Bank of Japan’s global challenges growing

The US Federal Reserve opened the year with a dovish turnaround in its monetary policy due to concerns over global economic growth and muted domestic inflation.

It was done by signaling adherence to the status quo on policy interest rates, for the time being, as well as a willingness to stop the balance sheet runoff earlier than envisaged. The U.S. stock market welcomed the moves with higher share prices and a weaker dollar. It also gave emerging economies breathing room to pursue higher yields.

However, the shift in U.S. monetary policy has generated greater uncertainty over Japan’s exchange rate and financial markets. First, the yen has stabilized at around 109 to 110 against the dollar, some- what below the comfortable 110 to 115 range which continued for over half a year until the rise in U.S. capital market volatility in late December.

In addition, the yen experienced a “flash crash” against the dollar on Jan. 3, appreciating nearly 4 percent to around 104 in less than 10 minutes. This speculative attack took place during the New Year’s holidays, when the foreign exchange market was shallow, and has kept Japan’s government on alert for another flash crash during the 10-day Golden Week holiday from late April.

Second, Japan’s long-term interest rate has re-entered negative territory this month, as the U.S. long-term interest rate has dropped to around 2.6 to 2.7 percent. This may reflect a return of some domestic investors from overseas portfolio investment and increased demand for foreign investors that shifted away from Japan’s stocks.

The negative or substantially low long-term yield might be necessary to maintain sufficient US-Japan interest rate differentials to contain the yen’s appreciation pressures. On the other hand, an excessively low yield threatens the financial sector, compelling the Bank of Japan to reduce the annual pace of Japanese Government Bond purchases at a level that can mitigate the above conflicting forces.

These market developments are a reminder that the yen remains a safe-haven currency against the dollar and other currencies. Growing concerns over global economic growth and the tense U.S.-China relationship could add to the yen’s appreciation pressures. It is also clear that the dollar-yen rate not only depends on Japan’s monetary easing but also U.S. market conditions such as higher stock prices and dollar strength.

So far, Japan’s government has coped with sharp yen appreciations by holding tri-party talks among the Finance Ministry, Financial Services Agency and BOJ, signaling possible intervention in the foreign exchange market to contain market pressures. The Finance Ministry has not intervened in the foreign exchange market since 2011 thanks to massive monetary easing doing the job effectively. Nonetheless, the government wishes to maintain foreign exchange intervention as an alternative tool in case monetary policy no longer works.

In this sense, the upcoming trade negotiations between Japan and the United States could be of great consequence to Japan. A trade deal that includes a foreign exchange clause requiring a commitment to market-determined exchange rates.