Putting the yen into perspective

"Japan Battles Soaring Yen," is the title of the front-page feature article in today's WSJ. The yen recently strengthened to 84 versus the dollar, the strongest level seen since the yen briefly flirted with 80 back in April '95. The yen has been the strongest currency in the world over the past 40 years, rising from just under 400 yen to the dollar in the early 1970s, to 85 today.

The inherent strength of the yen is also seen in this second chart, which shows the value of gold in dollars, euros, and yen. Since 1977, gold has risen about seven-fold in dollar terms, about five-fold in euro terms (linking the euro to the DM), and only two and a half-fold in yen terms. The yen's long-term strength is not so much due to some mysterious force, as it is due to Japan's central bank. Japan's currency is strongest relative to gold and other currencies because the Bank of Japan has done a much better job of keeping inflation low than any other central bank.

But currency strength is best measured in inflation-adjusted terms, not in nominal terms, and that's the point of the first and third charts. The blue line in the first chart is the nominal value of the yen/dollar exchange rate, while the green line is my calculation of the purchasing power parity (PPP) value of the exchange rate. The PPP value is the level of the exchange rate over time that would make prices in Japan roughly similar to corresponding prices in the U.S. This line is driven by changes in the relative inflation rate between the two currencies. Japan's PPP has been rising relative to the U.S. dollar ever since the late 1970s because Japan's inflation rate has been much lower than ours. In fact, Japan's CPI has risen only half as much as our CPI since early 1977. This inflation differential would dictate that the dollar should have lost about half its value against the yen, and that is reflected in the appreciation of the dollar/yen PPP exchange rate from 240 to 120.

The degree of a currency's strength can be measured by comparing its current value to its PPP value. On that basis, in the mid 1990s the yen was far stronger relative to the dollar than it is today, as seen in this last chart. By my calculations, the yen today is only about 40% "overvalued" vis a vis the dollar, which means that a U.S. tourist today should expect to find that things in Japan cost on average about 40% more than they do in the U.S.

According to the headlines, the yen is incredibly strong relative to the dollar. But when you look at relative inflation differentials, the yen today is not much stronger, on average, than it has been since the mid-1980s.