To understand how interest rates influence inflation, we need to understand how inflation works. Inflation is the result of too much money chasing too few goods. Over the last several months, this has occurred amid a surge in demand and supply chain disruptions worsened by Russia’s invasion of Ukraine.
In an effort to combat inflation, central banks will raise their policy rate. This is the rate they charge commercial banks for loans or pay commercial banks for deposits. Commercial banks pass on a portion of these higher rates to their customers, which reduces the purchasing power of businesses and consumers. For example, it becomes more expensive to borrow money for a house or car.
Ultimately, interest rate hikes act to slow spending and encourage saving. This motivates companies to increase prices at a slower rate, or lower prices, to stimulate demand.
1. Japan can defend its interest rate line by printing more money but at expense of the yen
2. Japan can defend the yen by hiking rates or by selling its reserves until reserves run out
Japan has a nasty choice
I received this email reply to the above Tweet from Michael Pettis.
“Looks right. I’d add that by weakening the yen, Japan seems always to support their exporters at the expense of their consumers, which may be why domestic demand is always so weak and growth so sluggish.“
The smart thing for Japan would be to hike rates and let the Yen strengthen.
Instead, if they stay on the same path, the yen might blow up.
All of Japan’s efforts to achieve growth by inflation and exports have backfired. One might think that after 40 years they would try something else.
The single worst choice for Japan would be to blow its currency reserves in an attempt to defend both the Yen and its interest rate peg.