The relationship between Japanese interest rates and the economy is unlike any other in the western world, and all as a result of the economic bubble bursting in the early 1990’s. Since then the central bank has been forced into a situation which has created two unique problems. Firstly, with such low historic interest rates, and unlike other central banks, the BOJ has had virtually no room for manoeuvre in which to use interest rates to manage inflation or to support economic growth, and secondly, the situation has prolonged the highly speculative financial “carry” trade: speculators borrow yen at low rates and then buy dollars and other currencies that are invested in higher-yield assets elsewhere. At one point this was estimated to be around 1 trillion dollars! Let’s take a look at the historic rates and where they are likely to head in the future, and the effect this could have on the yen to dollar rate.

Bank Of Japan Interest Rates

Bank Of Japan Interest Rates

The chart alongside shows the historic interest rates from 1955 to 2008 and are kindly provided by the Bank of Japan. As you can see, the rates have fallen from highs of between 7-8% in the 50’s, and 70’s, until, following the burst bubble at the beginning of the 1990’s, rates declined to zero in 2001 where they stayed for the next 5 years, until they were finally raised to 0.25% in mid 2006. Finally on the 21st February 2007, Japan’s central bank doubled its main interest rate to 0.5 per cent, the highest for more than a decade, amid mounting evidence that the world’s second biggest economy was on a solid recovery path. This rate has since remained unchanged. So what of the future, the prospects for economic recovery, and the effect that future interest rates will have on the yen to dollar exchange ? – let us consider some of the factors.

The Bank of Japan Policy Board meets every month for two days to discuss economic developments both in Japan and overseas. Having been trapped in a deflationary cycle for many years, the news no longer has the impact on the markets it once did, as the opportunities for change are extremely limited. The culmination of the meeting is the announcement of any changes to interest rates or other aspects of monetary policy. Like any other central bank the BOJ is tasked with ensuring price stability, while taking into account economic growth, employment, and recommendations from the elected government, although the relationship between the two has been inharmonious over the last decade. In general the government is opposed to higher rates which could affect the economic recovery adversely. With this goal in mind, a “Guideline for Money Market Operations” is established at each meeting. Changes in the rate have far-reaching consequences, affecting consumer loans, mortgages, bonds and of course the yen to dollar rate. The statement is the BOJ’s collective outlook on the economy as well as a source for clues on future monetary policy decisions. When it comes to interest rates, the future direction of rates is usually far more important than its current rate. The latest indication of future rates was issued on the 15th February 2008 with rates remaining unchanged. The BOJ believes the economy is still expanding at a moderate rate, but that it may slow temporarily, partly because of a drop in housing investments.

Now the question I am often asked in relation to this pair is simply this – what is the relationship between interest rates and the yen? A simple question, but one that is hard to answer. Many in the market believe that interest rate differentials are now the dominant factor behind the movement of the yen.  Japan’s interest rate remains the lowest in the world at 0.5% and the pace of the BOJ’s rate hikes has been slower than other major central banks. Even after the rate cuts in the US, the rate gap between the US and Japan, still stands at 1.75%, smaller than previously, and certainly a factor in the reducing  attraction of the yen carry trade. Of far more importance, in my view, is the cost of exports in overseas markets. Should the yen to dollar rate fall any significant distance below the 100 level, then the BOJ will have no option, but to intervene. And the interest rates – I expect a 0.25% cut by the end of the year!