BoJ Must Balance Interest Rate Normalization with Yen Overshoot Risk
The yen's recent surge has brought attention to an often-overlooked risk for policymakers: a yen overshoot. The Bank of Japan must balance its need to normalize interest rates with the potential consequences of further yen appreciation.
The latest rally in the yen, which saw the dollar-yen exchange rate fall from above 160 to around 154 in less than a week, has left markets uncertain about what triggered the move. While investors point to expectations of a more hawkish BoJ and speculation about shifts in the Government Pension Investment Fund's portfolio, these factors do not fully explain the scale of the yen's gains.
Tighter policy is needed to ease inflation and put the yen on a firmer footing, but it could also reinforce a rally that proves difficult to contain. The BoJ's current 1% policy rate remains accommodative, with markets expecting only gradual tightening. However, trend inflation and inflation expectation measures are around 2%, and the output gap is positive.
The BoJ must navigate these risks by emphasizing a faster but flexible approach to monetary tightening. Governor Kazuo Ueda should signal the Bank's willingness to accelerate normalisation while preserving flexibility over subsequent hikes. A measured approach would help strike the balance between containing inflation and preventing an excessive yen appreciation.