Bank of Japan faces September rate test as yen slide persists

US-Japan two-year yield gap widens to 2.8 points

Japanese authorities have stepped into markets again and again to prop up the yen — this time with assistance from the U.S. government — but the currency has still fallen nearly 5% against the dollar since the Iran war began in late February. A Wall Street Journal column published Aug. 4 argues that only the Bank of Japan can arrest the decline, and that a rate increase at its September meeting is the clearest way to do it.

Aaron Back, editor of the Journal’s Heard on the Street column, attributes the slide to a widening gap in monetary-policy expectations. Markets now believe the Federal Reserve is likely to raise rates in the near future, he writes, while they see the Bank of Japan moving more cautiously. Since the Iran war began in late February, the U.S. 2-year Treasury yield has risen from 3.39% at the end of February to around 4.25% recently, while the move in 2-year Japanese government bond yields has been milder. The gap between the two widened to about 2.8 percentage points last week from around 2.15 before the war. Over that same period, the yen depreciated nearly 5% against the dollar — a pattern that, Back writes, “suggests that BOJ tightening will be crucial to arresting the fall.”

Back describes the repeated official intervention as a “mowing the lawn” dilemma — temporary relief that does not address why selling pressure persists. The yen “appears undervalued” by one measure, he writes: travelers to Japan “will rave about the bargains to be had,” a stark shift from the era of yen overvaluation 15 years ago, when a dollar was worth about 80 yen and a trip to the country was a painful expense. The puzzle, he says, is why selling pressure persists even though a dollar buys twice as much of the Japanese currency; the weakness “appears to be a combination of fiscal and monetary concerns.”

On the monetary side, the Bank of Japan has held its policy rate at 1%, and in a statement after its last meeting it said inflation is likely to accelerate above its 2% target in the second half of the year. Japan’s headline consumer-price index rose 1.7% in June from a year earlier — inflation that “hardly looks out of control,” Back says — but the central bank expects the number to climb because of higher oil prices. The weak yen exacerbates that effect by increasing the cost of imported energy. “That should provide all the justification needed to start hiking rates in September,” Back writes.

Back argues the Bank of Japan could change the market’s perception by raising rates at its next policy meeting in September, after an earlier hike in June. The case becomes more obvious, he writes, if the Federal Reserve moves in mid-September — which most market participants currently expect. In that case, the Bank of Japan “would have little choice but to follow suit when its own meeting takes place a few days later.”

On the fiscal side, Back says Prime Minister Sanae Takaichi is unlikely to change course. Like former Prime Minister Shinzo Abe, she is convinced of the need for stimulus to keep growth going and pull Japan further out of its long deflationary spiral, and she has just announced a plan to sharply cut consumption taxes on food items. She is unlikely, in Back’s view, to support any kind of austerity to shore up the yen. “If the lady’s not for turning, that leaves the Bank of Japan,” he writes.

Back also addresses the argument that the Bank of Japan is hesitating because it fears higher rates on Japanese government debt would further undermine the country’s finances. Japan’s debt is “famously high” at roughly 200% of gross domestic product, he writes, but Japan’s underlying fiscal position is “stronger than many appreciate”: counting the government’s huge stock of financial assets, net debt to gross domestic product is about half that, and analysts at Capital Economics see it falling to 80% by 2028. He adds that for anyone concerned about Japan’s fiscal sustainability, “a collapse of market confidence in the yen should be the last thing they want to see.”

Back writes that even the prime minister — whom he describes as “growth-obsessed” and who was said in the past to be pressuring the BOJ to keep policy loose — should now see that “reinforcing the yen has become paramount to shoring up the country’s wider growth story.”