The Bank of Japan’s introduction of negative interest rates is one of the most significant events to hit the FX market recently. By taking this action, the BoJ has basically said that its bond-buying operations have reached their limit and they need to find other ways to support the economy. The likely channel is through the exchange rate: by depressing interest rates across the yield curve and (one hopes) raising inflation, the BoJ is aiming to lower real interest rates. This won’t benefit companies that much, because they can already borrow at extraordinarily low rates, so the aim must be to push down the yen by making overseas investment more attractive and at the same time implicitly guaranteeing Japanese investors that the authorities will prevent the yen from strengthening.

Looking away from the yen, how might this move affect other countries? There are two ways: through trade and through policy. On the trade front, countries that compete with Japan are not likely to give up without a fight. I would expect to see other trading countries, such as South Korea, allow their currencies to weaken, too.

The big question will be whether or how China responds. If China responds by letting its currency weaken too, then that could set off a repeat of the round of risk aversion that we saw last August. Note that China has changed its way of managing the CNY and is now managing it against a basket of currencies, rather than just against the dollar, so it may move to offset a weaker yen. On the other hand, the country’s exports to Japan are relatively low compared to its imports from Japan, so it may decide to let the move slide as a wash.

The policy implications may be even more important. Simply put, now that two major central banks have instituted negative rates, the policy is no longer experimental but rather is a “standard policy tool.” Thus the BoJ has in effect validated it for other central banks. This had an immediate impact on the UK, where the market is now pricing in more of a chance of a cut this year. Sweden, Denmark and Switzerland, which all have negative rates now, may be emboldened to lower them further. It may also help ECB President Draghi to overcome opposition on the ECB Governing Council to lowering rates further into negative territory. (Note that the BoJ specifically said it would buy bonds at yields below its deposit rate, contrary to ECB policy.)

The BoJ said it “will cut the interest rate further into negative territory if judged as necessary.” And if other central banks cut in response to Japan, and then it cuts again, and then they follow again…it looks like the currency war is in full swing. The loser of this war – and hence the strongest currency -- is likely to be the dollar, as the Fed will probably at least keep rates steady if not hike further.