What does a Japan with positive interest rates look like?
After 17 years, Japan moves away from negative interest rates, igniting discussions on the consequences for growth, fiscal sustainability, and the future of zombie companies
The Bank of Japan (BOJ) has “finally” made the call on March 19 to overhaul its financial policy. This move marks the end of the negative interest rate policy and the Yield Curve Control framework (YCC), shifting short-term interest rates to be maintained around 0% to 0.1%. Long-term interest rates will no longer have a set target, heralding the first rate hike in 17 years.
Under the banner of a 2% inflation target, Japan has seen almost two decades of the world’s most excessive monetary easing, and until a global shift in inflation rates, there was no sign that this was working.
Now when the whole world is caught in an inflationary pressure cycle, it remains unclear how far interest rates will rise in Japan, but adjusting both short and long-term rates as necessary will be crucial for its economy. If current growth rates and the 2% inflation target are to be maintained, long-term interest rates might need to be as high as 2-3%.
What is Japan’s Natural Interest Rate?
The transition to a world with interest rates raises concerns about increased fiscal borrowing costs and the potential worsening of corporate earnings or bankruptcies. However, I would argue that the prolonged period of low interest rates has, in fact, stifled growth. In the United States, the level of long-term interest rates aligns with growth rates and inflation rates.
Normalization of monetary policy and healthy economic growth necessitate determining an appropriate level of interest rates. This involves considering three key variables:
The real economic growth rate
The inflation rate
Long-term interest rates.
These factors are intricately linked and cannot move independently. Therefore, ignoring this relationship when deciding on monetary policy is not feasible.
Looking at the trends in Japan and the United States from 2001 to 2024, the average real economic growth rate in the United States was 1.95%, determined by factors like labor force growth and technological advancements. During the same period, the average consumer price inflation rate was 2.52%.
Given these two variables, the appropriate level for nominal long-term interest rates can be deduced. The rationale is that interest rates, neutral to economic activities, should match the potential growth rate of the economy. Monetary policy is believed to operate best when it aligns with the natural interest rate, known as the "Taylor Rule."
While the natural interest rate cannot be directly observed, it has been proven under certain conditions to equate to the economy's potential growth rate. For simplicity, let's assume that the average real GDP growth rate over a certain period represents the potential growth rate (and thus, the natural interest rate).
According to this logic, the neutral real long-term interest rate in the United States would be 1.95%. With an inflation rate of 2.52%, the neutral nominal long-term interest rate would be 4.47%.
With the yield on 10-year US Treasury bonds roughly at 4%, I would consider the US Federal Reserve (FED) to have done an excellent job in setting its interest rate.
In contrast, Japan's average real economic growth rate was 0.65%, with the actual average consumer price inflation rate at 0.36%. Despite this, the Bank of Japan has pursued a policy goal of achieving a 2% inflation rate.
Assuming a real growth rate of 0.65%, the neutral level of real long-term interest rates should be 0.65%. If the goal is to achieve a 2% inflation rate, then the nominal long-term interest rate should be 2.65%.
However, under BOJ’s former governor, Haruhiko Kuroda, long-term interest rates have been maintained at 0% as a policy target!
Under the new Governor, Kazuo Ueda, the Bank of Japan has become more flexible with the guidance of long-term interest rates through widening the fluctuation range and removing the upper limit, allowing for rates above 1%.
Still, I think this is too low. The Bank of Japan is still pursuing an unrealistic economic target with unchanged excessive monetary easing.
Is Japan’s inflation Even Real?
The mechanism behind price increases poses another issue. Both Japan and the United States have experienced global inflation effects due to supply chain disruptions and rising resource prices during the pandemic recovery. In the US, inflation has been driven by increased demand and the introduction of advanced IT services.
In Japan, despite targeting a 2% inflation rate, inflation did not reach that level for a long time. It only surpassed 2% in April 2022, but if normalized, consumer price inflation rates were in the 0% range for an extended period.
On the other hand, significant interest rate differences between Japan and the United States have triggered yen carry trades, leading to a weaker yen. This depreciation, starting in the fall of 2021, has been a key factor in raising Japan's inflation rate.
The current inflation rate standing at around 2% is primarily due to these factors. Therefore, keeping long-term interest rates artificially low has just contributed to inflation through a weaker yen, not structural change within Japan’s economy.
What Would Happen in BOJ Increased Interest Rates Further?
I would argue, that if BOJ is serious with its target inflation rate at 2%, the nominal long-term interest rate should be between 2% and 3%. Given that the current yield on 10-year government bonds is around 0.7%, significant rate hikes are necessary.
Even with such an increase in long-term interest rates, there would still be a difference with American rates, potentially leading to further yen depreciation. However, as the interest rate gap narrows, there could also be a possibility for yen appreciation. Additionally, if the US were to significantly lower its rates, a substantial appreciation of the yen could occur.
If Japan transitions to a world with positive interest rates, there would be various issues.
Firstly, the cost of fiscal funding through government bonds will rise. While this is problematic, the real issue has been the fiscal recklessness allowed by too-low fiscal funding costs.
Secondly, the significant depreciation of the vast amount of government bonds held by BOJ will lead to a substantial decrease in the bank's assets when valued at market prices. BOJ likely cannot avoid falling into a state of insolvency, but this should not pose a significant operational hindrance.
Thirdly, mortgage interest rates will increase, and so might the bankruptcy of so-called zombie companies (firms that earn just enough money to continue operating and service debt but are unable to pay off their debt, limiting their ability to invest in growth opportunities.). However, these are processes in which wasted resources due to previously too-low interest rates are corrected.
Read more about the massive amounts of Zombie companies in Japan here:
Conclusion
For too long, both the Japanese government and BOJ’s economic policy has taken the easy route of focusing on monetary easing over structural economic reforms and hope for a “magical” deflation exit, neglecting effective policies to enhance Japan Inc.’s real growth rates. This approach has been extremely unproductive, focusing on subsidies for zero growth-oriented existing industries and small businesses, leading to keeping thousands of Zombie companies alive that do cost the country billions without giving any value back!
Now, the Bank of Japan (BOJ) has been forcefully roused from its inactivity by global inflationary pressures, which have threatened to compel action to avoid being held accountable for an inflationary spiral in Japan. This situation may represent a crucial opportunity for Japanese companies to confront and address their structural issues. Faced with the pressing challenge of high inflation, they must take decisive action or risk death…