Japanese authorities have found themselves having to step into markets again and again to prop up the yen, this time with assistance from the U.S. government. To escape this "mowing the lawn" dilemma, the country, and specifically the Bank of Japan, has to address the root causes of yen weakness.
Viewed through one lens, the yen appears undervalued. Ask anyone who has traveled to Japan recently and they will rave about the bargains to be had. That is a stark shift from the era of yen overvaluation 15 years ago, when a dollar was worth about 80 yen and a trip to the country was a painful expense.
So why the continued yen selling pressure when a dollar buys twice as much of the Japanese currency? The answer appears to be a combination of fiscal and monetary concerns.
On the former, Prime Minister Sanae Takaichi isn't likely to change course. Like former Prime Minister Shinzo Abe, she is convinced of the need for stimulus to keep growth going and pull Japan further out of its long deflationary spiral.
So Takaichi is unlikely to support any kind of austerity to shore up the yen. Indeed, she has just announced a plan to sharply cut consumption taxes on food items. If the lady's not for turning, that leaves the Bank of Japan.
The yen's recent slide has largely tracked a widening gap between monetary-policy expectations in the U.S. and Japan. While the market now believes the Federal Reserve is likely to raise rates in the near future, it sees the Bank of Japan moving more cautiously.
That would be an easy perception for the BOJ to change by raising rates at its next policy meeting in September, after an earlier hike in June.
When the Iran war began in late February, markets started pricing in a higher likelihood of rate hikes by the Fed but less so for the BOJ. The U.S. 2-year Treasury yield, for instance, has risen from 3.39% at the end of February to around 4.25% recently.
The upward move in the yield on 2-year Japanese government bonds has been milder. The result is that the yield gap between Treasurys and Japanese debt has widened to about 2.8 percentage points last week from around 2.15 before the war.
Over that same period, the yen depreciated nearly 5% against the dollar. This suggests that BOJ tightening will be crucial to arresting the fall.
True, inflation hardly looks out of control in Japan; the headline consumer-price index rose 1.7% in June from a year earlier. But the BOJ itself expects that number to climb because of higher oil prices.
In a statement after its last meeting -- in which it kept the policy rate unchanged at 1% -- the BOJ said inflation is likely to accelerate above its 2% target in the second half of the year.
The weak yen exacerbates this impact by increasing the cost of imported energy. That should provide all the justification needed to start hiking rates in September.
Some argue the Bank of Japan is hesitating because it fears higher rates on Japanese government debt would further undermine the country's finances. At roughly 200% of gross domestic product, Japan's debt is famously high.
But the truth is that Japan's underlying fiscal position is stronger than many appreciate. Including the government's huge stock of financial assets, the net debt to gross-domestic-product ratio is about half that, and analysts at Capital Economics see it falling to 80% by 2028.
Moreover, for anyone who is concerned about Japan's fiscal sustainability, a collapse of market confidence in the yen should be the last thing they want to see. Even the growth-obsessed prime minister, who was said in the past to be pressuring the BOJ to keep policy loose, should now see that reinforcing the yen has become paramount to shoring up the country's wider growth story.
Luckily, there is a clear course of action the BOJ can take. This becomes even more obvious if the Fed moves in mid-September -- which most market participants currently expect. In that case, the BOJ would have little choice but to follow suit when its own meeting takes place a few days later.
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