“Our market-based estimates indicate that, when the BOJ announced its plan to move to negative policy rates, inflation expectations actually declined and then continued to trend downward afterward. Therefore, Japan’s case is an extreme but potentially informative example illustrating the challenges associated with raising well-anchored inflation expectations through negative monetary policy rates.” (FRBSF Economic Letter, August 26, 2019)

Negative interest rates may make for a difficult or unusual for monetary policy, but from a bond investor perspective, they can make sense, even if intuitively it is a bit hard to grasp.

Many central banks were forced to set their policy rates close to or below zero following the major global financial meltdown in 2008-09. 

As the Federal Reserve Bank of San Francisco recently observed, Denmark’s central bank policy rates fell below zero in July 2012, followed after by a number of other central banks, including the European Central Bank, the Swedish Riksbank, and the Swiss National Bank.

Japan is an interesting case to consider, since it has had an extended experience with ultra low policy rates after allowing its leading policy rate to fall below zero on January 29, 2016. Japan has been battling with very low inflation since the mid-1990s, and its policy rate and other short-term interest rates have been close to zero for much of that time.

Japan’s experience may also provide some useful evidence relating to whether negative policy rates are effective in terms of a central bank supporting a struggling economy.

As it turns out, inflationary expectations are the key to understanding the efficacy of low or negative interest rates in achieving central bank objectives. 

When the Bank of Japan announced its plan to move to negative policy rates in 2016, as one of the following charts illustrate, inflation expectations fell instead of increasing as the BOJ hoped.

Although the decline in inflationary expectations in Japan may not have been triggered by the BOJ’s negative rate policy, nonetheless it still underscores that considerable uncertainty surrounds the effectiveness of using negative interest rates as a tool of economic expansion when inflation expectations are very low.

The last chart highlights both the decline in nominal yields and the decline in inflationary expectations after the negative rate policy was announced.

In this chart, the breakeven inflation rate (BEI) is a measure of expected inflation derived from the financial markets. It is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. In other words, the BEI is an estimate of Japan’s inflationary expectations.

The final chart illustrates the FRBSF (August 26, 2019) estimates of 10-year BEI rates, with estimates since 2013 also adjusted for deflation protection. The discrepancy between the adjusted BEI rate and estimated expected inflation can be interpreted as an estimate of the inflation risk premium.

Finally, as my colleague Norman Mogil has observed to this writer, it makes sense for an investor to buy a negative interest rate bond if one understands that it is a way to protect the buyer from deflation.

“If the nominal rate is, say -0.5%, and deflation is 1.00%, then the real rate is +.5%. This is just what is expected in Germany as the EU deflates with German bonds -0.4%. Today, there are $12 trillion negative bonds (including, corporate bonds). Denmark is offering mortgages at a rate of minus 0.05%. Remember real rates of interest in Canada and US are negative, so a positive real rate in the EU is a better return.” (Norm Mogil, Feb. 2020)

Summary Comments On Low Interest Rates And Monetary Policy

As Lucrezia Rezia argues in a Project Syndicate article, economists are still a long way from understanding the dynamics of low inflation.

Accordingly, the right solution is not to cast aside monetary policy, but to find ways to strengthen its effectiveness in a low-interest-rate environment, possibly by finding ways to use negative rates more fairly and effectively.

Until then, with monetary policy hampered, and with fiscal policy the main effective game in town, we should expect more volatile business cycles.

There is however a practical problem relying on fiscal policy to play a more meaningful counter-cyclical role.

That is, the political decision lags on government spending or taxation are incredibly difficult to manage.

The advantage of monetary policy is that it is generally run by technocrats rather than governments and their legislatures.