Japanese monetary policy and dollar yen exchange rate volatility

JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY Japanese Monetary Policy and Dollar Yen Exchange Rate Volatility ＮＮＮＮＮＮＮＮＮＮ 2018/11/29 JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY Table of content 1. Introduction 2. Overview of Japanese Monetary Policy before and after the Global Financial Crisis 2.1. Monetary Policy adopted by the Bank of Japan before the Global Financial Crisis 2.2. Monetary Policy adopted by the Bank of Japan after the Global Financial Crisis 3. Japan’s Floating Exchange Rate Regime and Economic Performance .3 4. Factors Affecting Currency Volatility 5. Conclusion References 10 Figure 1: United States Dolllar (USD) exchange rate against Japanese Yen (JPY) JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY 1. Introduction Historically, the objectives of Japanese monetary policy have been identified based on the goals of the country as a whole. Bank of Japan has changed the monetary policy over the time in order to adapt with the changing goals of the country in different periods. Obtaining sustainable   economic   growth,   enhancing   employment   level,   well   controlling   inflation   and payment   balance   can   be   the   most   significant   goals   of   monetary   policy   and   fiscal   policy Currency rate, which is one of the most considerable macroeconomic fundamentals affected by monetary   policy,   and   the   factors   influencing   it   are   considered   important   in   obtaining   the economic   goals   The   purpose   of   this   essay   is   to   provide   an   overview   about   the   Japanese monetary policy before and after the global financial crisis and discuss on the exchange rate regime and economic performance of Japan 2. Overview of Japanese Monetary Policy before and after the  Global Financial Crisis 2.1. Monetary Policy adopted by the Bank of Japan before the  Global Financial Crisis One of the challenges faced by central banks in the world in implementing their monetary policies during the global financial crisis is the ability to “overcome the zero-lower bound”- the negative nominal interest rates (Nakaso, 2017) This indicates the facts that the monetary policy of the central banks has evolved in concordance with the relevant economic condition and objectives, so as to overcome the zero-lower bound on the short-term interest rates Since 1990s, JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY as a result of bubble economy and aging population (Hayashi & Prescott, 2002), potential growth rate of Japan started to decline from approximately 4% in early 1990s to 1% at the end of the 1990s (Ugai, 2007), accompanying with neutral rate of interest (i.e understood that the interest rate that can support the economy at full employment and maximum resources at which real GDP is growing) also decreased In 1997, the economy of Japan faced with low growth, low interest rates, low inflation and huge amount of bad bank loan Due to the bubble adverse, the Yen appreciated significantly through middle of the year 1995, along with the slowdown in economic growth Over such deflationary phase, both the neutral rate of interest and inflation rate expectation of Japan followed the downward trend In this regard, the easing monetary policy basically refers to mechanism which drives the interest rates below the neutral rate of interest In specific, in 1999, to provide the money market with more funds for support financial institutions to meet the prudential reserve requirement, the Bank enabled the uncollateralized overnight call money/call loan rate to maintain low at virtually 0% Such initiative aims to decrease the impact of deflation in Japan at that time After that, when Japan’s economy marked some recovery signals in 2000, the Bank changed the “zero lower bound” policy into quantitative and qualitative easing policy (Ugai, 2007), which focuses on the outstanding balance of the current accounts at the Bank of Japan as an operating target Along with the quantitative easing policy, the Bank put efforts to continue with the “annual rate of change in consumer price index” deployment 2.2. Monetary Policy adopted by the Bank of Japan after the Global  Financial Crisis JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY After the global financial crisis, the direction of Japan’s economy evolutions can be broadly summarized by the four main approaches (Nakaso, 2017) Firstly, the operating target was shifted from on the outstanding balance of the current accounts at the Bank into longer-term interest rate Given that the long-term interest rate is fundamentally the average of future shortterm interest rate adding term premium, the policy was expected to reduce the real interest rate by controlling the longer-term interest rate Secondly, the Bank attempted to control the risk premiums by purchase of risk assets to decrease the interest rate of risk-free asset such as government bond The goal of such initiative is to deploy the qualitative easing, reducing funding costs of corporation and household through reduction of risk premium of risk-free assets Thirdly, the Japan’s monetary authority applied negative short-term nominal interest Fourthly, the monetary authority decreased the real interest rate by affecting inflation expectation of people The effective quantitative and qualitative easing policy has produced remarkable impacts By increasing the inflation expectation and reducing the long-term interest rate, the Bank could take steps to mitigate the impacts of deflation such as increased annual CPI inflation; thereby the Japan’s economy has improved steadily 3. Japan’s Floating Exchange Rate Regime and Economic  Performance Countries worldwide have a broad range of exchange rate system to deploy, ranging from fixed exchange rate regime to freely floating exchange rate There is no fixed rule on selecting the most appropriate exchange rate to achieve the goals of the monetary policy and maintain macroeconomic stability The factors to choose suitable exchange rate regime should depend on the determined characteristics of