Given the challenges facing the Japanese economy, the question arises whether the Bank of Japan can maintain its current monetary policy stance.

The BoJ has been forced to rethink and act on its policy of quantitative easing and negative interest rates. A gradual tightening of monetary policy has become necessary to avoid financial instability and not only to support the banking sector. However, this must continue to be done very carefully so as not to jeopardise an economic recovery.

In addition to monetary policy, the Japanese government will need to focus more on structural reforms to increase growth potential. These include measures to combat demographic change, increase productivity and promote labor market participation. Fiscal policy will also play a greater role, particularly through targeted investments in infrastructure and innovation.

Interest rate and monetary policy in Japan have helped the Japanese economy to overcome a prolonged period of deflation and stagnation in recent decades. However, many challenges remain that are difficult to overcome by focusing solely on monetary policy. The recent interest rate measures were necessary and are unlikely to have any major impact on future economic development.

To achieve this, it will be crucial to gradually adjust monetary policy and supplement it with comprehensive structural reforms focused on the domestic market in order to secure Japan's long-term economic stability and growth potential. Japanese stocks will therefore remain interesting in the coming trading months. International investors have been giving the Japanese stock market a discount compared to other financial markets in the USA and Europe for some time now. As a result, the upcoming interest rate hikes do not represent a major risk and could present an interesting situation, particularly for Japanese financial and insurance companies.