Japanese Economy 2024:
Why does BOJ not raise interest rates?
Ryoichi IMAI

1

目次
1. Current States of the Japanese Economy
2. BOJ is slow in move under current inflation and the WeakYen
3. Price Hike in Energy and Food
4. What drives the Yen depreciation?

2

Current State of Japanese
Economy3• Japanese Yen
has been staying
in the rage of100-120Y/$ inthe last three
decades except
for the period of
2008-2013.
• However, thecurrent inflation
reducing theinternational
value of the Yen
unexpectedly.

Yen Depreciation
Yen / U$, Period Average
160.00140.00120.00100.00

80.00

60.00

40.00

20.00

2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

0.00

4

Inflation (CPI)

https://data.oecd.org/price/inflation-cpi.htm• In Europe and USA,inflation hikestarted in early
2021, and recorded
a peak in Spring2022.
• Japan’s inflation
follows the world
but is much behind
US and Europe. It
reached a peak inearly 2023.
• Now the inflation
rate seems toconverge to 3 to
4 % in the three
economies。
5

Cumulative Inflation Matters

https://data.oecd.org/price/inflation-cpi.htm• The impact of inflation on the national
economy should be assessed by the
cumulative inflation rate (or price level)from the base year to date, not thecurrent inflation rate.
• Although inflation in Europe and theUnited States is subsiding, price levels
are still about 30% higher than they were
before 2015.
• Prices in Japan, too, have risen by about
10% compared to 2015.
• Even if the inflation rate declines in the
short term, if wages do not rise enough tocompensate for the decline in purchasing
power, the standard of living will decline
for most citizens.
• Some citizens who invest in stocks andforeign currency deposits can thereby
preserve their own purchasing power, but
those with few assets will suffer inflation.

6

Long-term interest rates

https://data.oecd.org/interest/long-term-interest-rates.htm#indicator-chart• For 2015-2019, US andEurope seems to leave
the quantitative ease.
• However, theCoronavirus Pandemic
suddenly prevented
central banks fromreturning tonormalization.
• In the recovery from thepandemic, the central
banks let the long-term
interest rates rise to 4%
in US and 3% in Europe.
• In contrast to US andEurope, the BOJ has
kept a very-low interest
rate policy until recently,
while the long-term
interest rate is graduallyrising to 1%.

7

Short-term interest rates• The Covid-19
Period（20202021）：• US - zero
• Germany - negative• Japan – zero.

• In 2022, US andGermany started toraise the short-term
interest rates,
which has reached
5% in US and 4% in
Germany.
• BOJ still keeps zerointerest rate.
8

The Dollar (Yen) and the Long-term Interest
Rate Gap between US and Japan• After 2021, the U.S.-Japan interest
rate differential appears to explain
exchange rate fluctuations well.
• Before 2020, however, there does notappear to be a regular relationshipbetween the U.S.-Japan interest rate
differential and the exchange rate.
• In the 2010s, the U.S.-Japan interest
rate differential fluctuated widely inresponse to changes in U.S.
monetary policy, but the exchange
rate remained very stable until 2021.

Calculation by author from the data of IMF and OECD

9The Euro (Yen) and the Long-term Interest
Rate Gap between EU and Japan• Compared to the dollar-yen
rate, the euro-yen rate appears
to move relatively regularly to
the Japan-Europe (JapanGermany) interest rate
differential.
• However, since 2013, the yen
has tended to weaken
excessively relative to theinterest rate differential.

Calculation by author from the data of IMF and OECD

10

Short and Long Interest Rates: Japan
Japan
2.5

2

1.5

Long Interest
1

Short Interest

0.5• For most time, thelong-term interest
has been higher than
the short-term
interest rate.
• In 2013 and 2017, thelong-term interest
rate was negative.
• Since 2017, theshort-term interest
rate has been
negative.

-0.5

Jul-20Nov-19Jul-18Mar-19

Nov-17

Jul-16

Mar-17

Nov-15Mar-15

Jul-14

Nov-13Mar-13

Jul-12

Nov-11Mar-11

Jul-10

Nov-09Jul-08Mar-09

Nov-07

Jul-06Mar-07

Nov-05Mar-05Jul-04

Nov-03Mar-03

Jul-02

Nov-01Mar-01

Jul-00Nov-990

11

Current Accounthttps://data.oecd.org/trade/current-account-balance.htm• Changes in the current accountbalance have not had asignificant impact on theexchange rate.
• Germany's current accountbalance has been significantly insurplus since 2005.
• The U.S. current accountbalance deteriorated significantly
until the Lehman crisis (2008),
but then the deficit shrank until
the Corona crisis.
• In contrast, the underlying toneof Japan's current accountbalance is a surplus, although
not as large as Germany's, andtends to move just opposite tothat of the U.S.
• Nevertheless, the impact ofthese factors on the exchange
rate is unknown.
12Why does BOJ move so slowly?

