The further rise in energy prices in response to the war in Ukraine has dealt a serious blow to companies and households alike. In the midst of this, the depreciating trend of the yen in the exchange markets which is proceeding in parallel has inflated import prices, and concerns are starting to appear regarding the further deleterious effects this could have on the Japanese economy. At this point, the Bank of Japan’s adequacy to continue with its unprecedented aggressive monetary easing—which is the undercurrent of this ongoing depreciation—has to be called into question.

Difference in Japanese and US monetary policy are driving the yen’s depreciation

For a long time, the Japanese people have been exceedingly wary of the yen’s appreciation in the exchange markets, having fallen victim in some sense to a “strong-yen phobia”. In the past, including when the 1985 “Plaza Accord” (an international agreement to manipulate exchange rates) and the 1987 “Ruble Agreement” led the yen to appreciate rapidly versus the US dollar, and later when it appreciated to the 70-yen level against the dollar following the 2008 global financial crisis, the high yen rate has caused export companies to suffer a huge blow, leading many to fear that Japan’s economy would rapidly deteriorate. In such situations, the Japanese people demanded that the government take measures against the yen’s appreciation, and they clamored for the Bank of Japan to enact monetary easing policies. As a result, monetary easing was apparently taken too far, producing a bubble economy and causing various problems in a broader sense.
Contrary to these past trends, we’re now seeing companies and households paying more attention to the negative aspects of the yen’s depreciation, namely with how it’s driving price inflation, and it would seem that they’ve begun to look to the government and the Bank of Japan to take action to address the weak yen. Since last year, the yen exchange rate had remained relatively stable in the range of around 110-115 yen to the dollar, but then in March of this year it suddenly hit the 120-yen level, and it briefly even reached 125 yen, its lowest level in six years and seven months. Underlying this persistent yen depreciation is the different directions in which Japan and the US are taking monetary policy, or more specifically, the widening interest rate differential between the countries.
The US Federal Reserve Board (FRB) decided in March to raise policy interest rates by 0.25%. This rate hike was the first to occur since 2018. Furthermore, in response to the further increase in energy prices following the invasion of Ukraine, the FRB seems inclined to accelerate the pace of its rate hikes. In May it enacted another, larger rate hike of 0.5%, and the financial markets now anticipate that this will happen again in June as well.
At the time of the previous rate hikes that began in 2015, the first year’s worth of hikes amounted to a 0.5% increase, but this time around, the financial markets expect the hikes to come at a pace nearly five times that.

Will “bad inflation” occur in Japan?

Meanwhile, the Bank of Japan has clearly stated that it has no intention of amending its unprecedented monetary easing policy. The February CPI inflation rate (excluding perishable food) was up 0.6% from the same month a year earlier, quite low compared to the rates in Western countries. However, starting in April, when the effects of the temporary reduction in mobile telephone charges will have dissipated, it’s expected that this rate will suddenly be up around 2.0% from the same month last year, and will remain at that level for some time.
A CPI inflation rate of nearly 2.0% year-on-year is the price target that the Bank of Japan has been aiming to achieve for a long time. Yet the Bank of Japan nevertheless has stated there to be no need to amend its monetary policy, such as by terminating negative interest rates.
The Bank of Japan has explained that this current inflation uptick is different from a sustained rise in the inflation rate—the kind that happens when the Japanese economy grows and wages rise—but rather a temporary phenomenon brought on by skyrocketing energy-related prices seen largely overseas. This involves cost-push inflation, which could eventually lead to an economic downturn, and it’s what’s known as “bad inflation”. That’s why even with the inflation rate on the rise, the Bank of Japan has stated that there’s no need to alter its monetary easing policy.
However, in the Bank of Japan’s Tankan report that was recently released (March survey), the price forecast for all enterprises and industries in five years’ time was upwardly revised to +1.6%. With there now being a risk that a raise in the medium- to long-term price forecast for enterprises could lead to a protracted upward trend in the inflation rate, the circumstances demand that some care be taken.

