[Super Enjeo]④ Deepening Dilemma for BOJ... US-Japan Interest Rate Gap and GDP Shock

BOJ Raises Interest Rates but Super Yen Continues
Super Yen's Root Cause Is the US-Japan Interest Rate Gap
Possibility of a Second Plaza Accord Raised
Japan's Complex Calculations Make Yen Strengthening Difficult

[Image source=Yonhap News]

Last March, the Bank of Japan (BOJ) escaped from long-standing quantitative easing by raising the short-term policy interest rate from -0.1% to 0~0.1%, ending negative interest rates for the first time in 17 years. Japan, which has maintained a deliberate yen depreciation to boost Japanese companies' stock prices and overcome the lost 30 years, declared so-called 'interest rate normalization.' When news spread late last year that Japan would gradually start raising interest rates, expectations for yen appreciation briefly swelled. The yen-dollar exchange rate, which had reached the 150-yen level in the second half of last year, dropped to around 141 yen intraday in December.

However, despite the BOJ's rate hike, the yen remained weak. On April 29, the yen broke through the psychological barrier of 160 yen intraday. The last time the yen-dollar exchange rate exceeded 160 yen was in April 1990. The surprised Japanese Ministry of Finance immediately intervened in the market by using about $62 billion of foreign exchange reserves to suppress the exchange rate rise, but this was only a temporary measure. About two months later, on the 1st of this month, the yen-dollar exchange rate surpassed 161.72 yen intraday, hitting the highest level in 37 years and 6 months, proving that the super-weak yen remains solid. At the beginning of this year, the yen was around 140 yen per dollar, but in just half a year, it surged by 20 yen, creating the so-called 'super weak yen.'

There are several factors driving the weak yen. Among them, experts unanimously point to the most direct cause: the 'interest rate differential between the U.S. and Japan.' After COVID-19, while advanced countries including the U.S. raised interest rates to curb inflation, Japan kept its negative interest rate of -0.1% to overcome prolonged economic stagnation and stimulate the economy (increasing export companies' profits and stock prices).

As a result, the U.S.-Japan interest rate differential widened to an unprecedented level. According to the Bank for International Settlements (BIS), when Japan first introduced negative interest rates in February 2016, the U.S.-Japan interest rate differential was only 0.475 percentage points. As the U.S. gradually raised rates, the differential reached 2.475 percentage points in December 2018. During the global economic downturn caused by COVID-19 in 2020, the U.S. sharply cut rates, causing the differential to drop to 0.225 percentage points. However, from 2022, as the U.S. significantly raised rates step by step, the differential expanded greatly to 5.325 percentage points as of July 2024.

Recently, as the strong dollar caused the values of major currencies such as the yen and the Korean won to fall sharply, some have speculated that a 'Second Plaza Accord' might be pursued. Adam Posen, president of the Peterson Institute for International Economics in the U.S., said at a Korea Economic Association forum last April, "The increase in U.S. inflation and fiscal deficits could trigger a second Plaza Accord in 2026." The Plaza Accord was an agreement in 1985 where finance ministers of the five major countries (G5) met at the Plaza Hotel in the U.S. to induce artificial appreciation of currencies such as the yen and the Deutsche Mark to ease the strong dollar. At that time, due to the strong dollar, the yen traded around 250 yen per dollar, but two years after the Plaza Accord, by the end of 1987, it fell to around 120 yen per dollar. This led to a contraction in Japan's real economy, plunging it into a long-term stagnation known as the 'lost 30 years.'

[Image source=Yonhap News]

Ultimately, for the yen to turn strong, the U.S. must quickly cut interest rates, and Japan must boldly raise them. Currently, the U.S. policy rate is 5.25~5.5% annually, while Japan's short-term policy rate is 0~0.1%. Until the end of last year, there were expectations that the U.S. would start cutting rates and Japan would raise them. However, the timing of the U.S. rate cuts has been continuously delayed, and Japan's rate hikes have been modest compared to market expectations, insufficient to reverse the weak yen trend.

Fortunately, in the second half of the year, as U.S. economic indicators generally improve and inflation slows, there is growing assessment that the Federal Reserve's rate cut timing is near. The U.S. Consumer Price Index (CPI) for June rose 3% year-on-year, below market expectations (3.1%) and the previous month (3.3%). This marks three consecutive months of slowdown following April (3.4%) and May (3.3%). According to FedWatch at the Chicago Mercantile Exchange on the 11th (local time), the probability that the Fed will cut rates by 0.25 percentage points at the September Federal Open Market Committee (FOMC) meeting rose to 81.2%, up more than 10 percentage points from the previous day (69.7%). However, there are four FOMC meetings left this year (July, September, November, December), and with the U.S. presidential election scheduled in November, uncertainty may increase.

[Image source=Yonhap News]

The Bank of Japan is facing deep concerns. With the 'super weak yen' and a 'gross domestic product (GDP) shock' added, there are forecasts that this year's economic growth rate will be negative. Last month, the BOJ announced it would reduce monthly government bond purchases by 6 trillion yen, but on the 1st, Japan's first-quarter real GDP shrank by 2.9% annualized, returning to negative growth after two quarters. On the 19th, the Japanese government lowered its economic growth forecast for this year from 1.3% to 0.9%, citing a slowdown in personal consumption. This raises doubts about whether the BOJ can raise interest rates again at the monetary policy meeting scheduled for the 31st, following March, and whether it can sufficiently reduce the 6 trillion yen monthly government bond purchases.

Considering Japan's economic vulnerabilities such as an aging population, the yen's appreciation is expected to be difficult. Sanghyun Park, a researcher at Hi Investment & Securities, said, "It is positive that the Japanese economy has recently escaped deflation, but growth remains sluggish," adding, "Ultimately, the yen's weakness reflects Japan's failure to overcome its economic vulnerabilities."

Seongwon Lee, deputy director at the International Finance Center, explained, "The recent yen weakness is essentially because Japan's rate hikes are expected to be limited," and "Japan has a large government debt, so even if it wants to raise rates significantly, the interest burden would increase, making it practically difficult."

Youngsik Jung, head of the International Macroeconomics and Finance Division at the Korea Institute for International Economic Policy, also said, "About 25% of Japan's total fiscal expenditure is used for principal and interest repayments," adding, "Because Japan's national debt is very high, if interest rates rise, fiscal soundness issues could arise, making it difficult for the yen to rebound strongly from an internal policy perspective."