every nations such as current economic condition, scale of JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY economy and long-term economic policy goal For example, floating exchange rate system which is normally adopted by developed nations could not fit to the features of developing nations, where the financial market is not mature enough as compared to developed ones and where the economy is not stable enough to absorb the potential exposure triggered from exchange rate fluctuations Ghosh, Gulde, Ostry, & Wolf (1996) found that there is a relation between exchange rate regime and output growth, which is one of important indicators of economic growth The study also concluded that nations which adopt the fixed exchange rate system may achieve higher investment, but recorded lower productivity as compared to nations with floating exchange rate In general, per capita growth rate was relatively lower in nations with pegged exchange rates Huang and Malhtora (2004) also ascertained that the more flexible the exchange rate system is, the higher growth is achieved After the shift from fixed to floating exchange rate regime in which the price of JPY is decided by market forces, Japan has witnessed many impacts on the Japanese monetary policy during the period of appreciation The floating rates can bring benefits to Japan’s economy through main advantages, including providing independence to monetary policy, enabling quick and adaptive trade shock, and defending from speculative attack (Frankel, 2003) This enables a country allowing a floating exchange rate like Japan can deploy various monetary policy strategies for different economic goals such as aiming to money supply, inflation rates, or a nominal anchor Granger’s empirical results from the causality test showed a positive correlation between real effective exchange rate and the economic growth, with a highly significant coefficient The empirical results also found that the monetary policy is more effective than fiscal policy in the long term In fact, a strong exchange rate can be considered one of the most JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY important indicators of economic strength In the long run, an appreciating exchange rate tends to occur in nations with low inflation rate, enhancing competitiveness and strong economic performance, and Japan can be a good example in this case as it witnessed a sustained increase in the exchange rate after post war period However, the floating rate in which include accelerating uncertainty and softening the appreciation related pressures by interest rate reduction possible leading Japan into the liquidity trap understood as a situation when the zero-lower bound for the instrument rate (ZLB) is constrain, so that the central bank can face challenges to set the instrument rate at its optimal level Since 1999, the Bank of Japan has evolved its monetary policy with the concentration on the policy adopted after the influence from the Lehman shock Being a pioneer of untraditional monetary policy, the zero-interest rate policy was started in 1999 In 1999, the economic activity was still slow while both business/consumer sentiments were remained weak In August 2000, the Japanese central bank changed the zero-interest rate policy, encouraging the overnight rates to increase to 0.25% During the period from 2001 to 2006, the Bank of Japan followed the quantitative easing by changing the operating target from the overnight rate into the outstanding balance of current account of financial institution at central bank, which helps to facilitate its capacity to improve the ample liquidity After the global financial crisis, Bank of Japan has continued to introduce many policy initiatives to improve the economy performance, such as jointly with other central banks and reducing the impact of deflation Various monetary policy actions mainly focus on three areas: reducing the policy interest rate, ensuring stability in financial markets, and facilitating corporate financing The figure below shows the transition in monetary policy since 1999 JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY Source: Ministry of Internal Affairs and Communications 4. Factors Affecting Currency Volatility Fundamentally, there are two long­history and popular theories that are used to explain and identify exchange rate, which are purchasing power parity (PPP) and interest rate parity theory   (IRP)   The   theory   focuses   on   quantifying   the   inflaction   rate   and   exchange   rate relationship   This   indicates   that   PPP   will   take   exchange   rate   adjustment   as   a   basis   for determination of exchange rate in the two different nations. PPP theory includes two main forms, including absolute form of PPP and relative form of PPP. The absolute form of PPP shows that in the market circumstances of no international trade barriers, transportation cost and product differentiation, price levels in two different nations shouldd be similar when denominated in a JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY commonn currency, which means a unit of home currency will have the same purchasing power worldwide. For instance, exchange rates will ultimately adjust where a basket of goods will have the same price level in the United States and Japan when expressed in common currency. In the event that the price in Japan market is higher for the same basket, the price in the United States will increase and the price in Japan will reduce to reach an equilibrium where the price in both nations should be the same. With regards to the relative form of PPP, the theory ascertains that due to market imperfection, prices of the same basket of products in different nations will not be strictly the same due to the adjustment for differences in the inflation rates between two nations In this regard, the exchange rate shall be adjusted to reflect the movement in the inflation level of the two nations. The second theory for explanation and determination of exchange rate is the interest rate parity theory. The theory states that the interest rate differences between two nations is equal to the differences in forward exchange rate and the spot exchange rate.  