13

BOJ Inflation
Forecast

The left table was the BOJ's price forecast as ofApril 28, 2023, which showed a much higher
price forecast for FY23 but a decline to lessthan 2% in FY24. Therefore, last spring, the endof the extra-dimensional easing was postponed.

https://boj.or.jp/mopo/outlook/gor2304a.pdf

The right table is the BOJ's priceoutlook as of the end of January
2024. First of all, we can see thatthe Bank of Japan had estimatedprices for FY2023 to be about 1%
lower than they were at the end of
April 2023. This is the reason forthe delay in the policy shift, but
the previous governor, Kuroda, left
office last spring. It was difficult
for newly appointed Governor
Ueda to make a dramatic change
in policy immediately after his
predecessor retreated.

https://boj.or.jp/mopo/outlook/gor2401a.pdf

14

Who holds JGBs?

Bank of Japan

Pension Funds
Private Funds
Foreigners• According to the Bank ofJapan's Flow of Funds
statistics, the BOJ's share of
JGBs was around 10% until
2012. That has now reached
47%.
• Mr. Shirakawa, the former
Governor of the Bank ofJapan, must have realizedthat holding such a hugeamount of JGBs would leave
the BOJ with little flexibility inits monetary policy.
• The outstanding amount of
JGBs itself has been on aleveling off trend since 2020.
This is probably the result ofboth the consumption tax
hike and the inflation tax.

15

Balance Sheets of the Central Banks
Whereas European and U.S. central
banks were quick to shrink their central
bank balance sheets in response to therecent rise in inflation, the BOJ lagged
behind in asset reduction.

https://nikkei.com/article/DGXZQOUB256DQ0V20C24A4000000/
16https://boj.or.jp/mopo/outline/bpreview/bpr231206a.htm…
https://boj.or.jp/mopo/outline/bpreview/data/bpr231206c.pdf• The BOJ's BS problem is that if the BOJ
reduces its holdings of JGBs as it cuts backon monetary easing, interest rates will riseboth on government debts and on reserve
deposits held by private banks with the BOJ,
causing the BOJ to run a deficit.
• The BOJ refers to three scenarios. Under
the first scenario, the deficit will continue
for 20 years because the balance of JGBs
held by the BOJ will be dramatically reduced.
• In contrast, in the second and third
scenarios, the BOJ will continue to purchase
JGBs, so the balance of JGBs held by the
BOJ will not decrease that much and the
deficit will be avoided because the BOJ will
receive both the advantages anddisadvantages of higher interest rates.
• The question is whether there is a way for
the BOJ to raise interest rates without
selling JGBs.

17

QT: FRB, ECB and BOJ• Since the Lehman crisis, central banks inJapan, the U.S., and Europe havedramatically increased their holdings ofgovernment bonds.
• This trend was further extended in
response to the Corona disaster.
• However, in order to cope with inflation
during the economic recovery period, thecentral banks in Europe and the U.S.
rapidly reduced their JGB holdings,
whereas the BOJ's reduction of its JGB
holdings did not proceed rapidly.
• The reason is that the BOJ holds far morebonds as a percentage of GDP than theWestern central banks. At its peak, theBOJ's bond holdings exceed 120% of GDP,
while the Western central banks' bondholdings are 30-60% of GDP.
• This means that a rise in interest rates will
have a greater impact on the BOJ's BS thanon the US and European Central Banks.

https://boj.or.jp/mopo/outline/bpreview/data/bpr231206c.pdf
18BOJ can avoid
deficits simply bykeeping its BS

https://www.nikkei.com/article/DGXZQOCD1794J0X10C22A8000000/
19

Share of ECB holding to the EU sovereign debts

https://jri.co.jp/MediaLibrary/file/report/researchreport/pdf/14901.pdf

20

At the peak, ECB
held 40% ofsovereign debts
in EU

https://jri.co.jp/MediaLibrary/file/report/researchreport/pdf/14901.pdf

21

• The central banks of European countries haveincurred many deficits in the process of BS
contraction, but the accumulated deficits are
expected to be eliminated around 2030.
• Thus, there is not much concern that rising interest
rates will destabilize central bank finances, andcurrency depreciation has not occurred. Rather, theEuropean currency is overvalued.
• There are a number of ways for the BOJ to allow
interest rates to rise and not fall into deficit, so why
hasn't the BOJ raised interest rates?
• Perhaps it is because raising interest rates is
expected to bring about a recession in the shortterm. Not only would a rate hike make it moredifficult for small and medium-sized businesses tofinance their operations, but there are also
concerns that it would raise mortgage rates andcreate a bad loan problem in the real estate sector.
• Of fundamental importance, however, is that higher
interest rates will make government budgeting
more difficult.
22International Comparison of Government Debts• It is clear that the ratio ofgovernment debt to GDP rises
during deflationary periods andfalls during inflationary periods.
• During the DPJ administration,
life was easier due to a strong
yen and deflation, but the
government's finances worsened
as a result.
• With Abenomics, the yen
depreciated, and disinflation
reduced the debt to GDP ratio.
• Japan's debt ratio reduction issmaller than in the U.S. andEurope, where inflation is higher.
https://mof.go.jp/tax_policy/summary/condition/a02.htm

