Yen’s Historic Fall

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In April, the Japanese yen plunged to its weakest level against the US dollar since May 2002. Why did this happen, what will be the consequences, and what are Japan’s options? 

The Japanese yen had never been weaker in the past 20 years. When this article was written, 1 US dollar was worth 129.28 Japanese yen, up from 114.95 yen on March 7^th, around when the sharp depreciation of the yen started.  

USD/JPY, Change from 13 May 2021 to 13 May 2022 

Source: Yahoo! Finance, exchange rates 

1 euro, on the other hand, was worth 133.91 Japanese yen, while it was worth 125.55 yen on March 7^th. 

EUR/JPY, Change from 13 May 2021 to 13 May 2022 

Source: The European Central Bank, Euro foreign exchange reference rates 

This marks an 11.08% depreciation relative to the US dollar and a 6.24% depreciation relative to the Euro for the Japanese yen over 10 weeks. 

But why did the value of the yen fall to historically low levels? To understand this, let’s overview how monetary policy in Japan has evolved since the 90s and how it stands in contrast to US monetary policy today. 

Japan has been fighting deflationary pressures for decades. But in fact, in the 1980s, Japan had a remarkably fast-growing economy with respect to other developed nations. This changed with the equity and real estate bubble burst that took place in the early 90s. 

The stock market bubble in Japan burst in 1990, and by mid-1992, equity prices had fallen by about 60%. The real estate bubble burst that followed is among the biggest property market collapses in modern history. In 1991, at the market’s peak, all the land in Japan was worth about $18 trillion, which was almost four times the value of all property in the United States at the time. After the burst, however, land prices went into a downward spiral: they had decreased 70% by 2001. 

It is believed that The Bank of Japan (BOJ) was too aggressive in raising rates at the end of the 80s, inducing these bursts. The BOJ reversed its policy after the bursting of the asset price bubble, though critics argue that the intervention was late and timid. Throughout the 90s, the Japanese central bank tried to stimulate the economy with a very low interest rate (starting from 1995) and a zero interest rate (starting from 1999), but Japan ended up in a liquidity trap instead. 

In a liquidity trap, the policy rate is already so low that the central bank cannot stimulate the economy by lowering it further. When interest rates are equal to or close to zero, people are indifferent between holding cash and buying debt instruments, because the former brings no interest while the other brings almost no interest, and cash has the advantage of being the most liquid asset. Consequently, increases in the money supply do not translate into investment, instead, they end up as hoarded cash. In Japan, persisting deflation expectations caused people to delay consumption and sit on cash, perpetuating the liquidity trap. 

There are certain fiscal and monetary measures that can be used to lift an economy out of a liquidity trap. On the fiscal policy side, the Keynesian approach calls for increased government spending that drives the expected rate of return on investment up. Japan did employ fiscal stimulus to get out of the trap, but it was not effective because, according to many economists, the money injected into the economy was not well-targeted: it was spent on wasteful infrastructure projects and given to failing firms, instead of being given directly to consumers or being spent on strengthening Japan’s relatively weak social safety net.  

On the monetary policy side, starting from 2001, the Bank of Japan tried to overcome the liquidity trap by injecting money into the economy without targeting an interest rate, that is, by directly increasing the money supply by purchasing bonds. This unconventional form of monetary policy, advocated at the time by Paul Krugman and Ben Bernanke as a solution to liquidity traps, has the familiar name of “quantitative easing” (QE); the policy that upended central banking in the West after the Global Financial Crisis of 2008 had already been used in Japan since the beginning of 2000s. 

The QE1 that was implemented in Japan from March 2001 to March 2006 had little effect on inflation, even though it increased the monetary base by about 60%. This result can be attributed to public skepticism against BOJ’s commitment to increasing the inflation rate. Economic theory suggests that, even when a large amount of liquidity is injected into the economy, inflation may not increase if people believe that the policy will be reversed in the future. Assuming that this is a correct interpretation, one can say that the skepticism was understandable, as QE1 was suddenly halted in 2006 and then mostly reversed. 

Source: “Quantitative Easing in Japan: Past and Present” (Andolfatto & Li, 2014).   

