Wednesday, February 22, 2012
This chart shows the Japanese Yen/US Dollar exchange rate since the beginning of last year. What stands out this past month is the sharp depreciation of the yen, which has dropped 5.1% against the dollar in the past three weeks. It's the result of the Bank of Japan undertaking serious intervention steps to weaken the yen, which reached an all-time high of 75.8 against the dollar last October.
Typically, forex intervention is not very effective at changing a currency's value, since most intervention is "sterilized" by monetary authorities. For example, one arm of the government sells its currency for dollars in order to weaken it, thus increasing the supply of its currency, but then another arm sells bonds in order to mop up the extra supply of the currency. With no net change in the supply of its currency, the intervention leads to only a temporary change in the currency's underlying supply/demand fundamentals.
But as the chart above shows, this time the Bank of Japan is working hard to make the increase in the supply of yen permanent, by dramatically increasing its bond purchases and paying for them with bank reserves. In the upper right hand corner of the chart you can see where this latest version of quantitative easing has caused bank reserves to jump by 76% in the year ending Jan. '12. Not only is the BoJ intervening to weaken the currency and pumping up the supply of bank reserves to expand the money supply, but the BoJ has also announced a formal inflation target of 1%. They are working hard to stop the yen from appreciating further—since that leads directly to increased deflationary pressures—and they are actively trying to get inflation to rise at least modestly, from the current zero to 1%. These efforts stand a good chance of working, since they have worked in the past.
The above chart also shows how the BoJ pursued its first round of quantitative easing by greatly expanding the supply of bank reserves from mid 2001 to early 2006. During this time the yen averaged 115 against the dollar, which is about 30% weaker than it is today. In addition, inflation rose from a low of -1.6% in early 2002 to a high of 2.3% in 2008 (a lagged response to easy money in prior years). In other words, that round of quantitative easing produced results. But then the BoJ reversed its quantitative easing, slashing bank reserves by 75% over the course of 2006. This tightening set in motion the yen's record-breaking 60% rise against the dollar, from a low of 124 in mid-2007 to an all-time high of 76 in late October '11.
The chart also shows the origin of the deflation that has plagued the Japanese economy for so long. That's in the middle portion of the chart where I've highlighted the fact that the BoJ allowed zero net expansion of bank reserves from 1990 through 2001. With policy so tight, it is no wonder that the yen rose from a low of 160 in 1990 to 110 by the end of 2000—an appreciation of 45%.
Bottom line: Japanese monetary policy has tilted decisively in favor of at least some mild inflation, and decisively against further deflation. This may improve the outlook for the economy—and I note in that regard that the Nikkei 225 index is up 12% in the past month—if only because it will likely result in a pickup in aggregate demand as money velocity rises. The yen is likely to depreciate further against the dollar, thus providing some support to a dollar that has suffered from significant weakness against most currencies in recent years.
Posted by Scott Grannis at 12:07 PM