Over a four-day period Japan is suspected to have carried out two interventions to support the yen at an estimated cost of $59 billion dollars.
The first intervention came after the yen fell below 160 to the dollar for the first time in 34 years. The second intervention came a few days later after Jerome Powell announced that a rate hike was unlikely to be the Fed’s next interest-rate move.
The simplest explanation for the declining yen is that it is entirely driven by Japanese interest rates being low relative to other developed markets. People take their money out of the yen which is yielding 0 and put it in dollar denominated bonds to earn 5% - leading to a decline in the yen, but my friend Manoj Pradhan at Talking Heads Macro argues that this is a lazy oversimplification and that the Yen and Japanese markets are possibly the most interesting story in macroeconomics today.
So, to bring you up to date on the situation, towards the end of April the Japanese Yen fell to 160 against the dollar - a level where the Japanese Ministry of Finance felt it made sense to step in and they appear to have started selling dollars and buying yen to try and limit how weak the currency could become.
Japan has been unable to generate sustained inflation over the last three decades and the Bank of Japan appears to be determined to make it happen now and so they are running a monetary policy that is quite at odds with what the US fed and ECB are doing.
It is clear that the issue is Yen weakness and not just dollar strength (which can sometimes be argued when looking at currency pairs) as the Yen is weak against all currencies, not just the US dollar.
The Yen has been so weak that it’s back to the level it traded at in the mid 1980’s, and in real terms is back to its levels of the early 1970’s – which is before the Japanese electronics and auto manufacturing booms occurred.
The questions being asked right now are if the purchasing power of the yen makes sense when we look at the overall strength of the Japanese economy? And is the issue just down to interest rates differentials or has the yen possibly overshot to the downside?
The suspected intervention occurred when the Yen hit an intraday low of 160 to the dollar and the buying boosted the rate to 153, but as of the time of this recording, the rate is back to around 156 with concerns that it could slip further.
The Japanese ministry of finance would have obviously liked to see the price stay closer to that 153 level that it reached after the intervention and seeing this continued weakness are probably concerned that they will be expected to intervene again if it falls to back to 160.
The FT described the unilateral intervention as being futile - like the labors of Sisyphus, and while an intervention like this will work in the short term, as the buying pressure will (of course) push the price up, the question is will they have to keep intervening, and if they do, will they run out of firepower.
It is unlikely that the goal of the intervention was to change the the trend in the Yen, as that would be extremely unlikely to work. The real goal was most likely to send a signal and discourage speculators from trying to push the yen lower. The goal was likely to set a floor at 160 – and to prevent negative sentiment from building and overshooting to the downside.
If the yen continued to weaken and interventions didn’t work, we have to wonder if the Bank of Japan would need to join the ministry of finance in supporting the Yen by adjusting interest rates – which they really don’t want to do – as we’ll explain.
Let’s look at why Japan is pushing so hard for inflation when the rest of the world is trying to end it, why Japan is so different to the rest of the developed world, and how Japan’s super ageing society affects this issue.
So first up, why do Japanese policymakers even care about causing inflation when the rest of the world is trying to bring an end to high inflation? Well, the main reason policymakers (in general) aim for low inflation is to steer clear of deflation, which causes all sorts of economic problems. While it might sound great seeing goods getting cheaper and cheaper over time, deflation leads to economic stagnation as consumers defer their purchases waiting to buy later at lower prices. When purchases are deferred like this it leads to business failures and job losses. Businesses in such an environment become reluctant to hold inventories as these inventories are both difficult to sell and fall in value while they sit on shelves. Deflation and low interest rates also leave central bankers with very limited ability to respond to an economic crisis should one arise and make wage adjustments (which might be necessary) very difficult.
In March’s Bank of Japan meeting, the monetary policy committee talked about the return of a “virtuous inflationary cycle”, as rising wages would jump-start inflation after decades of falling prices. But Japanese inflation has since slowed and at the most recent monetary policy meeting, it was discussed that a weaker yen could spur price growth, allowing the BoJ to achieve its inflation objective.
