Thirty Years of Japanese Monetary Policy: From Interest Rate Cuts to Zero Interest Rates-QE-Negative Interest Rates, Transition from Quantity Control to Price Control

In March this year, the Bank of Japan made a historic announcement to raise the benchmark interest rate and abolish the Yield Curve Control (YCC) policy that has been in place for 8 years, marking the end of the era of negative interest rates. In July, they raised interest rates again.

Looking back, after the bursting of the real estate bubble in the 1990s, Japan entered the "Lost Decades", during which the transformation of the Japanese economy, policy responses, financial market performance, as well as institutional and household asset allocation behaviors, have significant reference value.

On September 5th, analysts Xiao Yu and You Yong from Zhongtai Securities released a research report, pointing out that Japan basically completed the interest rate marketization reform in the mid-1990s, establishing a transmission mechanism from policy rates to interbank market rates to bond rates/loan rates.

The report indicates that during the "Lost Decades" of the Japanese economy, it faced three major challenges: weak economic growth, financial market turbulence, and accumulation of non-performing assets. These issues prompted a shift in Japan's monetary policy from quantity-based control to price-based control, maintaining a loose stance in the long term.

Evolution of Japan's Interest Rate Framework

Japan's monetary policy framework includes policy objectives, policy tools, and transmission mechanisms.

It is important to note that the Bank of Japan is Japan's central bank, but it was not until after 1997 that the Bank of Japan truly gained independence. In the mid-1990s, Japan completed the interest rate marketization reform, leading to significant adjustments in monetary policy.

Subsequently, Japan's monetary policy showed two trends: a gradual shift from quantity-based control to price-based control, and a progressively loose monetary policy stance.

The report points out that in the first stage, financial liberalization and interest rate marketization reforms drove the monetary control framework from quantity-based to price-based; after the burst of the Japanese bubble economy, amidst weak economic growth, non-performing asset disposal, and financial market turbulence, Japan's overall monetary policy orientation shifted towards looseness.

In specific stages:

In the 1990s, Japan completed the interest rate marketization reform, and the focus of Japan's monetary policy operations gradually shifted to price-based policy tools. Japan began the interest rate marketization process in 1977, following the principles of "foreign currency first, domestic currency later; loans first, deposits later; long-term, large amounts first, short-term, small amounts later". The reform was completed in 1994, establishing a transmission mechanism from policy rates to a broad spectrum of rates. Based on this interest rate control system, the Bank of Japan continuously adjusted policy rates and operational targets.

Before 1998, the discount rate or rediscount rate was the policy rate of the Bank of Japan. The Bank of Japan mainly injected liquidity into the market through rediscounting. The rediscount rate is the loan rate provided by the Bank of Japan to eligible counterparties (usually large commercial banks). Since most of the loans provided are short-term, this rediscount rate is also known as the discount rate. The discount rate essentially represents the short-term funding cost of large commercial banks, which is transmitted from the interbank market to small and medium-sized banks and other financial institutions.

From 1999 to 2013, the policy rate switched to the unsecured overnight call rate. With the marketization of interest rates and financial liberalization, the link between market rates and the official discount rate weakened. The pricing anchor of market rates began to be tied to short-term market rates (specifically the unsecured overnight call rate)

From 2013 to 2016, with the implementation of Quantitative and Qualitative Easing (QQE), the unsecured overnight call rate has dropped to around 0, and interest rates have reached the lowest point. At this time, the monetary policy target is no longer interest rates, but the basic money supply.

In the era of negative interest rates that began in 2016, the policy rate is the interest rate on excess reserves that commercial banks hold at the central bank. In order to stimulate money flow into the real economy, the Bank of Japan started implementing a negative interest rate policy in 2016, with the interest rate on excess reserves of financial institutions such as commercial banks as the policy target. Negative interest rates are essentially a form of taxation, essentially taxing reserve deposits.

In summary, the policy rate transitioned from the discount rate to short-term market rates (unsecured overnight call rates), and then to the interest rate on excess reserves.

Before the marketization of interest rates, entity financing mainly relied on credit and the discount rate as the pricing benchmark for deposit and loan interest rates, becoming the policy rate . After the marketization of interest rates, the connection between market rates and the discount rate weakened, and the unsecured overnight call rate, as a short-term market rate, became the policy target rate.

The "Three Rises and Three Falls" of Japan's Policy Rate

Since the 1990s, Japan's policy rate has experienced "three rises and three falls". Japan has gone through three interest rate hike cycles, three interest rate cut cycles, three periods of zero interest rates, and one period of negative interest rates. Starting in 2024, Japan's monetary policy has once again begun to "normalize", and has already experienced 2 rate hikes.

Specifically, the report outlines the triggering factors and evolution process of each stage as follows:

(1) First rate hike: Rapid consecutive rate hikes burst the asset bubble (1989-1991). In May 1989, the Bank of Japan raised the policy rate from 2.5% to 3.25%, and in October and December each raised it by 50 basis points. By the end of 1989, the policy rate had risen to 4.25%. The rate hikes directly led to a decrease in stock market trading volume, and the real estate market also experienced adjustments.

