Japan’s lucky break

Just a couple of months ago, pundits were writing off the Bank of Japan, and particularly Kuroda’s policy of 2% inflation.  Now things are looking much more positive for the BOJ.  Since plunging on the night of the Trump election, the Japanese stock market has taken off like a rocket.

It’s not hard to understand why—the yen has been in almost free fall, down from about 100 to the dollar to 118 today.  To put that into perspective, back in April 1995, the yen was at 84 to the dollar.  As recently as September 2012, right before Abenomics was announced, it was at 78 to the dollar.

But those numbers don’t even come close to showing what’s going on with the yen. What really matters is the real exchange rate.  And since 1995, Japan has had an inflation rate that ran almost 2% a year lower than in the US.  The US CPI is up by more than 57% since 1995, while the Japanese CPI is barely changed.  Thus the real exchange rate for the yen has gone from 84 in 1995 to something like 180 or 185 today.  At these levels, the exchange rate is a gold mine for Japanese exporters, which explains why the Japanese stock market is doing so well.

The big puzzle here is why PPP is failing so abysmally in terms of explaining the dollar/yen exchange rate.  Generally when a country has persistently lower inflation than the US, its exchange rate tends to appreciate of time, and vice versa.  Thus the Swiss have low inflation and the Swiss franc trends upwards.  The Brazilians have high inflation and the Brazilian real trends downwards.  And over the very long run that’s true of Japan as well.  I recall when the yen was 350 to the dollar.

But since 1995 the yen has depreciated dramatically, even while Japan has had inflation rates that are roughly two percent less than the US.  Of course during this period Japan has had much lower nominal interest rates than the US (at least the Fisher effect works!), and the yen has generally been expected to appreciate (due to the interest parity condition).  Thus we’ve had a 21-year period where investors expected steady appreciation in the yen, and (on average) they got the exact opposite.

Going forward, one of two things will happen.  Either the BOJ will persist with its inflation policies, or it will not.  If it does persist, eventually investors will have to throw in the towel and admit that they were wrong about Kuroda.  The yen will no longer be expected to appreciate, and the level of Japanese interest rates will be much closer to US rates.

Or, the BOJ will abandon it goal of 2% inflation, and the yen will start appreciating, just as investors have been predicting for 21 years.  In that case, interest rates in Japan may stay close to zero.

It’s entirely up to the BOJ which road they prefer to take.  A few months ago, many people thought they had given up.  Today that’s much less clear. The higher global interest rates following Trump’s election, combined with the BOJ policy of pegging the 10-year bond yield at zero, has caused the yen to plunge in value.  PPP is elastic, but not infinitely elastic.  The yen can’t stay here indefinitely without generating serious inflation.  Otherwise at some point a Lexus 430 would be as cheap as a candy bar.

My instincts tell me that this weird discrepancy between market predictions and actual outcomes can’t go on much longer.  Within the next decade it will be clear whether Japan is seriously committed to a 2% inflation target.  At that point, either Japanese interest rates will rise sharply (success), or the yen will appreciate sharply (failure).

PS.  At Econlog, I have a post on Nick Rowe’s reply to John Cochrane, which might be seen as loosely relating to this post.



17 Responses to “Japan’s lucky break”

  1. Gravatar of morgan s warstler morgan s warstler
    15. December 2016 at 13:23

    Larry Kudlow fan of #Uber4Welfare and NGDPLT chairs CEA.

  2. Gravatar of Effem Effem
    15. December 2016 at 13:29

    The Japanese stock market has only done well priced in yen. The zimbabwe stock market also did “well” by that criteria.

  3. Gravatar of ssumner ssumner
    15. December 2016 at 13:48

    Morgan, I saw that, and just did a post.

    Effem, Not true, and how many time am I going to have to swat down that argument? Next time you report on the US stock market be sure to give it in Swiss francs.

  4. Gravatar of Scott Freelander Scott Freelander
    15. December 2016 at 18:58


    My explanation about the primary reason for the depreciation of the yen against the dollar since 1995 is the differential NGDP growth rates since. I picture an inverted U-shaped function here to describe the relative value of a currency, having a currency most valuable when an economy is at full employment, but with as low an inflation rate as possible without spurring expectations for increased risks to growth due to inflation being so low.

  5. Gravatar of Scott Freelander Scott Freelander
    15. December 2016 at 18:59

    Too low, not so low.

  6. Gravatar of Ray Lopez Ray Lopez
    16. December 2016 at 04:46

    Sumner makes several errors in this post. Let me point them out, since he’s in an echo chamber pace me, his only real critic on this blog. It’s fine to live in a fantasy world, but it does the world no service. If you’re the blogger that saved (or plans to save) the world, you have to save the real world, not the fantasy world of your mind.

    First, the JP stock market has only outperformed the NYSE Dow Jones index for the last 11 days. Before then, before Dec 5, it was actually trailing for a time: https://www.bloomberg.com/quote/NKY:IND So it’s unlikely the JP stock market taking off like a rocket (where the indexes are 50% owned by the Bank of Japan, coincidentally) is of much significance. Random noise is all.

    Second, the idea that the JP central bank somehow controls the JP/$ exchange rate is flawed. While it’s true the JP central bank tries to steer the exchange rate, they don’t have unlimited power and most commentators who study this market say the BoJ simply ‘leans into the wind’ to try and influence rates, but does not ‘set’ the rate. Exchange rates are set by a variety of factors, and they are nearly unpredictable, nearly random, and thus making money in Fx for most people is nearly impossible. Even the famed Plaza Accord of the 1980s was overrated: the dollar began to strengthen even more central banks intervened. If you want to call this ‘jawboning’ that’s fine, but you must acknowledge central banks follow markets. They can try and ‘steer’ a trend but they don’t make trends happen. Witness the Bank of England and Soros breaking of the same. If central banks were omnipotent, that would never have happened. Recall also speechwriter James Carwell’s remark to Bill Clinton about bond traders. The market is greater, in a floating exchange rate regime, than anything a central bank can do by fiat. Sumner’s proposal to just print money to influence exchange rates would be about as effective as bailing out an ocean with a teaspoon.

