The Japanese Yen Is Plunging. Here's What It Means for the World Economy.

The yen just plunged to its lowest level in 34 years against the U.S. dollar.

The Japanese yen is in absolute free fall. Since the start of the year, Japan’s currency has fallen by around 10% versus the U.S. dollar, pushing it to its lowest level since 1990.

What’s going on and what does it mean for the world’s fourth-largest economy? Let me explain. 

The main reason for the yen’s decline has to do with interest rates.

You might have seen headlines earlier this year about how Japan’s central bank, the Bank of Japan, hiked interest rates for the first time since 2007. But that hike, made back in March, was largely symbolic.

You see, for much of the past few decades, Japan has been battling deflation—a phenomenon in which there’s a broad-based decline in prices throughout the economy.

Deflation can cause all sorts of problems by encouraging consumers and businesses to hoard cash rather than spending or investing it.

The Bank of Japan tried a bunch of things to get rid of deflation and spur prices in Japan to rise, and one of the things that it did was cut interest rates to ultra-low levels— we’re talking about interest rates at zero and even below zero!

Unfortunately, those policies didn’t help all that much. Outside of a few exceptional years, prices in Japan remained in a rut.

That is, until 2022.

That’s when economies around the world started opening up after the Covid-19 pandemic. For a number of different reasons, as this reopening happened, inflation took off everywhere, and Japan was no exception.

In 2023, Japan’s core consumer price index grew by 3.1%, the fastest rate of inflation for the country in over four decades.

Unlike in other countries, inflation in Japan was welcomed. After years of fighting deflation, the Bank of Japan was thankful that prices were on the rise.

As the BoJ grew more confident that the price increases were sustainable and that deflation was in the rearview mirror, it began talking about normalizing monetary policy by hiking interest rates from their ultra-low levels.

That’s what the rate hike in March represented. It was the first step in the normalization process.

That hike took the overnight bank borrowing rate in Japan from negative 0.1% to a range of zero to 0.1%. But as you can see, that still leaves rates in Japan close to zero.

And they’re probably going to stay around there for a while.

Although the BoJ has indicated that it will likely hike rates again this year, it’s also said that raising rates is going to be a gradual process, because after all, the country had been battling deflation for decades— the central bank doesn’t want to do anything that might cause the economy to fall back into that quagmire.

That means that even though interest rates in Japan will probably go up from here, they’re going to remain extremely low for a while.

That’s in sharp contrast to the situation in most other countries, like the U.S., where interest rates are much higher.

In the U.S., the Federal Reserve has set the benchmark federal funds rate to a range of 5.25% to 5.5%.

And in recent weeks, expectations have grown that the central bank will keep rates at those elevated levels for longer than many people had thought because inflation in the U.S. is proving to be more stubborn than many people had thought.

So, you have short-term interest rates in Japan at around zero and you have short-term interest rates in the U.S. at over 5%.

That’s a big difference. An what that does is encourage money to flow from Japan to the U.S., as well as other countries where interest rates are higher.

The Japanese, in particular, have been buyers of foreign bonds. In order to buy those foreign bonds, they sell their yen and buy the currencies that those bonds are denominated in, like dollars and euros.

This drives the value of the yen down.

But it’s not just the Japanese who are selling yen. Because interest rates in Japan are so low compared to other countries, a lot of traders around the world are borrowing money in Japan at low rates and using that money to invest elsewhere at higher rates—a strategy that’s known as a carry trade.

The Economic Impact

To summarize: the yen is selling off so much because of the large interest rate differentials between Japan and the rest of the world. As you can see from this chart, there is a strong correlation between U.S.-Japan interest rate differentials and the USD/JPY (dollar to yen) exchange rate.

That raises a question: what does this steep decline in the yen mean from an economic perspective?

Well, for the Japanese economy, a weaker yen is both good and bad.

On the one hand, it increases the cost of imports for Japan. Any goods purchased from other countries will be more expensive for Japan.

The country is particularly vulnerable to higher import prices when it comes to food and energy. Japan relies on imports to meet 90% of its energy demand and upwards of 62% of its food demand.

On the other hand, a cheaper yen has benefits for Japan as well. It makes profits generated by Japanese companies overseas more valuable when converted back to yen. It makes Japan a more attractive destination for tourists. And it makes Japanese exports more competitive on the world market.

