Last Friday, Japan’s central bank surprised markets by setting the country’s first negative interest rates. The current global economic instability, reflected in stock markets and low commodity prices, is threatening to drive the country back into deflation.
The Bank of Japan is now the second major central bank to set negative interest rates, after the European Central Bank first did so in 2014. In Sweden, Denmark and Switzerland central banks also have negative interest-rate policies.
What’s A Negative Interest Rate?
During inflationary periods, assets become more expensive over time and money that is not spent or invested is just losing its purchasing power. People tend to spend money during these periods rather than let it lose more value holding onto it.
While in deflationary periods, people tend to accumulate their money instead of investing or spending it, resulting in falling demand and lower prices. In deflationary periods central banks usually loosen their monetary policy to deal with it. However, in strong deflationary periods, simply cutting interest rates to zero may not be enough to stimulate lending.
Negative interest rates mean that depositors must pay regularly to keep their money in the bank. This measure encourages people and businesses to spend, invest and lend money rather than pay a fee to save it and keep it safe.
Dollar Up, Yen Down
A result of the negative interests rates set on Friday was a devaluation of the Japanese currency against other currencies, including the US dollar. The dollar jumped almost 2% on Friday against the yen.
Europe Signals More Stimulus Soon
Also in January, The European Central Bank signaled that it would provide more stimulus at its next meeting in March. The euro fell against the US dollar on the news and, in theory, should continue to do so while domestic and European policies diverge.
Rising US interest rates, while global rates are falling, will normally result in a stronger dollar as borrowing costs domestically would make the dollar more attractive to investors seeking yields than other currencies. That would potentially make the dollar appreciate against other currencies, having a depressing effect on commodity/metal prices.
Federal Reserve: Tough Decision to Make
The US central bank lifted short-term interest rates by 0.25% in December and talked about four more increases to come this year. What the Fed didn’t know, at the time of that meeting, was the market turbulence ahead. Right now, the Fed is trapped in a very difficult situation.
Raising interest rates while global stock markets fall is probably not a good idea. On the other hand, not raising rates would mean that the Fed is acknowledging economic weakness and not delivering what it had previously promised. That could certainly hit the market’s mood and extend the current stock market selloff.
In its meeting last week, the Fed didn’t give many clues, seeming as if officials haven’t made up their mind about what they will do in March. Futures markets place just a 25% probability on a rate increase.
A further deterioration in financial markets could or could not prompt a delay in rate hikes. What’s yet to be seen is how markets will react following the Fed’s actions. What’s true is that in bear markets, people overreact to bad news while they don’t get very excited about good news. Whichever decision the Fed takes from now, it’s going to be a tough one…