While Japan’s incoming Prime Minister, Yoshihide Suga, may push for further monetary easing and a weaker yen, we think that, if anything, the risks to the yen lie to the upside.
Retiring PM Shinzo Abe will probably be best remembered, at least in financial markets, for his bold economic policies (known as “Abenomics”) aimed at reviving Japan’s economy. One of the more notable aspects of his policy package was the large-scale monetary easing that the Bank of Japan (BoJ) embarked on soon after his election win at in late 2012, which contributed to the yen falling by about a third in trade-weighted terms over the next two and a half years.
Incoming PM Suga’s suggestions that the BoJ should consider easing policy further, including by cutting interest rates further below zero, to help the economy recover from the coronavirus shock suggests that he may also be aiming to start his tenure by engineering a fall in the yen. However, in our view he is less likely to get his way, for three key reasons.
First, the BoJ, which meets later this week, appears reluctant to embark on another major round of policy easing. It has already reached further into the unconventional toolbox than any other central bank and appears worried that more easing, especially cutting rates further below zero, could be counterproductive because it would do further damage to Japan’s financial sector.
Second, even if the BoJ were to ease, it would be playing catch up with policymakers elsewhere. Other major central banks have already loosened policy significantly over the past year, and we expect further steps from, among others, the Fed, the ECB, and the BoE over the next year. In contrast, when the BoJ started easing policy in 2012 the Fed’s post-GFC easing cycle was coming to an end. So even as the BoJ was pushing interest rates in Japan down, US long-term rates were beginning to rise, which helped weaken the yen. (See Chart 2) This year, interest rate differentials have moved sharply in favor of the yen, making appreciation against the dollar more likely.
Third, the yen is much weaker now than it was back in 2012. While it has risen a bit over the past couple of years, as the US-China trade war and then the coronavirus pandemic boosted demand for safe havens, the yen is well short of the levels it reached in 2012. In addition, even if the yen is a bit stronger than its long-term average in nominal trade weighted terms, as a result of Japan’s persistently low inflation in real terms it is considerably weaker than its average. (See Chart 1 again.) So arguably, its valuation also points to upside risks for the yen.
In short, the case for a weaker yen is much less convincing now than it was in 2012. And while our end-2020 and 2021 forecasts for the yen/dollar exchange rate stand at 105, not far from the current level, we think the risks to that forecast is for a stronger yen.