There are still questions though, as while a weaker yen might cause inflation, would it be the right kind of inflation?
If a depreciating currency just pushed up the price of imported goods (which for Japan includes a lot of food and energy), reducing real (or inflation adjusted) wages, this might just have the effect of sending money abroad and reducing the money Japanese people have to spend on services within the country. This sort of inflation would not necessarily bring about the self-sustaining process – the “virtuous inflationary cycle” that the Bank of Japan is hoping for.
Manoj Pradhan argued in a note back in March that Japanese workers have seen two years of falling real wages – and this feeling of getting poorer might be one of the things suppressing Japanese consumer spending. He argued back then that consumption growth would only come after consumers have recouped the purchasing power they have lost due to inflation, and that they would need several quarters of wages outstripping prices before they feel comfortable increasing consumption.
Manoj makes a strong argument that simply focusing on interest rate differentials when looking at Japan is missing the forest for the trees.
He argues that there are a number of ways in which Japan is very different from the rest of the world. First, the phase of the economic cycle and the intentions of policy makers could not be more at odds, in that what Japan wants to do is the exact opposite of what every other country is trying do.
In most other countries, labor markets have been tight, and services inflation has been so sticky that the markets are wondering if rates can be cut at all. Over the last six months, rate cuts that had been priced in by market participants are no longer expected.
Japan’s problem – in contrast - is that their services inflation (which includes things like healthcare, restaurants, hotels, recreation, and culture) is too low, and they need to see it rise.
Another important factor that he highlights is that this is the first time in more than thirty years that Japan's corporate sector has had sufficient profits that big businesses can recognize the demographic problems being faced by the country and start spending enough on capex to replace workers with capital.
According to Nikkei, listed Japanese companies are posting record profits for the third year in a row, with profits 13% higher than the prior year, which were 6% higher than the year before that.
Profits from the manufacturing sector look set to grow 16% this year, with the nonmanufacturing sector set to climb 11%. Both of which would be record levels of profitability.
Japanese capex intentions are measured by the Tankan survey and are at multi- decade highs. In the previous peaks of that survey, they used to predict 7% 8% capex growth. In the latest cycle it has been at 15 percent and while the actual realization of capex in the past has fallen short by one or two percent, this time we have seen somewhere between 7 to 8% growth in capex already so while the rest of the world is struggling with housing investment and capex and whether factories and productivity can rise, Japan's on a path that is very different from anywhere else.
Part of the story driving profitability in Japan has been the weakness of the yen because most Japanese companies looked abroad, not just in terms of exporting, but also in terms of investment and so since the Yen has been weak most of these companies with international reach have really seen their profits grow partly due to the weak Yen and partly by weak monetary conditions at home despite pretty decent growth.
Now you cant just devalue your currency to generate wealth – for fairly obvious reasons, but the decline in the yen has improved business profitability which Japanese policymakers hope will lead to wage growth and capex. It has also brought about inflation in a country that has suffered more than 30 years of deflation and policymakers hope that this will spur the Japanese consumer to spend now – before prices rise further – stimulating the economy further.
Manoj argues that this approach has its pros and cons as there's a limit to where everything can go. The Bank of Japan discuss in their latest report that over a period of time they are fairly confident that the Japanese economy will get into a positive output Gap – and with that positive output Gap you'll see steady income growth for workers and with that steady income growth you'll get steady growth in consumer spending. This is the “virtuous cycle” that they are talking about between income and spending that they believe will get the Japanese economy rolling.
Now, the output gap is an economic measure of the difference between the actual output of an economy and its potential output. The output gap can be either positive or negative and a positive output gap occurs when actual economic output is more than full-capacity output. This might sound like it doesn’t make sense, but it happens when demand is very high and, to meet that demand, factories and workers operate far above their normal capacity.
