Yen's avoidable slide to 1990 level

The yen fell due to the prevailing blunt interest rate policy. But there is an alternative policy

Failure of existing rules is the prelude to a search for new ones  — Thomas S Kuhn (1962)

The exchange rate of the yen has plummeted all the way back to its 1990 level of around 160 yens per dollar. Why? What can be the policy solution in such matters for the future?

The Bank of Japan (BoJ) has abandoned its zero interest rate policy but even now its short-term interest rate is only 0.1 per cent. This is because of apprehension that Japan may once again return to low inflation or even deflation, coupled with low economic growth. On the other hand, the US Fed is not in a position to reduce its repo rate below 5.5 per cent as the US economy appears to be somewhat stuck with an inflation rate of 3.5 per cent, which is well above the 2 per cent target. The gap between the interest rates in the two countries is huge, and this is accentuating the capital flows from Japan to the US. Hence, the very low yen.

The BoJ apparently intervened by depleting its foreign exchange reserves by about $35 billion. There was some rise in the yen but the effect does not seem to be lasting. This is understandable, given that the basic problem lies elsewhere. The gap between the interest rates in Japan and the US is huge. And, it is unlikely to be bridged substantially anytime soon, given the very different macroeconomic conditions in the two countries. All this is in the context of the prevailing interest rate policy. The question is — can we have an altogether different policy so that the side-effect of the policy on the currency market is absent or minimal? Yes. Before we come to the interest rate policy proposed here, note two features of the prevailing interest rate policy.

First, the interest rate policy of the central bank has an inbuilt and implicit tax or subsidy scheme. At present, the BoJ has kept interest rates low for borrowers. It is like giving a subsidy to borrowers. On the other hand, the Fed is keeping interest rates high. It is like imposing a tax on the borrowers.

Second, the changes in interest rates by the central banks are intended to affect borrowing for investment, residential projects, and durables (Bird hereafter); the idea is to affect the aggregate demand in the economy. However, the policy is blunt as it affects other variables like the exchange rate.

With the above two observations, we can now come to the proposed interest rate policy. This policy is not implemented by the central bank. Instead, it is enacted by the Ministry of Finance (MoF) in Japan and the Treasury in the US. Let the MoF give an explicit subsidy in Japan and let the Treasury impose an explicit tax in the US. The subsidy in Japan or the tax in the US is applicable for Bird only; it does not apply to all borrowings. Let us see how it all works.

Under the proposed policy, in Japan the demand for funds would go up as a result of the explicit subsidy. So, the interest rate observed in the market would rise even as the effective (post-subsidy) interest rate for Bird falls in Japan. On the other hand, in the US, the demand for funds would fall as a consequence of the explicit tax. So, the interest rate observed in the market would fall even as the effective (post-tax) interest rate for Bird rises in the US.

It is interesting that under the proposed policy, it is only the gap between the effective interest rates for Bird in the two countries that is increased. The gap between the interest rates observed in the markets in the two countries is, in fact, reduced. And, given this reduced gap between the interest rates observed in the markets in the two countries, there is much less of an incentive for capital flows from Japan to the US. Accordingly, if the proposed interest rate policy were in place, the yen would not have fallen sharply. And, the objective of macroeconomic stabilisation in the home countries would be achieved. QED.

There is, of course, a whole lot more to the story that includes not only the possible side-effects of the policy for currencies but asset prices as well. It is all explained in this author’s forthcoming book, Macroeconomics and Asset Prices - Thinking Afresh on Basic Principles and Policy. The proposed policy is intrinsically simple. It is just new and unfamiliar.

In conclusion, the prevailing interest rate policy is very blunt and it has side-effects, which is why the yen fell sharply. This would not have happened under the proposed interest rate policy.  

The writer is an independent economist. He taught at Ashoka University, ISI (Delhi) and JNU. He thanks Chetan Ghate for comments on the initial draft;gurbachan.arti@gmail.com