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Understanding the rise of the yen




This morning in Japan, the yen flirted briefly with—yet failed to reach—a new record intraday high against the dollar (highest value to date is 76.25 on Mar. 17th of this year), thanks to forceful intervention by Japanese authorities. The yen and the Swiss franc have both been the beneficiaries of investors' concerns over the health of the U.S. economy and the prospect that the Fed, with the consent of Treasury, may seek a further depreciation of the dollar (which decline would supposedly boost the economy) by resorting to another round of quantitative easing.

The chart above seeks to put the yen's recent ascent against the dollar into the proper perspective, by comparing the yen/dollar exchange rate to a theoretical purchasing power parity exchange rate (which is calculated to equilibrate prices between the two countries). The reason that both the PPP and the actual value of the yen have been rising vis a vis the dollar is easily explained by the observation that inflation in Japan has been much lower than inflation in the U.S. In fact, Japan's CPI has not changed on net for the past 18 years, while the U.S. CPI has increased by about 56%. This rather large inflation differential would, by itself, explain the entire appreciation of the yen and then some. That's because the yen/dollar exchange rate needs to rise by the same amount as the U.S. - Japanese inflation differential in order to keep prices in the two countries from diverging. Put another way, higher U.S. inflation tends to produce an eventual weakening of the dollar vis a vis the yen, otherwise U.S. prices in dollar terms would rise relative to Japanese prices when converted to dollars.

Relative to its PPP, the yen is "overvalued" by almost 50% against the dollar. That means that the typical American tourist likely will find that prices in Japan tend to be about 50% higher than comparable prices in the U.S. The exchange rate market is willing to pay a premium for the yen in order to enjoy the virtues of its stable purchasing power and escape the ongoing decline in the value of the dollar. By comparison, I calculate that at the current exchange rate of 1.43, the euro is about 25% overvalued against the dollar, as can be appreciated in the chart below. European inflation has been only slightly less than U.S. inflation in the past 18 years, so the euro doesn't merit as much of a premium as the yen. That the euro is still trading at a premium, despite the ongoing and very real threat of a substantial restructuring of PIIGS debt, suggests that the market doesn't believe an ECU sovereign default will threaten the ongoing viability of the euro. By extension, it also suggests that the ongoing viability and purchasing power of the dollar is a risk to be reckoned with.


A weak dollar—which is undervalued on a PPP basis against almost every major currency on the planet, and whose real, inflation-adjusted value against a large basket of currencies is at or near an all-time low—has many unpleasant implications for the U.S. economy. For one, it means that foreigner's desire to invest here is weak, which is another way of saying that capital is expected to be more productive elsewhere. Two, it means that the purchasing power of all U.S. residents has been reduced significantly should a resident venture outside our borders. Third, it tends to put upward pressure on the price of all imported goods and services. Fourth, it encourages U.S. firms to raise the price of their exports, since otherwise they might be very cheap to foreign buyers. Fifth, if higher export prices hold, it then encourages firms here to raise their prices domestically. Sixth, it encourages foreigners to buy goods and services here in the U.S., particularly real estate which happens to be very cheap on its own merits. Finally, if the dollar sustains these low levels for long enough, inflation is bound to rise, thus undermining the purchasing power of all U.S. residents.

Some argue that a weaker dollar would strengthen the U.S. economy, but the arguments in favor of that proposition are notoriously weak. A weaker dollar might provide a temporary boost to export-oriented industries, but it would also tend to provide a more lasting boost to the prices of all imported goods and services, thus raising costs for everyone. Competitive devaluations in the end are a fool's game, and it can be said with some justification that no country has ever devalued its way to prosperity.

As a supply-sider, I have learned that it is very important to pay attention to market-based signals, since they can provide very good and timely information about the fundamentals of our economy and our financial markets. Currently, it's hard to find anything that is pointing in a healthy direction. And that is why I remain optimistic, because the world appears to be uniformly and profoundly pessimistic about the prospects for the U.S. economy, while I still hold out hope for improvement. For example, while the recent debt limit accord was far from perfect, it was a step in the right direction. And while the Tea Party is being painted as "terrorists," I believe they have the country's best interests at heart, and they will undoubtedly redouble their efforts to enforce some degree of fiscal sanity on Washington in next year's elections.

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