Why does raising the policy interest rate tend to lead to a stronger yen?
When watching the news,
“The central bank has raised the policy interest rate.”
“Following the interest rate hike, the yen has strengthened.”
you may come across news like this.
However,
“Why does the yen get stronger when interest rates rise?”
is a bit difficult to answer if asked.
This time,
policy interest rate → stronger yen
we will explain how these are connected as simply as possible.
And finally,
“If the policy interest rate rises, what happens to the exchange rate?”
let’s check with this question.
First, what is a “policy interest rate”?
The policy interest rate is
the benchmark interest rate that the central bank adjusts to conduct monetary policy.
In Japan, the Bank of Japan is responsible for monetary policy.
What is important here is that
the policy interest rate is
not the same as all interest rates in the world.
That is what it means.
When the policy interest rate changes,
it spreads its influence to various interest rates, such as bank lending rates.
In other words,
it is easy to understand if you think of the policy interest rate as the “starting point for interest rates” that affects the entire economy.
that is what it is like.
So, why is the policy interest rate related to exchange rates?
This is where the “interest rate differential” with overseas countries becomes the key point.
For example,
suppose that Japanese interest rates are low while
US interest rates are high.
Then,
“It might be better to invest in the currency of a country with higher interest rates than to keep my money in Japan.”
some people and companies will start to think this way.
Therefore,
selling Japanese yen
↓
buying dollars, etc.
this kind of movement may increase.
If the number of people selling yen increases,
the demand for yen weakens, which tends to lead to a weaker yen.
So, what happens if Japan’s policy interest rate rises?
Let’s think about the opposite here.
When Japan’s policy interest rate rises,
“Japan’s interest rates are also rising.”
is the result.
If Japanese interest rates become higher than before,
“The appeal of investing in yen has increased.”
the number of people who think this way may increase.
Then,
selling dollars, etc.
↓
buying yen
can lead to this kind of movement.
If more people buy yen,
demand for the yen becomes stronger,
which tends to lead to a stronger yen
is the reason.
Looking at the flow, it is like this:
Policy interest rate rises
↓
Japanese interest rates rise
↓
The appeal of holding Japanese financial assets may increase
↓
Can lead to movements to buy yen
↓
Tends to lead to a stronger yen
is the flow.
However,
“Raising the policy interest rate does not necessarily mean the yen will always get stronger.”
Exchange rates are affected by:
・Overseas interest rates
・Expectations for future monetary policy
・Economic conditions
・Prices
・Trade
・Investor behavior
and various other factors.
Therefore,
“Policy rate UP ↑ 👉 Stronger yen”
is
“something that can work in the direction of making the yen stronger”
—it is important to remember it this way.
This is where the “interest rate differential” comes in.
Let’s take one more step forward.
When thinking about exchange rates,
it is important not just to look at Japanese interest rates, but to look at the interest rate differential with foreign countries.
For example,
even if Japanese interest rates go from
0.5% to 1.0%,
if overseas interest rates are even higher,
you might think,
“Overseas is still more attractive.”
Conversely,
if the interest rate differential between Japan and overseas shrinks,
it could lead to a movement to buy the yen.
In short,
it is not just about “whether Japan’s interest rates have risen,” but also about
“how the interest rate gap with overseas has changed”
that is the key point to look at.
Learning “policy interest rates” and “yen appreciation” as a set
In certification exams or the Nikkei TEST,
you are not necessarily asked about “policy interest rates” in isolation.
For example,
Raising the policy interest rate
↓
Change in interest rate gap
↓
Impact on exchange rates
you may be asked about the causal relationship as a set like this.
Therefore,
rather than just memorizing terms,
you should also understand
“why exchange rates move when interest rates move.”
This is something you want to understand thoroughly.
Here is a way to remember it
I think this theme is easier to organize if you remember it this way.
Currencies with high interest rates tend to be more attractive to hold
↓
The number of people buying that currency may increase
↓
The value of that currency tends to rise
If Japanese interest rates rise and the interest rate gap with overseas narrows,
movements to buy yen
↓
stronger yen
tend to follow.