In the aftermath of the Global Financial Crisis, though relatively late, BOJ resorted again to quantitative easing. QE2 started in October 2010 and then gradually evolved into a larger intervention (QE3) that began in April 2013. QE3, which was officially called “Quantitative and Qualitative Monetary Easing” (QQE), aimed to double the country’s money supply with an injection of $1.4 trillion. This injection was part of the “quantitative” easing part of the policy, while the “qualitative” easing part refers to risk mitigation through the purchase of risky assets by the central bank and their replacement by government debt.  

However, even after three years of this policy, inflation was still under the 2% target, which urged BOJ to intensify the QQE with a negative interest rate policy (NIRP) in January 2016. Later, in September 2016, a new framework named QQE with Yield Curve Control (YCC) was introduced.  

A yield curve represents the relationship between yields of debt instruments such as bonds and their remaining time to maturity. In traditional central banking, central banks influence short-term interest rates, namely, the “short-end” of the yield curve, by changing the policy rate. However, after the 2008 crisis, near-zero policy rates in many advanced economies left little room for this traditional policy to effectively stimulate the economy, so, central banks started trying to directly influence the “long-end” of the yield curve through QE.  

The Bank of Japan, stating that the impact of QE on long-term interest rates is partly dependent on economic and financial circumstances, adopted a “yield curve control” policy under which long-term interest rates are explicitly set as an operating target. The target was an “around zero percent” yield on ten-year government bonds, close to the prevailing rate at the time. 

The effects of this policy became evident in a short time frame, with yields on ten-year government bonds settling close to the target and remaining around it until July 2018, when BOJ widened the fluctuation band around the target, increasing the volatility of yields. However, YCC seemed not to be very successful in increasing inflation: in the first half of 2020, core inflation was about 0.5%, barely higher than what it was when the policy was adopted. 

In March 2020, when the Covid-19 shock first hit, the BOJ started conducting “powerful monetary easing”, in parallel with many central banks around the world. However, while key Western central banks have implemented rate hikes and started to normalize monetary policy since the end of 2021, the BOJ has maintained its ultra-easy monetary policy, as inflation has still been well below the target of 2%. 

This policy now stands in contrast to the US monetary policy. The Federal Reserve, due to rising inflation in the US economy, increased the policy rate for the first time in more than three years in its March 16^th meeting. The 25-basis-point increase brought the federal funds rate into a range of 0.25%-0.5%. Interest rate hikes were scheduled for each of the remaining meetings this year, indicating a consensus federal funds rate of almost 2% by the end of 2022. The Federal Open Market Committee (FOMC) sees three more hikes in 2023 and none the following year.  

Source: Federal Reserve Economic Data (FRED), CPI 

In the consecutive meeting held on May 4^th, the Fed raised the federal funds rate by 50 basis points, which is the largest rate hike by the Fed since 2000. Fed Chairman Jerome Powell’s words hinted at future 50-basis point increases, but not at a more aggressive policy than that. In the same meeting, the Fed outlined a program to reduce the asset holdings on its $9 trillion balance sheet, which has been enlarged by asset purchases during the pandemic.  

The Fed’s commitment to tighter monetary policy has driven a yen sell-off, decreasing its value against the dollar and other major currencies, because it seems that Japan will continue to keep interest rates at the current low levels. 

In the era when Japan was a manufacturing superpower, a weak yen would be a cause to rejoice as it would increase exports and attract foreign investment. However, exports matter less in the Japanese economy at present, and many Japanese companies have already moved production plants abroad, which means the depreciation of the yen is less impactful on their product prices. Thus, a weak yen is more likely to suppress consumer spending in Japan than to stimulate spending on Japanese goods abroad. Moreover, the negative consequences of the depreciation are exacerbated by soaring global energy prices, given Japan’s heavy dependence on resource imports.  

Raising interest rates as a response might kill off the tepid inflation that started in September 2021 and push Japan into deflation again, and it might also make it harder for Japan to roll over its national debt, which is over 250% of its annual GDP. Some politicians suggested currency market interventions to restore the value of the yen, but this is an expensive policy that is unlikely to change the trend. What the government is now doing to mitigate the effects of the depreciation is subsidizing Japanese oil companies to make gas prices fall. 

If the yen keeps depreciating, the government may have to do more, as consumers may vote against an electricity bill that keeps rising in the Upper House elections scheduled for July 2022.