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Empty Mind after Ten Thousand Reasons

Too low neutral interest rate led to two unfortunate consequences.

Kazumasa IWATA


Mr. Powell, Chair of the Federal Reserve Board, said after the beginning of the year that the interest rate hike was terminated and the policy rate reached the lower limit (2.5%) of the neutral rate.

Neutral interest rates are interest rates that neither accelerate nor decelerate inflation. The real neutral interest rate in the US (also called “natural interest rate”), which is defined as the neutral interest rate minus the expected inflation rate (2%), hovers around 0.5%. If the real neutral interest rate is too low, the central bank will not be able to cope with the recession simply by reducing the interest rate, given the zero lower bound on nominal interest rates combined with the low inflation expectation.

Among the major central banks, the Bank of Japan suffers the most. According to Japan Center for Economic Research, Japan’s real neutral interest rate stands at about minus 0.5%, which has the opposite sign of the US. If the expected inflation rate (0.2%) is added to minus 0.5%, the neutral interest rate in Japan is minus 0.3%.

One unfortunate consequence of low neutral interest rates is that deflation is difficult to overcome if the negative size of policy interest rates is too small. Japan’s short-term policy interest rate is currently minus 0.1%. The Bank of Japan has set a higher policy interest rate (minus 0.1%) than the neutral interest rate (minus 0.3%). Thus it implies that the BOJ adopts a tightening policy stance in terms of short-term interest rate policy.

Of course, in addition to the asset purchase program, the long-term rate which is also fixed at 0% (plus or minus 0.2% margin of fluctuations). Thus, it can be said that the BOJ maintains easing policy stance as a whole. But it’s not enough to deal with the next recession and rising deflationary risks.

Another unfortunate consequence is that the real neutral interest rate has fallen to a negative range. This suggests that the rate of increase in real per capital consumption will be negative, and that the standard of living for Japanese people will decline.

Since the average growth rate after Abenomics is 1.2%, there is a view that the Japanese people won’t be poorer in the future. However, given the fact that the growth rate of real wages last year was close to 0% and the increasing public burden of workers due to the declining birthrate and aging population, the risk that the per capita real consumption level will decline is not negligibly small.

One way to escape unfortunate consequences, is to increase the expected inflation rate to 2% with a quantitative easing policy as adopted by Haruhiko Kuroda, Governor of the Bank of Japan. If its policy succeeded, the real policy interest rate should be less than minus 2%, leading to a lower level than the current real neutral interest rate. Unfortunately, this method has yet to confirm success.

The other is to follow the European Central Bank and transform the “negative interest rate policy as a tax” to “negative interest rate policy as a subsidy.” The current negative interest rate policy is equivalent to 0.1% tax when private financial institutions make deposits more than a certain amount at the Bank of Japan account. If the negative interest rate is applied to the Loan Support Program and liquidity supply through market operations, currently being run at 0% interest rate by the Bank of Japan, it is possible to switch to “subsidy from tax.” It will alleviate the difficulties of private financial institutions suffering from the reduction of profit margin.

The fundamental prescription is to raise negative real neutral interest rates to the positive territory. Lawrence Summers, former US Treasury Secretary, argued in a recent paper that the real neutral interest rate in developed countries was raised by 3-4% due to the expansion of the government sector’s excess investment. In Japan, there is limited scope for further expansion of the government sector’s excess investment. The best approach is to increase private sector productive investment, especially intangible asset investments such as artificial intelligence, big data, and human capital, to correct the excess corporate savings trend.

(The english translation of the article was published in the Nikkei morning edition 2019/04/05.)