Inflation and the yen

Now let’s conclude by taking a longterm look at the yen relative to Japanese inflation. The declining inflation rate in Japan led to continued firming of the yen except during those periods when the U.S. consciously pursued a strong dollar. These retracements are noted with green trendlines. The last two periods so marked, the late 1980s and mid- 1990s, saw both an upturn in Japanese inflation and a weakening of the yen. We would have to conclude future yen weakness will emerge if the BOJ is successful in increasing inflation, unless inflation and interest rates rise faster outside of Japan.

The opposite effect — a weaker yen leading to an upturn in the rate of inflation — does not appear in the data at all. The 2006-2007 time frame, called a period of yen weakness by some, is not a period of yen weakness by historic standards. Moreover, the unwinding of various yen carry trades and widespread expectations of more relaxed monetary policies in the U.S. and Europe during the July-August credit crunch actually strengthened the yen.

Eventually the credit crunch will end and the world’s central banks will return to their mission of the first half of 2007 — fighting inflation via higher short-term interest rates. The lesson for currency traders is clear: Whenever a central bank declares war on its own currency and wins, go with the flow and sell that currency. What has made the last decade tough for yen traders is deflation in Japan. If this ends — and the BOJ appears ready and able to end it prior to July 2007 — the trade of selling the yen could be a profitable one for a long time to come.