More complications arise after the introduction of negative rates policy in Japan

The Bank of Japan announced last Friday to implement negative interest rates on financial institutions' reserves, as a surprising move. In order to mitigate the adverse impact on their earnings, a multiple-tier system will be adopted - banks' current account held at the central bank will be divided into three tiers, which respectively receive a negative interest rate of -0.1%, a zero interest rate and a positive interest rate. 

Together with the disappointing inflation and growth data seen last Friday, should have been the major triggering factors of this policy move. In light of the oil price declines and global economic uncertainties, the BOJ highlighted the risks during the statement that the conversion of deflationary mindset would be delayed and the underlying inflation trends might be negatively affected. The official inflation forecast for FY2016 was cut notably to 0.8% from 1.4%. And the timeline for achieving the 2% price target was postponed to 1H FY2017 from 2H FY2016. 

The immediate reaction in the financial markets appeared to be not so strong as in Apr13 (when the BOJ established the QQE program) and in Oct14 (when the size of QQE was expanded). The JPY depreciated 1.7% against the USD last Friday, a smaller amount than the 3.5% drop on 4th Apr13 and the 2.8% on 31st Oct14. Friday's rebound in the Nikkei (2.8%) was comparable to that on 4th Apr13 (2.2%), but smaller than that on 31st Oct14 (4.8%). Whether the upward movements in the USD/JPY and the Nikkei could be sustained this time is a big question mark, taking into account the fragile global sentiment, heightened emerging market volatility and diminishing expectations for monetary policy divergence between the G3 central banks. 

By implementing negative rates, the BOJ hopes to incentivize banks to reduce cash holdings and increase lending to corporates/households so as to boost investment/consumption growth. The impact on the real economy would be mixed. The banks would still prefer to hold the long-term JGBs that offer positive yields currently, before taking more risks to lend. Whether banks' reluctance of selling JGBs will create difficulties for the BOJ to maintain large scale of bond purchases under the QQE program remains unclear. Meanwhile, should banks decide to cover their profit losses by lowering interest rates paid on depositors, it could depress the incomes of pensioners and wage-earners and hurt consumer spending. 

The implementation of negative rates has complicated the BOJ's policy framework. Future policy moves could be either a further cut in the negative rates on reserves, an expansion in the size of QQE, or an adjustment in the composition of asset purchases. Whether resorting to the interest rate tool represents a widening of overall policy options or a constraint of the QQE program could be interpreted variedly by market participants. 

In fact, Friday's policy decision was based on highly divided opinions within the BOJ (a 5-4 vote) as some board members also expressed concerns about the confusion and misunderstanding caused. What's clear at present is that the BOJ's battle with deflation is far from over. Further policy easing within this year remains possible, the next important timing will be April when the annual wage negotiation results become available and the BOJ conducts the next quarterly economic outlook review.