FX International Payments
By Frances Coppola
In March, however, the dollar-to-yen foreign currency exchange rate strengthened. At the same time, Japan's inflation rate dipped, falling to 1.1 percent year-on-year.4
At present, therefore, it appears that Japanese inflation is negatively correlated with the dollar-to-yen exchange rate. Economic theory says that low inflation attracts investors looking for stable returns, and thus tends to push up the exchange rate of the low-inflation currency. But it seems that for Japan, other effects are counteracting this. What could those effects be?
Perhaps the most obvious explanation for the apparent positive correlation between inflation and the dollar-yen currency exchange rate is simply that exchange rate effects can take a while to feed through into inflation. This is because currency exchange rate changes influence inflation via import prices, and many importers place orders for supplies in advance, locking in prices for perhaps three months or even more, depending on supplier terms and delivery times.
Thus, analysts say that the yen's appreciation early in the year could affect prices in May or June.5 Inflation could therefore stay weak for some months to come, before increasing again as the yen's March currency exchange rate fall feeds through into import prices.
Because inflation in Japan is so low, the Bank of Japan is maintaining negative interest rates and doing a substantial QE program. But here in the U.S., the Federal Reserve is raising rates and shrinking its balance sheet. The monetary policies of the two central banks are diverging.
As the interest rates of the two countries gradually diverge, there is an incentive for banks and traders to borrow in yen and lend in dollars, profiting from the widening spread. This is known as a "carry trade," and it affects currency exchange rates. The theory of "uncovered interest parity" says that the dollar-to-yen exchange rate should adjust to eliminate the profits arising from interest rate differences. But the foreign exchange component of a dollar-yen carry trade involves selling yen and buying dollars, which tends to depress the yen's exchange rate and strengthen the dollar.
If carry trades are reappearing, the yen's exchange rate could weaken irrespective of the direction of Japanese inflation, provided that Japanese interest rates remain well below U.S. levels. This could perhaps help to explain the yen's fall in March. If currency exchange rates are influencing inflation with a time delay, then carry trades could help to raise inflation via import prices.
Some economists think that the Japanese economy is showing signs of lasting recovery. The rate of GDP growth has now been increasing steadily for over two years.6 Rising wages and very low unemployment could indicate that both GDP growth and inflation will continue to increase, irrespective of the behavior of currency exchange rates.7
Some analysts also argue that the fact that inflation remains far below the Bank of Japan's 2 percent target arises from structural features of the Japanese economy that could be very difficult to change. In a piece for Bloomberg, Michael Schuman argues that Japan's stubbornly low inflation is due to well-anchored expectations that prices will not rise even when the economy is growing well, and it is therefore unnecessary to try to raise inflation any further – and could even be harmful to Japan's large elderly population, whose savings would be eroded by higher inflation.8
It's possible that the Bank of Japan may be thinking along these lines. The Wall Street Journal reports that the central bank is no longer forecasting when inflation will reach 2 percent.9 Most analysts took this as indicating that QE and negative rates will continue for the foreseeable future. However, a minority thought that if the Bank of Japan no longer felt "under pressure" to achieve an inflation rate of 2 percent, it might end QE sooner rather than later.
It's hard to predict when, or if, Japan's long-running "lowflation" saga will end. Japan's economy is growing steadily, though not quickly. However, volatility in the dollar-to-yen currency exchange rate is feeding through into consumer prices, making the inflation rate vulnerable to sudden changes. Perhaps because of the uncertain path of inflation, the Bank of Japan appears to be in no hurry to exit from QE and negative rates.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Japan; Inflation rate continues to rise,” Nomura; https://www.fxstreet.com/news/japan-inflation-rate-continues-to-rise-nomura-201803230547
2. “USD-JPY X Rate,” Bloomberg; https://www.bloomberg.com/quote/USDJPY:CUR
3. “Good News Is No Longer Unspeakable In Japan,” Bloomberg; https://www.bloomberg.com/view/articles/2018-04-03/bank-of-japan-can-now-nod-to-end-of-quantitative-easing
4. “Japan March 2018,” Japanese Statistics Bureau; http://www.stat.go.jp/english/data/cpi/1581-z.html
5. “Japan’s March Inflation Dip Doesn’t Signal Reversal Of Trend,” Bloomberg; https://www.bloomberg.com/news/articles/2018-04-19/japanese-inflation-slips-as-kuroda-begins-new-term-at-boj
6. “Real Gross Domestic Product for Japan,” FRED Economic Data; https://fred.stlouisfed.org/series/JPNRGDPEXP#0
7. “Japan’s March Inflation Dip Doesn’t Signal Reversal Of Trend,” Bloomberg; https://www.bloomberg.com/news/articles/2018-04-19/japanese-inflation-slips-as-kuroda-begins-new-term-at-boj
8. “Japan’s Hopeless Inflation Target,” Bloomberg; https://www.bloomberg.com/view/articles/2018-03-14/japan-s-hopeless-inflation-target
9. “Bank of Japan Ditches Inflation Target Date,” The Wall Street Journal; https://www.wsj.com/articles/bank-of-japan-ditches-inflation-target-date-1524799762