Japan imposes a negative interest rate: What that means for them and us

The Bank of Japan announced Friday it was imposing a negative interest rate for the first time, an effort to jumpstart the Japanese economy out of years of stagnation.

The bank's governor, Haruhiko Kuroda, said the measure was intended to bolster business confidence and consumer spending. It's also a weapon to fight deflation, which has long dogged Japan as consumers held off on spending in expectation that prices would fall.

In addition, Kuroda said, global economic worries prompted the bank to introduce the negative interest rate.

"Global financial markets have been volatile against the backdrop of the further decline in crude oil prices and uncertainty such as over future developments in emerging and commodity-exporting economies, especially the Chinese economy," he said in a statement.

But what are negative interest rates, and what effect could they have on Japan and the rest of the world? Here's what you need to know.

What is the Bank of Japan actually doing with interest rates?

This negative interest rate policy doesn't directly affect consumers, but rather the financial institutions that hold money at the Bank of Japan.

Most cash currently held at the central bank will continue earning the same 0.1% interest rate as before. However, required reserves, or the amount of money banks are required by law to hold against deposits made by customers, will earn zero interest now.

A rate of negative-0.1% will apply only to future funds that exceed the reserve requirements parked at the central bank.

Sung Won Sohn, an economist at Cal State Channel Islands, called it "a storage fee." The reason for the strategy is simple: to encourage lending and investment by making financial institutions pay for hoarding money.

"They are essentially saying, 'I am going to make it more expensive to keep money at the central bank,'" Sohn said. "It's to encourage banks to lend money rather than depositing it."

Why is the Japanese central bank doing this?

The negative interest rate is an effort to boost Japan's flagging economy, which is still the third-largest in the world.

After Shinzo Abe became prime minister in 2012, he appointed Kuroda to head Japan's central bank. Both were quickly lauded for bold economic policies, including a large fiscal stimulus and a huge bond-buying program. Dubbed Abenomics, the experiments scored some early wins, boosting the stock market and sending consumer optimism soaring.

But the earlier gains have largely petered out, and Japan has slipped in and out of recession in recent years.

Economists have said that Japan's economy can't achieve long-term growth without implementing the third part of Abenomics — structural changes in the economy. That includes smoothing the way for entrepreneurs, overhauling how corporations are governed and rethinking massive farm subsidies. However, these reform efforts have made little progress in the face of fierce opposition from interest groups invested in the status quo.

The central bank has few tools left, economists said. That's partly why it is imposing a negative rate.

"They have gone through a number of programs," said Lindsey Piegza, chief economist at Stifel Fixed Income. "Part of the concern is, they don't want to wait too long. They could sit with current policies in place and that could foster growth, but they don't want to get behind the curve."

Have negative interest rates worked before?

A few other countries such as Sweden and Denmark have adopted negative interest rates. In 2014, the European Central Bank also introduced negative rates on funds deposited there.

But economists said it's hard to tell whether these efforts have stimulated growth.

Piegza, the economist at Stifel, said the economies of some European countries, such as Spain and France, are showing improvement. But it's impossible to figure out exactly what helped and what didn't.

"It's very difficult to point to one policy," she said.

Will this have any effect on U.S. Federal Reserve's plans?

Maybe, but only slightly, some economists said.

The Fed reaffirmed this week that it still plans to raise interest rates gradually despite turmoil in stock markets and worry about slowing economic growth. In December, the Fed raised interest rates for the first time since the financial crisis.

Sohn said the Fed is hard-pressed to deviate once it has committed to a plan.

"The central bank is very reluctant to flip-flop," he said. "They don't want to look flippant because they made the decision to raise interest rates after a long, long deliberation."

The Fed may raise rates only once or twice this year, Sohn predicted.

Twitter: @ByShanLi

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