23

DebtsGovernment
Debts Matters

Interest Rate
Interest
Payment

https://mof.go.jp/tax_policy/summary/condition/a02.htm• Despite the rapid growth of outstanding
government debt, interest payments
have continued to decline thanks tovery low interest rates.
• However, if the BOJ reduces monetaryeasing, interest rates will rise, andhigher interest expenses will make it
difficult for the government to compile
a budget.
• It is said that raising interest rates would
result in a loss of earnings for the BOJ.
But the fundamental reason for theinability to raise interest rates is thegovernment budget deficit.
24

Price Hike in Energy and Food25

Term of Trade matters little

Drawn by the author using data compiled by BOJ
https://www.stat-search.boj.or.jp/index.html• Term of Trade is the ratio ofexport prices to import prices.
• Current inflation increases
export prices and greatly
benefits business and theirshareholders.
• The term of trade of Japan
improved drastically in 1980,
had deteriorated since 1990
until 2008 (Lehman crisis),and since then has stabilized.
• However, it deteriorates again
recently, reflecting world
inflation.
• Japanese people’s welfare isaffected more by the importprice index than by the export
price index.
• The import price index isgreatly affected by prices infood and energy.

26Home goods
Furniture

Total

Food

HousingutilityConsumer Price
Index (CPI)• Cumulative rise in CPI affects
people’s recognition of theeconomy more directly than thecurrent rise in CPI.
• Cumulative CPI is normalized to
100 for 2020.
• In May 2024, Total CPI is 108.
• CPI is• 117 for food• 103 for housing rent
• 113 for utility• 119 for home goods andfurniture• Most of food, energies, andhome goods are imported fromabroad, much affected by world
inflation.
27

Rising foodpricehttps://www.jircas.go.jp/ja/program/proc/blog/20240408••

World food prices rose sharply during the economic
recovery after the Corona disaster. This is the maincause of the recent political turmoil.
However, as we move into 2024, the price increase
has subsided and some prices are declining.

https://fao.org/worldfoodsituation/foodpricesindex/en/28• Although PM Abe resigned because of its failure of handling theanti-Corona measures, Corona was only one of the foreign
circumstances that made his situation worse.
• These days, foreign circumstances have a greater impact on
Japanese politics than the performance by domestic policies.
• The impact of foreign shocks on domestic politics differs
depending on whether exchange rate fluctuations amplify theshocks or, conversely, reduce them.
• In the past, the dollar/yen rate moved in the direction of reducing
shocks from abroad (war, recession, inflation, etc.), so politics was
not destabilized.
• During the DPJ administration, world food prices were also high,but domestic prices did not rise because of the strong yen.
• Recently, however, the yen has weakened in tandem with risinginternational prices for energies and food, amplifying the shocks
and increasing public dissatisfaction with politics.

How foreignexchange rates
affect politics?

29

Living cost is more important than political scandals• The dollar-yen rate has risen by about 1.5 times
compared to its stable period. With rising food prices
coming to Japan, it is no wonder that the approval
rating of the administration is falling.
• The media is still saying that "politics-money
scandals have caused distrust in politics," but theeconomy and people's lives are much more
important.
• Gerald Curtis (Columbia University) said on JapaneseTV that "the issue of politics and money is nothingcompared to the era of Kakuei Tanaka and Shin
Kanemaru."• What the people are most upset about is the risingcost of living.
• Reflationists say, "There are many advantages to a
weak yen," but they cannot persuade the public.
Nikkei Shinbun

30

World Oil Price
Abenomics• World oil prices remained stable at low
levels until 2000, but rose sharply after
2000, reaching a high of around $100
in the 2010s.
• The price then declined sharply
through the Corona period but has
recently risen sharply again.
• It can be said that the stability of the
Abe administration has been broughtby the low and stable price of crude oil.

https://ecodb.net/commodity/group_oil.html

31

Return of the Pessimism

https://fao.org/worldfoodsituation/foodpricesindex/en/• The long-term trend of the realindex of the World Food Price(perhaps denominated by the CPI)
shows that it was high until about
1975, then declined and remained
stable at a low level until about
2005.
• The period from 1975 to 2005 canbe described as a period of
optimism, while the period after2005 is the return of pessimism
originally proposed by the Club ofRome in 1972, which emphasized
the upcoming food crisis.
• The rise in the price of food andenergy might have been brought by
the Globalization with economic
growth of emerging countries.32

What drives foreign exchange rates?