In a situation like this where machines and labor are being stretched, businesses end up having to pay more for everything in order to run flat out like this. Workers are in high demand and are earning overtime and can demand pay raises.
In the long run businesses have to deploy capital to increase worker productivity (this means greater mechanization) – and that is badly needed in Japan with their ageing population. Additionally, you simply can’t run overcapacity in the long run, but for short periods an economy can have a positive output gap, but there is a cost associated with that and the idea is that this positive output gap will feed into the virtuous cycle.
Japan is a bit of an interesting country where it can be both amazingly high tech – but also low tech where many stores won’t have things like cash registers. There is plenty of room for increased mechanization in the country.
Now, as I just mentioned, corporate profits in Japan are at all-time highs, but real wage growth has been weak and that is why policy makers are pushing very hard for higher wages.
Bank of Japan officials have stressed that the timing of their decisions will depend on things like wage negotiations. Policymakers hope that big pay rises will boost household spending and produce more durable growth in the broader economy.
This is a period of big change in Japan as while deflation slowly made Japan relatively poorer over the last 35 years, certain salaried workers who made steady incomes did quite well out of the situation as though they didn’t get pay raises, their money went further and further each year due to deflation. This prolonged period of deflation means that almost the entire Japanese workforce – those under the age of 55 – have never seen inflation and are used to a world in which the best strategy is to cling onto your job for dear life, and benefit from a steady decline in the cost of living.
This approach to work does not lead to huge innovation or risk taking within the economy. Leo Lewis writes in the FT that there are, currently, some compelling counterpoints to the gloom in Japan. He says that labor shortages are today forcing long-overdue reform on companies and allowing younger Japanese workers to take greater risks and show greater entrepreneurialism than they would have in the past. He says that this change may ultimately provide the context in which the central bank is able to confidently raise interest rates as real wage growth becomes entrenched.
In March, Japan's biggest companies agreed to raise wages by 5.28% for 2024 which was the biggest pay hike in Japan in 33 years. This change fed into the decision to end the negative-interest rate policy in March.
Manoj points out that a problem with Japanese policymakers plan for a positive output gap to kickstart the economy is that the output gap at this point in time in the bank of Japan’s own figures is zero.
He highlights that the most recent Bank of Japan report says that they are worried about the Yen for two reasons. Number one is that Yen weakness will eat into corporate expectations of what they need to do in the future. He argues that this makes no sense as Yen weakness has helped profits.
The second thing the Bank of Japan worries about is that if the yen is weaker the higher cost of imports inflates away wage gains – essentially because a weak yen causes the wrong type of inflation.
Manoj says that while this argument is economically sound, it makes no sense as corporate profits have been a function of a weak yen and if you try to strengthen the yen you will hurt firms reducing the output gap and any potential future wage gains that would come from that.
He highlights that this is the first time in the last few decades that firms inflation expectations in Japan have really gone up substantially and that's because the government is on their case to lift wages. He says that the government's popularity has taken a pounding because real wages in Japan have fallen so badly that it's now pressuring everyone it can to raise worker wages and if that happens over a period of time you're going to get inflation – and the right kind of inflation. So, he feels that policy makers need the domestic labor market to remain tight.
He says that they don't want to raise interest rates because he thinks they understand that goods inflation is coming down and Services inflation is not high enough. He says Yen intervention is a case of the Bank of Japan wanting their cake and wanting to eat it too.
The big winners from the declining yen so far have been multinational firms, who generate profits around the world that are denominated in yen, exporters – who receive foreign exchange, and financial firms with exposure to international markets.
The tourism sector has been booming in Japan with the number of monthly visitors having exceeded three million for the first time this March driven by the weaker yen, but the Japanese themselves are not traveling for a few reasons, including high airfare costs and low buying power abroad, both of which are driven by the weak yen. In March, outbound travelers were less than half the number of inbound travelers, and travel was down 37% compared to the same period in 2019. When you combine a low yen with the fact that Japanese workers haven't had a raise in 30 years it doesn’t encourage lavish holidays.
