Over the past week, the Bank of Japan has conducted what Is known as a rate check, or a formal inquiry into the buying or selling price of the Japanese yen. This rate check has been done in preparation for a possible intervention into foreign exchange markets to prop up the declining yen.
Intervention into currency markets by a major central bank is rare and almost always fails.
Intervention into currency markets by a major central bank is rare and almost always fails. And even when it partially succeeds, the intervention is supported by other major central banks, which is also rare.
Why is the Bank of Japan doing this now?
The rate check is almost certainly linked to elevated oil prices, a soaring dollar and the highest inflation to grip the global economy in decades.
Because the Japanese must purchase oil in American dollars, an appreciating greenback means that crude has become that much more expensive. That rise, in turn, sends inflation higher.
Given the likelihood of increasing rate differentials, geopolitical tensions and an energy crisis in Europe, the probability of the U.S. dollar continuing to appreciate against the major currencies is rising.
The result is that the central banks may be reconsidering their long-held reluctance to intervene in currency markets.
For the major central banks outside the United States—the Bank of England, European Central Bank and Bank of Japan—coordinated intervention makes some sense.
But for the Federal Reserve, it’s a far more difficult decision. First, a stronger dollar tends to dampen inflation on the margin, which supports the Fed’s policy objective of price stability.
Yet at the same time, the Fed cannot dismiss the concerns of domestic exporters that struggle as the dollar rises.
Our view is that central banks and finance ministries ought to refrain from intervening in foreign exchange markets wherever and whenever possible.
Intervening in markets tends to result in a misallocation of resources and less optimal economic outcomes than would otherwise result.
But the current inflation shock may outweigh this reluctance. We may be entering an era of intervention in foreign exchange markets.
State of play
Consider how dramatically the economic landscape has changed. The yen has lost 15% against the dollar since the start of the year, and 3.3% in the first two weeks of September alone. Since the end of 2020, the yen has lost 38% versus the dollar.
But perhaps even worse considering its status within Asia, Japan’s currency has weakened by 35% since May 2020 versus China’s renminbi.
This isn’t the first time such a dislocation in currency markets has occurred. In the 1980s, a perfect storm of currency weakness versus the dollar took place when U.S. monetary policy and its fiscal policy moved in the dollar’s favor.
The Federal Reserve had jacked up short-term interest rates to 18% to slow inflation, while Reagan-era government spending became expansionary.
Interest rates in the rest of the world failed to keep up, resulting in international investment flocking into U.S. assets and a rising dollar.
The Plaza Accord of 1985 ended the dollar’s run but created other asset bubbles and economic distortions. Those distortions required the Louvre Accord of 1987, which halted the dollar’s freefall and stabilized the currency markets.
Do we need another Plaza Accord to stop the dollar from moving higher against the yen? And given past experience, why would the U.S. even consider another round of currency intervention?
Let’s start with the second question, which might be more about mutual protection than anything else.
If Japan’s economy needs a lifeline, there are many reasons for the U.S. to provide one. Japan is a steadfast ally, a major trading partner and a willing investor in the U.S. economy. This is perhaps because of our commitment to the democratization and prosperity of Japan after the war.
In recent decades, however, Japan was surpassed by China and the Asian tigers in manufacturing and then by Taiwan and South Korea in technological advancements.
We have to assume that Japan’s diminished role in Asia is in large part because of China’s economic ascension and its investment in neighboring economies.
One result has been a breakout of the renminbi versus the yen following the financial crisis, and then a 35% depreciation of the yen versus the renminbi starting in May 2020.
The currency forecaster Michael Rosenberg argues that the need for intervention might be more a function of protecting Japan’s status in Asia and protecting its economy from currency-induced inflation.
If the rise of the dollar versus the yen might be ancillary to Japan’s other issues, that brings us back to the first question: Why is an intervention needed now?
After all, diminishing the value of the dollar to save the yen would contradict efforts by the Federal Reserve to reduce U.S. inflation. A stronger dollar makes foreign-made products that much cheaper for Americans to buy. And if we are to mitigate the effects of a global recession, then we would assume that American purchases of foreign goods would stimulate global growth as well as domestic commercial activity.
For Japan, the decrease in the yen’s value might be expected given its diminished role in international trade. In the early 1980s, Japan was responsible for nearly 7% of global exports. By the mid-2000s, that percentage had been halved.
And although the higher cost of imported energy and food in Japan—priced in dollars on the international markets—is not going away anytime soon, we would have to assume that the weaker yen would otherwise increase Japan’s comparative advantages.
As to the effects of a stronger dollar on Japan’s inflation, we find limited evidence to suggest much of relationship. The yen has weakened on average by less than a half percentage point per year since the Louvre Accord, and inflation has not been an issue in Japan outside of spikes in oil prices.
In recent decades, Japan’s economic growth has been moribund. If anything, its economy has been threatened by deflation rather than inflation. If we are to help a friend, we need to think of other avenues.
History of currency intervention
The Exchange Stabilization Fund has been operated by the U.S. Treasury since the 1930s. Direct currency intervention (buying and selling foreign currencies) has been used to varying degrees as the foreign exchange market transitioned from the regimentation of the gold standard to the free-floating of developed-market currencies in the early 1970s.
In the 1980s and 1990s, the operational concept that provided the policy framework was that conditions inside the FX market did not always reflect underlying economic conditions. Those conditions brought about the need for coordinated FX operations among the central banks to correct the economic imbalances that were occurring.
As reported by the Treasury Department, U.S. monetary authorities as late as June 1998 purchased yen for the purpose of strengthening Japan’s economy.
In September 2000, a coordinated intervention was initiated by the European Central Bank out of concern for potential unruly movements of the newly formed euro exchange rate and their effect on the world economies. This measure of caution came despite prior years of transition through the European Currency Unit.
In this current episode, the FX market is responding to the consequences of dependence on inconsistent supplies of energy.
In this current episode, the foreign exchange market is responding to the consequences of dependence on inconsistent and limited supplies of energy.
North American economies should be less susceptible to shortages of oil and natural gas than those affecting Europe.
So if a currency’s value is determined by the return on holding assets supported by a growing economy, then you would expect the U.S. dollar to appreciate against other currencies.
The same holds for the renminbi and China’s economy, which is an exporter of oil and remains willing to purchase oil from Russia.
Policy questions
Despite being an energy exporter, the United States is just one part of a global economy, and the worldwide shortages of oil and natural gas are having dire consequences on potential U.S. growth.
We understand that the decision to intervene in currency markets might already have been made.
Still, after decades of currency stability, the debate is whether disruption of the currency market is necessary to resolve imbalances in other markets.
While fluctuations in currencies are the result of the interaction between supply and demand, imbalances in the market for goods stem from the lack of accurate price signals that pre-date the current crisis.
In addition, flexible currency regimes provide a crucial mechanism of adjustment for large global trading economies.
Oil crises have occurred regularly over the years, with little attention from policymakers or market makers to the root cause of OPEC being the dominant supplier and price-setter for fossil fuels.
More recently, China has been allowed to dominate the supply of goods, with little attention given to supporting domestic production in Western economies.
The West has refused to price in the risk of yet another energy embargo. The consequence of that avoidance is about to disrupt Europe’s standard of living and its manufacturing capabilities.
As for imbalances in the production of goods, the West has failed to price in the real possibility of a supply chain shutdown out of Shanghai.
The takeaway
If there is a concerted effort to stabilize the currency market, the monetary authorities must make clear that it is an emergency response and that it will be temporary. In return, the fiscal authorities should consider once and for all reducing their overdependence on fossil fuels.
