Japanese Monetary Policy and the Yen
Japan’s new prime minister, Shinzo Abe, has been concerned about the yen’s appreciation and has attributed the yen’s behavior to exceptionally easy monetary policies abroad, notably in the United States and the euro area. He claims that the yen’s appreciation puts Japan’s exporters at a competitive disadvantage, contributes to slow growth, and adds downward pressure to prices—through lower traded goods prices—in an already deflationary environment. To remedy the situation, he has asked the Bank of Japan to ease up on monetary policy by doubling its inflation objective and expanding its asset purchase program to that end. He also advocates an additional fiscal expansion.
Although an easier monetary policy could lower the yen and lift Japan from deflation, the yen’s past appreciation has not obviously hampered the competitive position of Japan’s trade sector. The yen does not seem overvalued.
It is true that the yen has generally appreciated in foreign-exchange markets since the inception of generalized floating in 1973, as J.P. Morgan’s broad nominal effective—or trade-weighted—yen exchange rate shows. The U.S. dollar contributes the largest single currency weight in the construction of this rate, and movements in the yen-dollar exchange rate account for approximately three-fourths of the trade-weighted exchange rate's annual variation. Since 2006, just prior to the recent global meltdown, the yen has appreciated 32 percent on a trade-weighted basis and 38 percent against the dollar alone.
But exchange rates alone provide an incomplete explanation of trade patterns. Prices matter too. A real exchange rate incorporates information about prices. On a real basis, the yen has shown little movement on balance since 1973, although it has appreciated 15 percent since 2006. This lack of a strong trend in the real effective yen contrasts sharply with the steady appreciation of the nominal effective yen, but it is not surprising given the growing integration of world markets.
Globalization tends to shift trade away from the high-inflation countries toward low-inflation countries. In the process, traders buy—thereby appreciating—the currency of the low-inflation country, and they sell—thereby depreciating—the currency of the high-inflation country. Over long periods of time, movements in exchange rates should exactly offset cross-country inflation differentials, leaving real exchange rates unchanged. Ultimately, the global search for trade bargains establishes parity among the various currencies’ purchasing power, which should leave real exchange rates trendless.
The adjustment to purchasing power parity can take a very long time; in the interim, other economic factors can push exchange rates far off course, and measuring the whole thing presents some exceedingly sticky issues. Still, over long periods of time, real effective exchange rates should tend to return to a value consistent with purchasing power parity. If so, the yen does not look out of line. Its value as of December 2012 seemed to confer neither an obvious advantage nor a disadvantage to Japanese trade.
The long-term movements in the nominal and real effective yen suggest that the yen appreciates because Japan’s inflation rates generally remain below those of its trading partners. Since the mid-1990s, for example, inflation in Japan has rarely exceeded 1 percent—the Bank of Japan’s recent interim inflation goal—and Japan has experienced persistent and reoccurring bouts of deflation.
Prime Minister Abe has advocated more aggressive fiscal and monetary policies to shock the Japanese economy out of its deflation-induced torpor. Recently, he proposed a ¥20 trillion fiscal package. One-half of the amount represents loan guarantees to small businesses and requires no immediate outlays, and one-quarter represents infrastructure spending. The remainder is spread out over other programs, including incentives for corporate investment.
While this fiscal shock may jolt the economy awake, its long-run consequences could prove troublesome. Japan’s public debt burden—around 235 percent of GDP on a gross basis and growing—exceeds that of all other advanced economies. Financing it down the road could come at the expense of private investment and economic growth.
At its last policy meeting, the Bank of Japan adopted some of Prime Minister Abe’s recommendations for attacking deflation more aggressively. The Policy Board doubled its near-term inflation objective from 1 percent to 2 percent, and it also promised to ramp up the Bank’s Asset Purchase Program—quantitative easing—until it reached the new inflation target.
But the Bank of Japan’s January policy announcement left markets unimpressed. They expected more, and the yen initially appreciated. The Bank’s proposal for another ¥10 trillion in asset purchases may not have seemed any different than past changes to the program. Moreover, the addition pertains to 2014 and years beyond. It does not affect the coming year. The Bank also did not appear to tilt its asset purchases more strongly toward longer-term securities, which conceivably might exert greater downward pressure on long rates. Some observers expected the Bank to lower its overnight policy rate and its interest rate on excess reserves. These are already very low, but seemingly trivial gestures can pay dividends in the credibility department.
Further monetary policy changes may be in the offing. Persistent deflation—like inflation—is a monetary phenomenon. To be sure, a monetary expansion aimed at eliminating deflation may induce a near-term yen depreciation, even on a real basis. It may provide a temporary boost to Japanese exports. Temporary, however, is the crucial word—one often absent in such discussions.