Too much of anything is not good - Yen's weakness must end

KS Advisory - Insights - April 02, 2024

_{“For whoso hath too much of any good, Of that same good he shall be soon bereft.”}

^{John Lydgate, 1430 “The Fall of Princes”}

According to BIS data, the Japanese yen has depreciated by 23% on a broad trade-weighted nominal effective exchange rate (NEER) basis, which comprises 64 countries, since the beginning of 2019, reaching historic lows and beyond the lows seen in 1997.

Indeed, there are advantages to having a weak currency. The economy can benefit in various ways. However, it is crucial to understand the economy's current and potential future composition. Currency weakness affects an economy differently depending on its composition. Moreover, excessive currency weakness can lead to negative spillover effects. Unless Japanese authorities address this issue, the reserve currency status of the Japanese yen may also need to be questioned.

The images below illustrate the movement in nominal effective exchange rates (NEER) of key reserve currencies. It's important to note the outliers: Japan and Switzerland have experienced extreme shifts. The first image covers the period from 1994 to February 2024, while the second image, displayed below, focuses on December 2019 to February 2024.

Japan has experienced various benefits, including some inflation, from its decades-long ultra-loose monetary policy. However, while other central banks have tightened their policies, Japan's adherence to this strategy has weakened its currency to levels not seen since the late 1990s. The currency has now become excessively weak, raising concerns about broad negative spillover effects across the economy (refer to the table below).

Japanese authorities appear less concerned about the risks associated with this negative spillover and are primarily focused on the evolution of wages. Despite wages showing some increase, they have not risen enough to prompt a stronger policy response. However, considering Japan's other challenges, particularly demographics, Japan must halt the precipitous slide of the yen.

Continuing on this path may lead to various problems, including significant inflation driven by broader wage gains across the economy. In the words of German economist and central banker Karl Otto Pöhl, “Inflation is like toothpaste. Once it's out, you can hardly get it back in again. So the best thing is not to squeeze too hard on the tube.”

Last month as expected, the Bank of Japan finally put an end to its negative interest rate policy put in place NIRP on 29 January 2016, by hiking the policy rate by 10bp to a range of 0-0.1%. However, the yen continues to slide versus most currencies.

While the Bank of Japan finally has some much-wanted inflation, inflation should come with a “handle with care” label. Without careful management and a holistic perspective, inflation can quickly escalate and become difficult to contain. Japan may have transitioned from the era of 'moderate but persistent deflation' to one characterized by moderate but persistent inflation unless decisive action is taken at an accelerated pace. Too much of anything, persistent yen weakness and the risk of persistent inflation are not good. The combination of a strong shift to a higher monetary bias coupled with large-size foreign exchange intervention is needed. Bank of Japan officials should think this over carefully, next time they brush their teeth on the morning of April 26th, the date of the next monetary policy meeting.Source:

Source - Data FRED, www.stat.go.jp

Transitioning from the advantages to the drawbacks, what are the potential consequences when currency weakness reaches excessive levels? The table below offers insights into this question.

References:

1. Bank of Japan - The Effects and Side Effects of Unconventional Monetary Policy -Summary of the First Workshop on the "Review of Monetary Policy from a Broad Perspective", March 2024
2. The Research Institute of Economy, Trade and Industry (RIETI) is a policy think tank established in 2001.
3. RIETI - Has Policy Succeeded in Influencing Expectations? - KOBAYASHI Keiichiro Program Director and Faculty Fellow, RI, February 14, 2024
4. IMF - The Japanese Yen as an International Currency - Mr. George S Tavlas and Yusuru Ozeki , January 1991

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