International transmission of Japanese monetary shocks under low and negative interest rates: A global factor‐augmented vector autoregressive approach

• Date: 01 February 2018
• DOI: http://doi.org/10.1111/1468-0106.12252
• Published date: 01 February 2018
• Author: Mark M. Spiegel,Andrew Tai

SPECIAL ISSUE ARTICLE

International transmission of Japanese monetary

shocks under low and negative interest rates: A

global factor-augmented vector autoregressive

approach

Mark M. Spiegel | Andrew Tai

Federal Reserve Bank of San Francisco, San

Francisco, California, USA

Correspondence

Mark M. Spiegel, Economic Research, Federal

Reserve Bank of San Francisco, PO Box 7702,

San Francisco, CA 94120.

Email: mark.spiegel@sf.frb.org

Abstract

We examine the implications of Japanese monetary shocks

under recent very low and sometimes negative interest

rates to the Japanese economy and three of its major trad-

ing partners: Korea, China and the United States. In partic-

ular, we investigate the implications of shocks to the

2-year Japanese government bond rate in a series of

factor-augmented vector autoregressive (FAVAR) models,

in which both local and global conditions are proxied by

latent factors generated from domestic economic indica-

tors and weighted indicators of major trading partners,

respectively. Our results suggest that shocks to 2-year Jap-

anese government bond rates have substantive impacts on

Japanese economic activity and inflation in conditions of

low or even negative short-term rates. However, we find

only modest global spillovers from Japanese monetary

policy shocks compared to innovations in 2-year US Trea-

sury yields over the same period.

1|INTRODUCTION

This paper examines the implications of recent shocks to Japanese monetary policies on its own

economy and those of three of its primary trading partners, Korea, China and the United States.

Evaluation of Japanese monetary policy shocks in the current negative interest rate environment

can be challenging. The Bank of Japan (BOJ) has utilized both conventional and unconventional

measures recently to provide additional stimulus to its economy and escape deflation despite its low

(and more recently negative) interest rate policies. Most recently, the central bank announced a 0%

target for its 10-year Japanese government bond (JGB) yield and also committed to overshooting its

Received: 1 December 2016 Revised: 1 March 2017 Accepted: 1 April 2017

DOI: 10.1111/1468-0106.12252

Pac Econ Rev. 2018;23:51–66. wileyonlinelibrary.com/journal/paer © 2018 John Wiley & Sons Australia, Ltd 51

2% inflation target. The implications of such a combination of conventional and unconventional

monetary policies is particularly challenging around the zero lower bound, where movements into

negative nominal rate territory may be limited and not fully reflect the expansionary implications of

such commitments on agents’expectations about future financial conditions.

In response, we follow the literature (e.g. Swanson & Williams, 2014) in evaluating monetary

shocks on the basis of movements in yields on longer-term assets. We concentrate on the yields on

2-year JGB. The time series for these bonds, as well as the 2-year US Treasury rate and the BOJ

policy rate, is shown in Figure 1. While nominal movements in the Japanese 2-year rate are more

muted than those of the US 2-year rate over our sample period, it does move more than the BOJ pol-

icy rate. Moreover, most recently the 2-year JGB yield has gone negative, providing increased stim-

ulus even when the policy rate remains at zero.

1

As a result, we conclude that the BOJ had the

opportunity to pursue expansionary monetary policy even when policy rates were constrained at or

near the zero lower nominal bound. As in Swanson and Williams, this easing of policy could have

been achieved through unconventional policies, either through long-term asset purchases or through

policies that altered agents’expectations of the future policy path. Recent policy changes pursued

by the BOJ appear to have been aimed at easing monetary conditions through both channels. We

assess the implications of Japanese monetary shocks on both that country’s economy, and those of

three of its most important trading partners: Korea, China and the United States.

Our study follows a long literature measuring the global implications of monetary policy shocks

through a vector autoregression (VAR) approach (e.g. Christiano, Eichenbaum, & Evans, 1996;

Kim, 1999, 2001). Kim finds evidence of spillovers from US monetary policy shocks among the

non-US G6 countries. The channel of this transmission is primarily through influences on global

interest rates, rather than through trade balances. Similarly, Canova (2005) finds evidence of spill-

overs from US monetary policy shocks to Latin America.

These results are unsurprising given the uniquely influential role played by the United States in

the global economy. In contrast, Mackowiak (2006) examines the implications of Japanese monetary

policy shocks on several East Asian nations from 1987 to 2002.

2

Unlike the strong evidence for

spillovers from US policy in the earlier literature, Mackowiak finds only a modest impact of

0 2 4 68

1998 2000 2003 2006

Year

2009 2012 2015

US 2-year Japan 2-year BoJ policy rate

FIGURE 1 Japan government bond yields and Bank

of Japan policy rate 1998–2016

1

Since January 2016, the BOJ policy rate has also gone negative. However, we continue to follow the 2-year yields as our proxy for

Japanese financial conditions because we have little experience in movements in negative nominal yields on very short-term

instruments.

2

Mackowiak (2006) considers smaller Asian countries than those examined here, including Hong Kong, Korea, Malaysia, Philippines,

Singapore and Thailand.

52 SPIEGEL AND TAI