It's been a bad week for Abenomics, the stimulus strategy that propelled Japanese Prime Minister Shinzo Abe to power three years ago with the promise of defeating entrenched deflation, reviving Japan's moribund economy and restoring its lustre as a global power.
First, Economy Minister Akira Amari, the key cabinet minister steering his boss's reform agenda, including the Trans-Pacific Partnership trade deal, resigned in the face of bribery allegations.
Then the Bank of Japan dropped a bombshell Friday, adopting negative interest rates for the first time as it rummages through a depleted toolbox for anything that could boost lending and spending, weaken the yen and restore a modicum of inflation as global conditions worsen.
The move, which sent shock waves through global financial markets, underscores the failure of Abenomics to get Japan's economy back on the rails despite rock-bottom interest rates and massive injections of fiscal and monetary stimulus.
The Bank of Japan becomes the fifth central bank to resort to once-unimaginable negative key rates, following the European Central Bank and counterparts in Switzerland, Sweden and Denmark. More are sure to follow, as they wrestle with increasingly volatile financial markets, a sputtering global economy, darkening trade outlook and the ever-present threat of crippling deflation.
"I don't know why it is such a surprise [to the market]," said Albert Edwards, Société Générale's London-based global strategist. "It is the next logical step in the central bankers' ever-evolving armoury. In a year or 18 months' time, I expect most policy rates, including Canada and the U.K. and the Fed's, to be negative."
Still, the Japanese move did catch financial markets off guard, driving up global equities and sending yields on Japanese government bonds to record lows. Five- and seven-year Japanese bonds slid into negative territory for the first time.
But they were in good company. Yields have turned negative on most short- and medium-term debt issued by the likes of Germany, France and a handful of other European countries.
Bank of Canada Governor Stephen Poloz mentioned in a speech last month the possible use of the negative-rate tool in event of a crisis. And U.S. Federal Reserve Board and Bank of England officials have made similar comments.
Bank of Japan Governor Haruhiko Kuroda summed up the situation this way: "We think there is an increasing risk that an improvement in the business confidence of Japanese firms and the conversion of deflationary mindset may be delayed, and that the underlying trend in prices might be negatively affected."
In the early days of Abenomics, initial successes in driving down the value of the yen enabled major exporters to fatten their profits and boosted equities. But the hefty corporate gains didn't translate into higher wages, more borrowing or significant increases in domestic spending. And recent devaluations by China and other Asian trading partners have been taking a toll on Japanese competitiveness.
The yen fell in value against most other major currencies, including the Chinese yuan, as soon as the Bank of Japan announced that it will apply a negative interest rate of 0.1 per cent to some of the current account deposits it holds for commercial banks.
The central bank said it could venture even deeper into the uncharted world of negative rates if necessary to combat a return of deflation.
"It is the effect on the currency that matters … as there is a drive to gain competitive advantage via devaluation," said Satyajit Das, a risk consultant who advises banks on their derivatives exposure. "I think that low rates have limited effect on demand and economic activity."
Indeed, the jury is still out on whether negative rates will have any meaningful impact on business or consumer confidence. But at least the unorthodox measure has not yet triggered any major financial disruptions.
"Perhaps the key lesson so far has been that the adverse effects of negative interest rates have been less than many had feared, even though interest rates in some economies are now far lower than many considered feasible," Oxford Economics said in a note.
"There has been little substitution to cash and little sign that banks have sought to cover losses associated with the policy by raising interest rates on new lending."