Of course, actual exchange rates are more complex.
However,
keeping the basic idea that “when interest rates rise, the appeal of holding that currency tends to increase”
will make it easier to read the news.
Let’s summarize what we have covered so far
I will summarize the key points of this session in three steps.
① Policy Interest Rate
The interest rate adjusted by the central bank for monetary policy.
↓
② Interest Rate Gap
How much the interest rates in Japan and overseas differ.
↓
③ Exchange Rate
Changes in interest rate gaps and other factors influence the movement of buying and selling currencies.
↓
When the movement to buy yen strengthens, it tends to lead to a stronger yen.
However, be careful here.
When reading economic news,
“The policy interest rate was raised!”
↓
“So, a stronger yen!”
It is dangerous to think of it simply.
In the market,
“They are likely to raise interest rates from now on”
—this expectation also affects exchange rates.
Also,
“Japan raised interest rates, but US interest rates remain high”
—in such a situation, a large interest rate gap may still remain.
Exchange rates move not only based on current interest rates, but also including “what is expected to happen in the future.”
If you can grasp this much, economic news will become one step easier to read.
Three questions here
Finally, let’s check the content covered this time with some questions.
Question 1
When the policy interest rate is raised, what generally tends to happen to that country’s currency?
A. The appeal of buying that currency increases, which can lead to a stronger currency
B. It always leads to a weaker currency
C. It has no effect on exchange rates at all
Question 2
Even if Japanese interest rates rise, if a large interest rate gap with overseas remains, what is the appropriate way to think about it?
A. It will always lead to a stronger yen
B. Interest rate differentials are also an important factor to consider for exchange rates
C. Interest rate differentials are unrelated to exchange rates
Question 3
“If you raise the policy interest rate, the yen will always strengthen.”
Is this correct?
A. Correct
B. Incorrect
Answer
Question 1: A
An increase in the policy interest rate can make holding financial assets in that country more attractive, leading to movements to buy the currency.
However, because exchange rates also move due to factors other than interest rates, it does not necessarily mean the currency will strengthen.
Question 2: B
When looking at exchange rates,
it is important to look not only at Japanese interest rates but also at the interest rate differential with overseas.
it is important to look at that.
Question 3: B
Exchange rates fluctuate due to various factors, such as:
・Interest rates
・Interest rate differentials
・Expectations for monetary policy
・Economic conditions
・Prices
・Investor behavior
Exchange rates fluctuate due to various factors, such as the above.
Therefore,
“Policy interest rate ↑ = always a stronger yen”
is not necessarily true.
Things to remember today
Here are the three key points for this time.
1. The policy interest rate is the rate adjusted by the central bank for monetary policy purposes
2. When looking at exchange rates, the “interest rate differential” between Japan and overseas is important
3. When the movement to buy yen strengthens due to changes such as interest rate differentials, it tends to lead to a stronger yen
And, something you want to remember is,
currencies with higher interest rates tend to be more attractive to hold
is the way of thinking.
Connecting this to the previous article on “yen depreciation”
Last time, we organized the flow of,
yen depreciation
→
import costs
→
impact on prices
as a sequence.
This time, it is the flow of,
policy interest rate
→
interest rate differential
→
exchange rate
→
tends to lead to a stronger yen
as a sequence.
In economic news, these two do not appear separately, but
sometimes appear connected.
That is why, rather than just memorizing terms one by one,
“What does this term lead to next?”
it is important to think about.
Turning “knowing” into “solving”.
Studying economics is
not just about knowing terms.
Understanding the meaning
↓
Understanding the mechanism
↓
Understanding how it is used in the news
↓
Being able to make judgments on problems
By progressing this far, you will gradually get closer to being able to “solve” problems.
At the Qualification and Economic Knowledge Laboratory, we will continue to create articles that turn
“I know it, but I can’t explain it”
into
“Oh, that’s what it means!”
.
The next time you see the term “policy interest rate” in the news,
“What is the interest rate gap between Japan and overseas?”
try thinking about that.
Even just doing that will change how you see the news a little bit.