Not even a historically cheap yen can convince Japan to raise its ultra-low interest rates

In a statement, issued after the close of a key policy meeting in Tokyo, the BOJ included an unusual reference to foreign exchange rates among its list of financial risks. But the statement’s headline message was that the bank is sticking with its “ultra-loose” monetary stance. The BOJ said it will continue to offer to buy unlimited amounts of 10-year Japanese government bonds at 0.25% every business day, and leave its short-term interest rate target unchanged at -0.1%.

The yen sank to 134.64 against the dollar on Friday afternoon, a nearly 2% decline from where it traded prior to the bank’s policy meeting. But the Japanese currency avoided the precipitous slide that many analysts had predicted if the BOJ failed to emulate central banks in the U.S. and Europe, which are aggressively raising interest rates to combat inflation.

The yen’s modest retreat Friday could be seen as a victory, of sorts, for Haruhiko Kuroda, now nearing the end of his second five-year term as BOJ governor. Throughout Kuroda’s tenure, the BOJ has kept interest rates near zero in an effort to stimulate consumer spending and business investment. Japan’s central bank remains far more worried about avoiding the very real risk of deflation—a downward spiral of consumption, wages, and asset prices—than the remote prospect of its opposite.

But as the world emerges from the pandemic, the BOJ’s preoccupation with growth has diverged from the priorities of central bankers in the U.S. and Europe, where inflation has soared to multidecade highs. In April, Japan’s benchmark inflation measure rose just 2.1%, while consumer prices in the U.S. and Europe are surging more than 8%.

On Wednesday, in an effort to rein in runaway prices, the Federal Reserve raised interest rates by three-quarters of a percentage point—the U.S. central bank’s biggest one-time rate hike since 1994. Fed officials have signaled they plan more rate increases this year. On Thursday, central banks in the United Kingdom and Switzerland followed the Fed’s lead. The European Central Bank, citing pent-up consumer demand, strong labor markets, and rising energy prices, last week promised rate increases in July and September.

Higher interest rates in the U.S. make dollar-denominated assets more attractive to investors than those denominated in yen. While the BOJ holds rates for 10-year Japanese government bonds at zero, the yield on 10-year U.S. Treasury notes has climbed above 3%. The result: Investors are dumping yen and scrambling after dollars. The yen has fallen 18% against the dollar over the past year.

Japan’s political leaders once welcomed a weaker yen as a boon for the nation’s economy. A decline in the yen relative to the dollar was seen as a boost to the competitiveness of Japanese exporters in overseas markets, raising their profits when the money was repatriated. But analysts say that the benefits of a weak yen have diminished over the last two decades as so many Japanese manufacturers have shifted factories overseas. This time around, the yen’s slump is spooking consumers—and Japan’s political and business leaders—because it is driving up the cost of critical imports like oil and food. The high cost of energy imports has helped tip Japan’s trade balance into the red for the past 10 months; in May, the country posted a $17.8 billion trade deficit, the country’s largest monthly trade shortfall since January 2014.

“I think there’s a reluctance to spike [the zero interest rate policy] just before inflation really has an opportunity to take root,” said Tobias Harris, a senior fellow at the Center for American Progress. “They still want to see more wage and income increases, the hallmarks of a more sustainable inflation…But they’re stuck. There’s not really a good option. Clearly households are feeling the squeeze from higher prices of food imports, higher prices of energy imports, and we are finally seeing price increases.”

All but one of the 45 analysts surveyed by Bloomberg last week forecast that the BOJ would decide in Friday’s meeting to leave monetary policies unchanged. But a growing number of foreign currency speculators are betting that the Japanese central bank will eventually be forced to abandon its effort to hold interest rates at zero. On Wednesday, the BOJ spent more than $5.2 billion buying bonds to defend its 10-year yield ceiling, according to Reuters.

Among the attackers: BlueBay Asset Management, whose London-based chief investment officer Mark Dowding told Bloomberg he considers the Japanese central bank’s battle to control the yield curve to be “untenable.” BlueBay has a “sizable short on [Japanese government bonds],” Dowding said.

But other experts warn against underestimating the BOJ’s tolerance for further yen depreciation. Eisuke Sakakibara, known as Mr. Yen for his ability to influence currency fluctuations during his tenure as Japan’s vice minister of finance in the late 1990s, predicted in a recent interview on Bloomberg TV that it is “quite possible” the yen could plunge to as low as 150 to the dollar—a threshold the Japanese currency has not breached since 1990. “If it goes beyond 150,” he said, “then I think the Bank of Japan would be somewhat concerned.”

“If the yen depreciates to 150, we’ll see really quite a lot of pain from Japanese households, and that’s going to be a real problem” for Japan’s political leaders, Harris said.