yen

Why the yen needs to be restrained

March 18, 2011: 6:42 AM ET

The dollar is going to keep getting sand kicked in its face till the U.S. economy finally flexes some job-creating muscle.

The yen's surge this week prompted the G-7 rich countries to pledge Thursday evening to limit the Japanese currency's gains against the dollar. The United States, European Central Bank, United Kingdom and Canada will sell yen, in hopes of snuffing out a rally that threatens to add to Japan's economic distress by making its exports pricier.

The downside of low rates

Thursday's announcement comes a day after the yen hit a record high against the dollar, breaking decisively through 80 yen for the first time since 1995. This hardly seems like the time for the yen to be setting records, given the crushing blow Japan's economy took this past week – after spending most of the past two decades in bed, no less.

But as poorly as the Japanese economy has performed recently, the reality is the U.S. has not exactly been setting records either – unless you count the trillions of dollars the government ponied up to save the bankers.

So while Japan has been busy finishing up its second lost decade, the dollar has managed to lose 36% of its value against the yen since the financial crisis started (see chart, right).

What gives? As always, there are many forces swirling about in currency markets. But it will warm your heart and Ron Paul's too to see that the single biggest driver of yen gains is the zero interest-rate policy of the Federal Reserve – something that is unlikely to change for at least a year and perhaps longer.

Strong yen? Get used to it.

"That looks wrong, for the yen to be trading around 80," says BMO Capital Markets strategist Andrew Busch. "But in a low-rate environment, it makes sense to see what we've been seeing."

The key factors driving the action in the dollar lately include inflation – which the United States has had a bit of in recent years, and Japan next to none – and interest-rate differentials, or the gap between yields on government bonds sold in the two countries.

When credit markets started cracking in the summer of 2007, interest rates were firmly on the dollar's side. The Federal Reserve's overnight bank-lending target rate was 5.25%, vs. next to nothing in Japan.

But a year and a few months later, by the time the financial crisis of 2008 was history, the Fed rate was down to the current range of 0% to 0.25% -- putting it on par with Japan, which hasn't been above 1% since the early 1990s.

When the Fed took the next step two years ago today and signed up for its first round of quantitative easing, there was no mistaking that the dollar, rather than the yen, was the currency traders wanted to sell to finance higher-yielding investments. And so the dollar has lost more than 10% of its value since then against a country that is itself widely viewed as on the brink of an unthinkable  fiscal disaster.

That's not to say easy Fed policy is the only factor at work in the yen's appreciation. Trade flows also favor the yen, because Japan exports $10 billion a month worth of goods to the U.S. – twice as much as it imports -- and exporters must change their dollars for yen before bringing funds back home.

There are also idiosyncratic factors, such as the close of the Japanese fiscal year at the end of this month, the rush of Japanese companies to raise cash for what could be a tough few months ahead, and the ever-present speculative interest in testing the central bankers' limits.

And tempting though it is, it would be irresponsible to blame Ben Bernanke for this mess. He certainly played a role in the wrongheaded U.S. monetary policy of the early 2000s, which enabled the housing boom and bust. But by the time 2007 rolled around, he was playing the only cards left in his hand – cut rates early and often. He is a surgeon operating repeatedly on a patient who awoke one day to find his nine-pack-a-day habit hadn't worked out as plan.

Now, the Fed is entering the late stages of its second round of quantitative easing – a policy Bernanke is crossing his fingers will boost domestic demand for goods and services and, by extension, employment. If there are hopes for a sizable dollar rebound, they are more or less all in that basket.

"U.S. jobs growth is what could get us out of this," says Busch. "If we start to see some big employment numbers, we could start to see the dollar move back up."

Even, if you can imagine, without the assistance of the G-7.

Also on Fortune.com:

Follow me on Twitter at @ColinCBarr.

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