After the suspected intervention Janet Yellen refused to comment to the press on whether the intervention had happened or not, but she did say “we would expect these interventions to be rare and for consultation to take place.”
Historically when asked about currency interventions Yellen has referenced a long-standing agreement between G7 countries that the free market should be allowed to determine exchange rates, saying that intervention can only be justified to smooth out volatility, but not to influence exchange rates.
The implication from her statements is that this was a one-sided intervention and that Japan had not spoken with the United States before stepping in. An exchange rate is a bilateral price and successful interventions often involve a discussion between both sides where they agree that something is wrong and should be dealt with by both central banks.
The recent interventions in the Yen are not the first in recent years, The Ministry of Finance intervened three times in late 2022, spending almost sixty billion dollars when the currency fell below 150 Yen to the dollar.
Obviously that level didn’t hold.
This then leads to the question of whether central banks should ever intervene in currency markets. We have recent examples that I have covered on this channel of Turkey and Egypt who essentially squandered their entire central bank reserves trying to maintain an artificial foreign exchange price which collapsed as soon as they ran out of firepower. I have also covered the story of George Soros versus The Bank of England in 1992.
An example of an intervention that did work was when currency speculators sold the Hong Kong Dollar and shorted Hong Kong stocks during the Asian Financial crisis of 1997. The Hong Kong Monetary Authority controversially stepped in with a series of interventions in 1998 buying both foreign exchange and stocks - squeezing the shorts out of their position. The Hong Kong Monetary Authority ended up owning six percent of the stock market by the end of their intervention which they later packaged into a fund which they sold to local investors at a small discount.
A cheap yen is helping Japan with inflation, corporate profits and wage increases, but the pace of the currency’s decline – which is down about ten percent against the dollar year to date is possibly starting to spook Japanese consumers, which could lead them to reduce their spending – which is the opposite of what policymakers want to happen.
In Leo Lewis’s FT piece from a few weeks ago, he wrote about how people in Japan have started discussing the risk that Japan could slip back into becoming an emerging market once again – possibly not as a serious concern but as more of a motivational tool.
While the Japanese economy has many structural problems, the risk of becoming an emerging market does seem like a huge risk. The three key differences between emerging markets and developed markets according to my friend Manoj are that in Emerging markets – labor is cheap and technology is expensive. Emerging markets have to pay a high price to attract capital, and emerging markets have weak institutions and powerful individuals. None of these descriptors apply to Japan.
Japan’s debt reached $8.6 trillion dollars at the end of last year, and at 255 percent of GDP it is more than twice the debt to GDP ratio of the United States and is the highest in the developed world. Japan has a super aged society where based on current projections, there will be almost the same number of workers in Japan as retirees by 2050.ccvv
Preliminary GDP data that came out on Thursday showed that Japan's economy shrank 2.0% annualized in the first quarter from the prior quarter as consumer spending notched its longest downward streak since early 2009. Household spending fell0.7% from the previous quarter in a fourth consecutive quarterly decline. This presents quite a challenge for the Bank of Japan.
Downwardly revised data showed GDP barely grew in the fourth quarter of 2023, due to downgrades to capital expenditure estimates.
The GDP decline can partially be blamed on a production disruption at Daihatsu and an earthquake that struck on New Years Day.
The Bank of Japan Governor said in a recent speech that “If the outlook for prices is revised upward or if upside risks become high it’ll be appropriate for the bank to make an earlier adjustment of the policy interest rate,” noting that changes in exchange rates were more likely to affect prices than in the past.
Lower inflation in the United States which might lead to an interest rate cut would also help Japan as that would reduce the interest rate differential which is putting pressure on the Yen.
I think Manoj might be right about Japan being one of the most interesting stories in Macroeconomics right now.
Thanks for tuning in to this week’s podcast – with a special thanks to my supporters on Patreon who make this all happen. Have a great week and talk to you again soon. Bye.