Harada & Watanabe (2009) posited that election, terrorist, war and political scandals which indicate the political stability , can create significant impacts on the foreign exchange market. It is noticed by McFarlin (2001) that exchange rate market responds faster to political issues   than   other   forms   of   financial   investment   During   geopolitical   events   and   political instability, investors tend to seek for safety choice through divesting their investment, leading the depreciation   of   the   exchange   rate   This   is   because   the   floating   exchange   rate   regime   may strengthen   and   weaken   domestic   currency   in   an   unexpected   manner,   in   this   regard,   causing investors to anticipate uncertainty and exposures in which a premium is required to achieve for a forward position, therefore fluctuating the spot and forward exchange rates. Geopolitical events can have considerable adverse influence on the domestic currency when the event affects the JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY confidence and expectation of investors. Natural disasters also cause substantial impacts on the market and infrastructure, and thus the currency. Given that natural disaster such as earthquakes could   slow   down   production,   the   disruption   in   export   activities   will   lead   to   the   econony slowdown in case that the economy relies on export activities (Zylberberg, as cited in Harada & Watanabe,   2009)   Thus,   less   demand   for   a   domestic   currency   will   happen   when   domestic economy cannot meet the foreign currency demand due to the natural disaster. The figure below shows the movement of dollar yen exchange rate from 1980 to 2018 Figure 1: United States Dolllar (USD) exchange rate against Japanese Yen (JPY) Figure shows that USD/JPY exchange rate has witnessed lots of fluctuations during the period under review. The volatility of exchange rate between dollar and yen will have considerable impact on foreign trade. For example, although the yen’s appreciation as compared to dollar may benefit Japanese tourists and firms which conduct merger and acquition in the United States, it can harm Japanese exporters who desire to sell their goods to American consumers. Mackenzie (2018) posited that JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY the rise in the JPY is due to investors’ avoidance of dollar­based projects and turning to Japanese ones. This trend, however, may pose a threat to exporters in Japan because they can lose some foreign   revenues   and   reduce   their   production,   which   potentially   harms   Japanese   economic performance due to its sensitiveness and dependence on export markets for natural and labor resources. Moreover, Haque & Boger (2011) determines different factors including U.S. interest, U.S. export, U.S. import, current account balance of U.S. and U.S CPI which will ultimately cause   volatility   in   dollar/yen   exchange   rate,   leading   to   significant   impacts   on   trade   volume between the two countries. It is because the exchange rate volatility shall increase uncertainty for the participants of foreign exchange market, and affect the flow of international trade (Peree & Steinherr, as cited in Harada & Watanabe, 2009). In addition, more stable exchange rate enables companies to evaluate their performance of investment, financing and take hedging initiatives for operational exposures (Nieh & Wang, as cited in Harada & Watanabe, 2009).  5. Conclusion In conclusion, the volatility of dollar yen exchange rate will have a great deal of effects on foreign trade and economic performance of Japan. The exchange rate volatility can increase uncertainty for the participants of foreign exchange market, and affect the flow of international trade  Firms have continuously taken into account and struggled with the dollar yen exchange rate’s   movements   through   both   financial   and   operational   hedges   to   manage   their   currency exposure.  JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY References Frankel,   J   A   (2003). Experience   of   and   lessons   from   exchange   rate   regime   in   emerging economies (No. w10032). National Bureau of Economic Research Ghosh, A. R., Gulde, A. M., Ostry, J. D., & Wolf, H. C. (1996). Does the Exchange Rate Regime Matter   for   Inflation   and   Growth,[International   Monetary   Fund,   Economic   Issues   No 2/1996] Washington DC. International Monetary Fund Hayashi, F., & Prescott, E. C. (2002). The 1990s in Japan: A lost decade. Review of Economic Dynamics, 5(1), 206­235 Haque, M. A., & Boger, G. (2011). The volatility of the dollar yen exchange rate: cause and effect. Journal of Economics and Economic Education Research, 12(1), 55 Harada, K., & Watanabe, T. (2009). News effects on high frequency Yen/Dollar exchange rate and its volatility behavior. Chuo University Mackenzie, M. (2018).  Why a stronger yen has room to appreciate further. Retrieved 23 Nov, 2018 from https://www.ft.com/content/a7bf4c94­2832­11e8­b27e­cc62a39d57a0 McFarlin, M (2011, 04) Top forex fundamentals Futures, 40, 46-47 Nakaso, H. (2017). Evolving Monetary Policy: The Bank of Japan’s Experience. Speach at Ugai,   H   (2007)   Effects   of   the   quantitative   easing   policy:   A   survey   of   empirical analyses. Monetary and Economic Studies­Bank of Japan, 25(1), 1 10 ... Figure 1: United States Dolllar (USD)? ?exchange? ?rate? ?against? ?Japanese? ?Yen? ?(JPY) JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY 1. Introduction Historically, the objectives of? ?Japanese? ?monetary? ?policy? ?have been identified based on.. .JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY Table of content 1. Introduction 2. Overview of? ?Japanese? ?Monetary? ?Policy? ?before? ?and? ?after the Global Financial Crisis... economic condition, scale of JAPANESE MONETARY POLICY AND DOLLAR YEN EXCHANGE RATE VOLATILITY economy and long-term economic policy goal For example, floating exchange rate system which is normally