(2) First rate cut: Shift to monetary easing (1991-1999). After the bursting of the bubble brought serious consequences, financial market turmoil and weak economic fundamentals were the main reasons for Japan's rapid interest rate cuts. In July 1991, the Bank of Japan lowered the discount rate from 6% to 5.5%, marking a shift in monetary policy from tightening to easing. In a little over 2 years, the policy rate had returned to the level before the rate hikes in 1989.

(3) Second rate cut: Gradually entering the era of zero interest rates (1999-2006). In February 1999, the Bank of Japan announced that it would provide ample liquidity to the market to guide the unsecured overnight call rate "as low as possible," essentially reaching the level of zero interest rates. As the Japanese economy recovered, Japan's monetary policy normalized, briefly raising interest rates from 0 to 0.25% starting in August 2000. However, the burst of the U.S. "dot-com bubble" spread to Japan, causing the economy to weaken again （4）Second Round of Rate Hikes: Quantitative Easing Restarted After the 2008 Financial Crisis (2008~2016). Starting from 2004, with the rapid expansion of the global economy, the Japanese economy grew steadily. In July 2006, the Bank of Japan exited the zero interest rate policy, raising the unsecured overnight call rate from zero to 0.25%, and then further to 0.5% in February 2007. At the same time, it continued to purchase government bonds to maintain market liquidity stability.

（5）Third Round of Rate Cuts: Introducing Yield Curve Control, Entering the Era of Negative Interest Rates (2016~2024). In September 2016, the Bank of Japan adjusted its monetary policy operational target, returning from base money to interest rates, and introduced Yield Curve Control (YCC) under the Quantitative and Qualitative Monetary Easing (QQE) policy. The revised interest rate operational targets include short-term and long-term interest rates. The short-term policy rate was set at -0.1%, and the target level for 10-year government bond yields was around 0%.

（6）Third Round of Rate Hikes: Farewell to the Era of Negative Interest Rates (2024). In March 2024, the Bank of Japan took a historic step by raising the benchmark interest rate from -0.1% to a range of 0% to 0.1%, while also discontinuing the Yield Curve Control (YCC) policy. In July, the policy rate was raised again from around 0% to 0.1% to about 0.25%.

Characteristics of Interest Rate Changes in the Japanese Market

Market interest rates mainly include deposit and loan rates, as well as government bond rates.

（1）Deposit and Loan Rates

Since the marketization of deposit rates in 1994, deposit and loan rates have gradually decoupled from the discount rate. The change in deposit rates is mainly influenced by two factors: the central policy rate and the cyclical changes in deposit rates after marketization.

In the long term, with a downward trend in the central policy rate, both deposit and loan rates have been declining, leading to a narrowing net interest margin. Deposit rates have dropped from over 2% to almost 0, while loan rates have decreased from over 4% to 0.56%, and the net interest margin has narrowed from over 1.8% to as low as 0.51%. The decline in loan rates reflects the decline in corporate balance sheets after the bursting of the real estate bubble in the 1990s, leading to insufficient financing demand.

The report also points out that the pace of changes in deposit and loan rates is not completely synchronized. During periods of rate hikes, deposit rates usually lead; during rate cuts, there is no clear differentiation in the timing of changes in deposit and loan rates, with both rates being lowered almost simultaneously.

Due to Japan's long-term environment of aging population, weak economic growth, and deflationary cycle, the economy lacks internal momentum, making it difficult to sustain loan demand, resulting in a continuous narrowing of interest spreads. After the zero interest rate period post-2009, Japanese bank loan rates further decreased from 1.4% to around 0.9% by the end of 2015 After the Bank of Japan implemented negative interest rates in 2016, loan interest rates further decreased to around 0.7%, with rates even dropping below 0.6% in some individual months.

（2）Government Bond Yields

The overall downward trend of long-term Japanese government bond yields has been accompanied by multiple fluctuations, showing a "bull long, bear short" pattern. On one hand, with the downward shift of the economic growth center, the long-term trend of government bond yields remains downward; on the other hand, factors such as monetary tightening, fiscal stimulus, increased government bond supply, and temporary economic recovery have led to periodic increases in bond yields.

Historically, the driving factors behind the rapid increase in 10-year government bond yields have been monetary tightening, fiscal stimulus, increased government bond supply, and temporary economic recovery. Before the introduction of the QQE policy in 2012, despite short-term rates being near 0%, the existence of term spreads meant that the lower limit for 10-year government bond yields was close to 1%. However, QQE and negative interest rates can even push 10-year government bond yields down to 0%.

The main viewpoints in this article are from a report titled "Revelation of Japan: Monetary Policy in the Era of Low Interest Rates" released by Xiao Yu (SAC license number: S0740520110001) and You Yong (SAC license number: S0740524070004) of Zhongtai Securities on September 5th