How the Yen Drives Japan's Monetary Policy

If price stability is the legal mandate of the Bank of Japan (BOJ), and the central bank’s official target for price stability is 2%, as measured by the Consumer Price Index (CPI),* then why are fluctuations in prices the norm for Japan? The answer—and expectations for the BOJ’s next steps—lies in the exchange rate.

Hitting Japan’s Inflation Target Has Been Tough

At its policy meeting in April, the BOJ refrained from adjusting its negative interest-rate policy (NIRP) and yield curve control (YCC) policy in the face of CPI and core CPI (excluding fresh food and energy) at 3.2% and 3.8%, respectively. Citing weak real wages, the central bank judged the recent increase in inflation to be temporary.

Given Japan’s historical record (Display), the policy board was likely right, in our view. Japan has spent most of the past 25 years with inflation well below target, despite the central bank’s efforts.

Japan Has Struggled for Decades to Meet Its Inflation Target

The latest comparatively hot inflation numbers may be short-lived if other countries are a guide. Indeed, in past cycles of inflation, the US has led to increases and decreases in CPI. With US inflation having already peaked in this cycle, it’s now widely expected that inflation will soon subside in Europe and Japan (Display).

Historically, the US Leads the Inflation Cycle and Europe and Japan Follow