Raising Interest Rate is the Sole Option to Halt the Significant Depreciation of the Yen

The significant depreciation of the Japanese yen (JPY) against the U.S. dollar (USD), coupled with the notable strengthening of the USD against other currencies, have emerged as major issues in today’s financial markets. Earlier, we witnessed the remarkable surge in the Japanese stock market and the significant decline of the JPY against the USD. With the JPY breaking through the 155 mark, there is renewed interest in conducting further analysis. The conclusion is straightforward: the Bank of Japan (BoI) must consider raising interest rates. 

In recent years, the BoJ has injected a significant amount of liquidity, starting with quantitative easing (QE). Unlike other countries that implemented one or two rounds of it, Japan has continued with QE, releasing a substantial amount of liquidity on an astonishing scale. Typically, when money is printed excessively, its value diminishes, hence the depreciation of the JPY. This has attracted considerable capital to short the Japanese currency, thereby exacerbating its depreciation.

Is there a way to slow down the depreciation of the JPY? The only option, as things stand, is to raise interest rates. Yet, this hike of interest rates by the BoJ should not be based on the usual objectives of targeting the economy or price levels. Instead, the focus should be on slowing down the depreciation of the currency, aiming to encourage holding the JPY rather than selling it.

On the one hand, raising interest rates can narrow the U.S.-Japan real interest rate differential, reduce arbitrage trading pressures on the JPY, and dispell market expectations of maintaining or widening interest rate differentials. This effectively slows down the trend of selling short on the yen, putting a halt to its depreciation. Conversely, post-interest rate hikes, the JPY will strengthen, prompting investors to divest from overseas assets and acquire Japanese assets, resulting in an influx of yen and subsequent appreciation. Additionally, increased yields on the yen will rejuvenate Japan’s financial sector.

Looking at the stock market, the Japanese economy is performing well, which also warrants consideration of raising interest rates. Therefore, considering all factors, it appears that the sole option for the BoJ at present is to raise interest rates and refrain from intervening in the foreign exchange market, as that would not be a sustainable monetary policy operation.

Written by Chan Kung.

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