Japan Institute for National Fundamentals

　
On January 24, Bank of Japan Governor Kazuo Ueda not only raised the policy interest rate from 0.25% to 0.5%, but indicated his intention to continue the rate hike. In the background is the need to hold down price increases accompanying the yen’s depreciation that has been progressing with the inauguration of the second Trump administration in the United States.

However, interest rate hikes will not necessarily stop the yen depreciation, but put downside pressure on stagnant domestic demand. The BOJ should return to a monetary policy of giving priority to the economy rather than currency exchange rates.

Continuing interest rate hikes will lead to economic deterioration

At a press conference after the decision to raise the policy interest rate, Ueda said that the central bank’s monetary policy would move “incrementally and gradually” in the future. Noting that a “neutral” policy interest rate level that neither overheats nor dampens the economy is 1.00-1.25%, he emphasized the BOJ has room to raise the rate further. Ueda thus indicated he remarkably makes light of the current economic situation in Japan.

Since the late 1990s, domestic demand in Japan has slipped below supply as real wages have continued to fall, with household consumption remaining sluggish. Therefore, deflationary pressure has stayed strong amid demand shortages, even with prices rising due to cost hikes. If the central bank continues to raise interest rates in such a situation, working people in their prime will suffer from rising adjustable mortgage rates, and many small and tiny enterprises that rely on borrowings from banks will see profits squeezed and fail to raise wages significantly.

Giving priority to preventing the yen from depreciating against the dollar, the Ueda-led BOJ terminated negative interest rates in March last year and raised the policy interest rate in July. While the U.S. Federal Reserve began to raise interest rate substantially in March 2022, the BOJ maintained ultra-low interest rate below 0%, which widened a Japan-U.S. interest rate gap, and speculative currency market players sold the yen heavily.

However, the BOJ’s small rate hikes do not narrow the interest rate gap remarkably, leaving currency market players to continue selling the yen and call for further rate hikes. The BOJ’s proactive rate hikes may lead to a vicious cycle of rate hikes, the yen’s depreciation, additional rate hikes, and economic deterioration. In order to clearly narrow the Japan-U.S. interest rate gap, Japanese interest rates must be raised by several percentage points, but this would plunge the Japanese economy into the abyss of deflation.

Expand domestic demand

In the “lost three decades” for the Japanese economy, chronic deflation and a decline in real consumption have brought about sluggish domestic investment, leading Japan money to flow into U.S. and other overseas financial markets. Through the process, the yen tends to be sold while the dollar tends to be bought. While the government is promoting investment through the new Nippon Individual Savings Account system for small tax-free investment plans, households use the new NISA system to buy foreign mutual funds rather than domestic ones, contributing to the yen’s depreciation. Without domestic demand-led efforts to enrich the Japanese people, the yen’s depreciation will not stop. Not only the Ueda-led BOJ, but also Prime Minister Shigeru Ishiba and his government should keep this point in mind.

Hideo Tamura is a Planning Committee member at the Japan Institute for National Fundamentals and a columnist for the Sankei Shimbun newspaper.