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Bank of Japan Punished for Dovish Policy Stance

Jacob Hess
September 26, 2022

Central banks are in the spotlight and have been for some time. Every policy move is being picked apart by markets and forecasters making asset prices and forecasts especially sensitive to changes in policy rates across the globe. The foreign exchange market is no exception. The JPMorgan Global FX Volatility Index has jumped to new near-term highs in 2022 as a result of this flurry of monetary policy activities.

The developing FX story has been the yen’s depreciation in the last few months. Holders of the yen have seen it perform poorly against the US dollar and the euro so far this year. The drop against the euro tracks to about -6.3% year-to-date while the strong greenback has the JPYUSD pair trading -20.2% lower in 2022. The yen is even down around -11.2% YTD versus its neighbor, the Australian dollar. Most of the losses against these currencies have accumulated in the last two quarters, and the most recent trading in September has pushed the yen to the lowest points in each of these markets.

From StockCharts

The massive depreciation in the yen has pushed Japan to intervene by buying yen for the first time since 1998. The intervention almost 20 years ago was done in a similar environment where it felt like yen markets were out of control. In particular, the steep slide of the yen against the dollar in the mid-1990s worried the Japanese government as leaders saw the depreciation as a threat to Japan’s economic growth. This prompted the government to buy dollars to protect against further damage. However, the purchases did little to stop the momentum as the Asian crisis in 1997 created too much uncertainty.

Just as in the 1990s, September’s yen intervention announcement didn’t come in a vacuum. A sharp increase in global inflation rates has been the impetus for the hawkish shift in central banks across the world creating systemic financial tightening. The Bank of Japan, however, remains frozen in time on its policy and dovish stance. This has created the conditions for the yen’s depreciation.

Many have wondered whether the Bank of Japan could’ve made a move away from its extremely dovish policy that has lasted since the Asian crisis. Over the last 20 years, deflationary pressure and low growth have been reasons for Japan’s central bank leaders to keep rates low. In the last 6 years, short-term rates turned negative and have remained that way throughout the pandemic. The current inflationary environment seems to be reason enough to shift away from indiscriminate dovishness. On the contrary, its monetary policy announcement in September suggests that any kind of hawkishness is off the table for the time being. Because of that, it’s unlikely the yen’s recovery against the dollar will stick.

In general, it seems that central banks that aren’t hiking “enough” are being exposed and the market has been punishing them. The Chinese yuan has seen a steady decline against the dollar this year, down -10.8% YTD, as the People’s Bank of China has been forced to remain accommodative to help the struggling real estate sector. Just recently, the British pound has faced some depreciation as the Bank of England looked to be slowing down its pace of rate hikes despite inflation near double-digits. In the last 30 days, the pound has fallen -6.5% against the euro, a currency that has not been particularly strong so far in 2022 (see EURUSD).

The moral of the story is that markets expect central banks to defend their credibility against inflation. If monetary leaders seem uninterested in asserting price stability as a concern, there will likely be consequences. This isn’t just because dovishness is not trendy in 2022, but because inflation is no longer thought to be transitory. Because of that, central banks that do not take this opinion as their own, like the Bank of Japan (and perhaps the Bank of Japan is the only central bank strongly in this category), will have to face volatility.

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