Trade-off

There are pluses and minuses to a weaker yen, and Japanese authorities are weighing these various factors when they look at the sharp decline in the currency.

They like that the cheap yen is fueling Japanese exports to record levels, and how it’s encouraging foreign companies to set up shop in Japan to take advantage of the currency’s decline.

What they don’t like is how households are having to pay so much more for things like food and energy.

That’s the trade-off that’s happening as the yen weakens.

Based on comments from Japanese government officials, they seem to be okay with this trade-off, as long as it happens in an orderly way.

When the yen’s decline becomes disorderly, the government has pledged to take action to bring stability to the market.   

For instance, in 2022, when the yen lost nearly a quarter of its value versus the dollar in a matter of months, the Japanese government stepped in and purchased the equivalent of around $60 billion worth of yen using its stockpile of foreign currencies.

That put a floor under the yen for around a year.

Now with the yen starting to make new lows versus the dollar again, the government has threatened to intervene once more.

In fact, while the government has yet to confirm it, there are indications that it may have intervened this month with purchases of another $58.5 billion worth of yen.  

We’ll see if that’s enough to stem the decline in the currency or not in the coming weeks.

Bearish Views

By now you have a sense of why the yen is going down and what it means for the Japanese economy.

But that’s just my interpretation of things. As you can tell, I’m not that worried about the decline in the yen, and I don’t think it’ll have a major impact on the Japanese economy, let alone the world economy.

There are others who, though, are much more alarmed by the drop in Japan’s currency.

This tweet from Robin Brooks, Senior Fellow at The Brookings Institution, encapsulates many of those bearish views.

Brooks says that Japan is in a currency crisis that’s caused by the country’s high levels of debt.

He agrees that the yen is falling because interest rates in Japan are so low.

The problem, according to him, is that the only way to stop the decline is by hiking interest rates— but the Japanese government can’t raise interest rates by very much because doing so would cause a fiscal crisis, presumably because at higher rates, the government wouldn’t be able to afford to pay the interest on its debt.

In other words, Brooks is suggesting that Japan is in a box. It can’t hike interest rates when it should hike rates, and so that’s causing a currency crisis.

What Crisis?

Now, leaving aside the issue of whether Japan can or should hike interest rates more aggressively (that in and of itself is debatable), what I’m skeptical of is this idea that Japan is in a currency crisis.

Yes, the yen has fallen significantly and may continue to go down further from here, but should that be characterized as a crisis?

As I pointed out earlier, there are both good and bad consequences stemming from the yen’s decline. But not even the negative effects, like higher food and energy bills, are big enough to have a dramatic impact on Japan’s economy.

There’s also another thing I haven’t touched on yet, which is that the biggest beneficiary of the yen’s decline is the Japanese government. The government holds massive reserves of foreign currencies like dollars and euros, last estimated to be worth the equivalent of more than $1.2 trillion.

As the yen has fallen, the value of these reserves in terms of yen has surged, giving the Japanese government a windfall with which it can use to occasionally support the Japanese currency, as it did in 2022 and this month.

Japan also has a current account surplus—meaning that it takes in more money from the rest of the world than it pays out— and the yen is a reserve currency held by central banks around the world, neither of which is typical of a country prone to a currency crisis.

Not to mention, Japanese stocks are at all-time highs and the Japanese economy is growing, which again, aren’t things you’d expect to see if Japan was experiencing a crisis.

So, the bottom line is this: the yen is falling because of large interest rate differentials between Japan and the rest of the world. This has both good and bad effects on the Japanese economy, but it’s not causing a crisis.

Where the yen goes from here will be determined by a ton of different factors—movements in interest rates, trade and investment flows, economic growth, and speculation.

No one knows exactly where the yen will bottom out. The dollar-yen exchange rate could go to 200, like some are predicting, or it could fall back to where it was a year ago, below 140. Who knows?

What we do know, though, is that at some point, the yen will stop going down.

Japan’s currency is currently trading at all-time lows in real terms. That means that adjusted for purchasing power, the yen has never been cheaper relative to other currencies.

So, if you’ve been thinking of taking that trip to Japan, well, now is as good a time as ever to do it.