33

Theories to explain exchange rates• Current account approach: The idea that exchange rates are
determined by current transactions of currencies, such as tradebalance and income balance. This was the mainstream approach
until the 1970s.
• Asset approach: The idea that exchange rates are determined byasset transactions such as deposits, bonds, and stocks, whichbecame the mainstream idea around the 1980s.
• Interest rate parity• Purchasing power parity• Labor Productivity
34

Uncovered Interest
rate parity (UIRP)• The idea that exchange rates are
determined in such a way as toequalize the rates of return ofeach currency.
• There are different versions withand without currency hedging.
• For example, the currency of ahigh-interest-rate country will
eventually depreciate, but at thestart of the comparison, thecurrency will instead rise in value
to reflect future depreciation.

• To complicate matters, forexample, the dollar/Yen rate iscurrently appreciating due to thelarge difference in interest rates
between Japan and the U.S.
• However, in order for the rate of
return to equalize, the dollar
should depreciate in the future.
However, in a phase of widening
interest rate differentials, thecurrencies of higher-interest-rate
countries will apparently rise.
• Under the interest rate parity
theory with currency hedging on
the contrary, the rate of return on
a currency is equalized after
paying a premium to protect
against exchange rate
fluctuations.

35

Covered Interest Rate Parity (CIRP)• You can hedge the return to invest in
dollar by signing a forward contract tosell dollars at forward rate,• Assume that the interest rate per annum
is 0% for Japan, 5% for US.
• The spot rate is $1=¥150.
• If you invest ¥1500 into Yen, you will get$1500 one year later.
• Today you will get $10 by exchange your¥1500 for dollars.
• If you invest $10 into dollar, you will get$10.5 one year later.
• If the yen appreciates one year later,
your investment return will lose a part ofits value if you convert it to Yen.

• But you can assure the Yen value of
your investment into by selling dollars at
a forward rate.
• If you now sign a forward contract tosell your dollar at forward rate
142.857(=1500/10.5), you will get¥1500 for sure one year later.
• This is the covered interest rate parity.
• The forward rate is based not on theinvestor’s speculation on the futureexchange rate but on the prevailinginterest rate spread.
• CIRP always holds if various transaction
costs, institutional differences, andpolitical costs are considered.

https://en.wikipedia.org/wiki/Interest_rate_parity#Covered_interest_rate_parity

36

Purchasing Power Parity (PPP)• PPP says that exchange rate
will converge to the rate at
which all the prices ofcommodities will be equatedacross countries.
• However, the market
exchange rate might diverge
from its PPP rate for longtime.

• Japanese yen has been
overvalued against US dollar
for 5 decades until 2021.
• Japanese yen has been
undervalued against Euro for5 decades. Diversion seems
to expand.
• Euro was against US dollar• undervalued for 1999-2003• overvalued for 2003-2015• undervalued for 201537

Dolar/Yen• Black: market rate
• Red: PPP basedon consumer
price index (CPI)• Green: PPP basedon corporate price• Blue: PPP basedon export price.

38

Euro/Yen• Black: market rate
• Red: PPP basedon consumer
price index (CPI)• Green: PPP basedon corporate price• Blue: PPP basedon export price.

39

Euro/Dollar• Black: market
rate• Red: PPP basedon consumer
price index (CPI)• Green: PPP
based oncorporate price• Blue: PPP basedon export price.

40

Labor Productivity?
GDP per hour worked (USA=100, PPP adjusted)
120

100

DEU

GBR

80

ITA
JPN
60

40

20

0
1970

1980

1990
DEU

2000
ITA

JPN

2010

• Productivity seems not to well
explain the exchange rate.
• GDP per hour worked in Japan has
been 70% of the US.
• There is no such a large decline inJapan’s labor productivity from its
peak recorded in the middle of
1990s.
• No Japanese people havecomplained about the weak Yen
until 2021, even though the relativelabor productivity has been much
lower than US for a long time.
• Relative decline in productivity inEurope seems to be larger than inJapan, while no continuing trend of
Euro depreciation is observed,• Japan’s labor productivity might beundervalued because of some data
problem.

2020

GBR

https://data.oecd.org/lprdty/gdp-per-hour-worked.htm

41

Conclusion• Interest Rate Parity (UIRP or CIRP) seems to most convincingly
explain the current Yen depreciation, while there are many
residuals to be explained by other theories.
• The flow factors such as trade and capital investment, seem to be
too small to generate such a large trend toward the weak Yen.
• Speculative incentives might affect the Yen depreciation.
• In the long-run, foreign exchange rates tend to converge to their
PPP, while their inexplicable deviation might emerge for very longtime.
• Productivity gap does not well explain the long-term trend of
foreign exchange rates.
42