  7. Gravatar of ssumner ssumner
    16. December 2016 at 12:28

    Scott, That may be, but in that case you don’t want to look at NGDP. Strong real growth can make a currency rise, whereas strong inflation depreciates a currency–so combining them is deceptive.

    Ray, You are hitting rock bottom. The Plaza Accords weakened the dollar.

  8. Gravatar of Scott Freelander Scott Freelander
    16. December 2016 at 13:55


    Yes, and actually it is the reciprocal for my formulation of NGDP that applies:

    NGDP = (Sm/Dm)RGDP, where Sm is the supply of money and Dm is the demand for money.

    So, the change in value of one currency versus another is determined by relative difference in changes in the ratios of Dm/Sm.

    Hence, the exchange rate should be (Dm/Sm)RGDP for currency issuer A / (Dm/Sm)RGDP for currency issuer B, if I haven’t made a typo or simple mental mistake.

    And then there are short-run versus long-run effects, such that if the ratio Sm/Dm is expected to be down enough for longer than a short time, RGDP can fall, reducing the value of one currency versus another, ceteris paribus.

    Can it really be that simple, or do economy-wide savings rates, etc. matter?

  9. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    16. December 2016 at 16:53


    118 dollar/yen make occur achieving 2% inflation target(core CPI)?
    In recent situation, which level is desireble?
    125 yen? 140 yen?

  10. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    16. December 2016 at 17:01

    I know rule-based non-discretionary MP is preferable.
    But,still there is political limitation.

  11. Gravatar of ssumner ssumner
    17. December 2016 at 08:06

    Scott, Sorry, I don’t follow that.

    Wasshoi, The 118 rate is too low, I’m not sure how high it should be. But the most important thing is to keep it fairly stable in the long run. Even 118 would be enough if held there for 100 years.

  12. Gravatar of Scott Freelander Scott Freelander
    17. December 2016 at 08:15


    Sorry, I wasn’t clear. In the short-run, a negative supply shock with regard to money increases the forex value of the currency. In the longer run, a lower NGDP path will mean a lower value for that currency, as shock converts to more permanent expectations of slower growth.

  13. Gravatar of ssumner ssumner
    17. December 2016 at 08:17

    Scott, In 2008 Zimbabwe had a very high NGDP growth rate, and yet their currency plunged.

  14. Gravatar of Scott Freelander Scott Freelander
    17. December 2016 at 09:29


    Yes, my statement didn’t allow for disproportionate inceeases in the expected growth of the money supply versus falling RGDP. An adjustment is needed.


  15. Gravatar of Scott Freelander Scott Freelander
    17. December 2016 at 09:36


    My equation above accounts for Zimbabwe, but I’ll have to get better at communicating in words.

    Forex value = (Dm/Sm)RGDP, ceteris paribus, where Dm is demand for money and Sm is supply of money.

    Interestingly, making demand for money explicit even covers for the case when inflation is high enough that currency abandonment begins.

    I keep getting tempted to use something like forex value = RGDP/NGDP, ceteris paribus, like many market monetarists do, but I keep seeing value in making demand for money explicit.

  16. Gravatar of Benjamin Cole Benjamin Cole
    17. December 2016 at 22:32

    Scott or anyone, see below. The BoJ is operating on whole higher plane than the Fed. Are they aggressive enough? Maybe, although they are getting lucky with the Fed. Export markets look better.

    What I find interesting is how BoJ bankers talk stimulus, Fedsters talk about monetary nooses.

    Guess how this will end up?

    Nikkei Asian Review ( a good read, btw)

    December 15, 2016 4:50 am JST

    BOJ boosts bond buys to hold down Japan’s long rates
    JGB yields reverse recent rise; new purchases planned Friday

    The yield on benchmark 10-year Japanese government bonds has risen sharply in recent months.
    TOKYO — The Bank of Japan increased purchases of Japanese government bonds Wednesday for the first time since adopting its new monetary policy framework in September, seeking to counteract market forces that have pushed long-term interest rates higher in recent weeks.

    The central bank bought 320 billion yen ($2.77 billion) in bonds with maturities exceeding 10 years, up from the originally planned 300 billion yen. “We took into consideration the recent sharp rise in yields on ultralong JGBs and concern about further yield movements,” an official from the bank’s Financial Markets Department said.


    BOJ Deputy Iwata Says No Shift Away From Asset Purchases
    by Toru Fujioka and Masahiro Hidaka
    December 7, 2559 BE 10:45:53 AM GMT+07:00 December 7, 2559 BE 2:12:17 PM GMT+07:00
    BOJ will continue expanding monetary base as needed, he says
    Asset buying effective in overcoming deflation, he says
    Bank of Japan Deputy Governor Kikuo Iwata said the central bank hasn’t shifted its focus away from expanding the monetary base as it seeks to reach its inflation target.

    Iwata stressed that the BOJ will continue its large-scale asset purchases after it introduced a new policy framework that targets interest rates in September.

    “Some argue that the bank’s policy focus has shifted from quantity to interest rates under the new policy framework, but such an understanding is inappropriate,’’ Iwata told local business leaders in Nagasaki on Wednesday.

  17. Gravatar of ssumner ssumner
    18. December 2016 at 05:54

    Thanks Ben.

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