Industry Rakes in Over 1 Trillion Yen Amid Government and Bank of Japan Turmoil
The purpose of providing interest on reserve deposits is to ensure the penetration of tightening effects.
As mentioned earlier, regular bank current accounts do not earn any interest. So why does the central bank provide interest on banks’ reserve deposits?
Before entering a phase of monetary tightening, central banks in Japan, the U.S., and Europe implemented quantitative easing policies that flooded the financial markets with funds. This led to a sharp increase in reserve deposit balances. If the central bank attempts to tighten monetary policy without offering interest on reserve deposits, what happens? Let’s explain using the Bank of Japan as an example.
Currently, the Bank of Japan’s policy interest rate, the uncollateralized overnight call rate, has a target of 0.25%. If no interest is paid on current accounts, banks will find it pointless to keep funds there and will seek to invest them in short-term financial markets to earn any interest. This would lead to a large influx of funds into the uncollateralized call market, exerting downward pressure on the overnight rate.
As a result, many transactions are likely to occur at rates lower than 0.25%. The daily financial adjustments by the Bank of Japan (BOJ operations) would not be able to prevent this situation, leading to a failure to achieve the desired tightening effect—this is a significant problem.
Therefore, by offering a policy rate equivalent to the interest on reserve deposits, banks can avoid having to engage in short-term financial market transactions. When banks do operate in the uncollateralized call market, they will aim for transactions at rates higher than 0.25%. Consequently, this makes it easier for the Bank of Japan to maintain its target. This understanding is shared among central banks.
Does the concept not apply to Japan, which is on the mend from deflation?
However, in Japan’s case, there is considerable room for debate on whether the aforementioned methods are appropriate. In simple terms, if the target is set at 0.25% and the actual short-term interest rates fall below this, one might ask, “Is there any problem with that?”
In cases like the U.S., where the economy overheats and faces severe inflation, rapid and significant interest rate hikes make sense. This is because there is a risk that the effects of monetary tightening could diminish, leading to a delayed response in curbing inflation.
On the other hand, for Japan’s economy, which has endured “lost 30 years” due to serious deflation, there seems to be no urgency to transition to a “world with interest rates.” The “supply-demand gap,” which indicates the divergence between total demand and potential supply capacity, remains negative, and it cannot be said that we are in a phase of economic expansion. Price pressures are weak, and even the Bank of Japan admits that achieving its inflation target of +2% year-on-year is uncertain.
In Japan’s case, rather than worrying about the diminishing effects of monetary tightening, it would be prudent to be more concerned about over-tightening. The fact that the uncollateralized overnight call rate has fallen below the target does not suggest an imminent cause for concern.
Rather, the downsides are becoming more apparent. Banks can earn interest spreads without risk by leaving funds in Bank of Japan current accounts. While reserve deposits are supposed to be merely a means of settlement, they have turned into a market for investment. Given that corporate demand for funds is not robust, substantial excess reserves are likely to persist.