The yen’s depreciation is a “plus” for the Japanese economy, says the Bank of Japan

While companies and households are focusing more on the negative aspects of the depreciating yen, namely that it could feed inflationary trends and deal a blow to Japan’s economy, the Bank of Japan has repeatedly opined that a weak yen is essentially a plus for the country’s economy.
This explanation has intensified the view in the financial markets that the Bank of Japan has accepted the yen’s ongoing depreciation, and in fact it even seems that the bank’s stance has itself become a factor propelling this depreciation. Further, the debate over whether the weak yen is positive or negative for the Japanese economy has gradually heightened within Japan.
The Bank of Japan has indicated its view that although the yen’s depreciation brings both positive effects such as promoting exports and negative effects like lower consumer spending caused by high prices, in an overall sense the effect is positive. According to the Cabinet Office's ESRI Short-Run Macroeconometric Model of the Japanese Economy (2018 Version), the cumulative effect of a 10% depreciation of the yen against the dollar over one year would be a boost to GDP of 0.46%. Initially, rising prices caused by the weak yen will lead consumer spending to drop, but as the effects of the increase in exports and capital investments become more widely felt, consumer spending will also come to see positive effects from the yen’s depreciation. The results of this model calculation would appear to indicate the soundness of the Bank of Japan’s view that the yen’s depreciation will basically be a plus for the Japanese economy.
However, it’s typical for this econometric model to be created using older data from rather far back. Even when this Cabinet model was created, some of the oldest data used was from the 1980s. This conceivably means that these calculation results might not fully reflect the most recent changes in Japan’s economic structure.
In response to the dramatic appreciation of the yen in the wake of the 2008 financial crisis, Japanese businesses started moving more quickly to shift their production bases abroad. As a result, a greater proportion of overseas exports from Japan consisted of exports of raw materials and intermediate goods by companies to their own overseas locations. This constituted internal trade within companies, and it was less susceptible to the effects of exchange rate fluctuations. As a consequence of this change in the trade structure, the export-boosting effects of the weak yen by way of these businesses’ improved international competitiveness was even smaller than before.
On the flip side, more companies responded to this dramatic appreciation of the yen by using comparatively cheaper imported products domestically, and this led to a greater import penetration of the economy (imports ÷ total domestic product supply). For example, when the proportion of imported goods used to manufacture household appliances went up, the rise in the price of goods resulting from the yen’s depreciation made it more likely for product prices to rise, and thereby created a headwind for consumer spending. In other words, the weak yen led the deterioration in consumer spending to get worse.
Moreover, the ones who were particularly dealt a blow by the Covid-19 crisis were not exporters, who significantly benefit from the yen’s depreciation, but instead were mainly businesses in sectors like transportation, the food industry, retail, tourism, the hotel business, and other industries more vulnerable to the adverse effects of rising prices for imported goods caused by the depreciation. In the aftermath of the Covid-19 crisis, industries that were more likely to be at a disadvantage from the depreciating yen have become the weak point for the Japanese economy.

Will the Bank of Japan heed the ongoing depreciation of the yen?

If we consider the issue in terms of the changes to Japan’s import/export structure and the characteristics of the Japanese economy following the Covid-19 crisis, as I’ve discussed, then it seems we can’t simply say that a weak yen is essentially a plus for the country’s economy, as the results of the model calculation suggest. In these circumstances, wouldn’t it be desirable for Japan’s policy management to fully account for the negative aspects of the yen’s depreciation?
The Bank of Japan has set a target of 0% for ten-year government bond yields (yield curve control), and has indicated a policy that would keep the yield within a fluctuation range of about plus or minus 0.25%. What prompted the yen’s further depreciation most recently was the fact that when yields approached the +0.25% upper limit of the fluctuation range, the Bank of Japan used its monetary control to take a strong stance that it would not permit these yields to rise any further. There was a growing perception that in order to curb the rise of ten-year government bond yields which could potentially impede monetary easing effects, the Bank of Japan was willing to allow a further widening of the long-term interest rate divergence between Japan and the US, as well as the further depreciation of the yen that would result.
The Bank of Japan is expected to embark on full-scale normalization of its monetary policy—including terminating negative interest rates—sometime after Governor Kuroda steps down next April. However, if by essentially permitting long-term government bond yields to rise the Bank of Japan can control the risk of further yen depreciation, which is a major concern for companies and households, then perhaps it ought to do that right away. If the Bank of Japan’s monetary control leads the yen to depreciate further and intensifies the upward pressure on prices, that would also be a concern for the government, which is looking to piece together its anti-inflation measures by the end of April. That’s because the ongoing depreciation of the yen could also hinder the effects of its policies.
The Bank of Japan is not responsible for the country’s exchange rate policies, and Japan’s monetary policy is not directly intended to have an effect on the exchange market. Nevertheless, from the viewpoint of showing consideration for the concerns of companies and households, and emphasizing cooperation with the government, maybe the Bank of Japan will look to amend its current stance of strictly curbing any rises in long-term government bond yields, and show a certain amount of care towards the depreciation risk of the yen.