The Bank of Japan must normalise rates faster while guarding against the underappreciated risk of a yen overshoot. The yen’s latest rally shows how quickly its gains can surprise markets and why policy-makers cannot assume that appreciation will be easy to contain.
Dollar-yen fell to around 154 from above 160 in less than a week, but what prompted the move remains unclear (Figure 1). Investors have cited expectations of a more hawkish BoJ and speculation about a shift in the Government Pension Investment Fund’s portfolio, but neither fully explains its scale. Rate pricing has shifted only modestly relative to the scale of the appreciation, while the prospect of greater domestic investment by GPIF was first reported in July.
The episode brings an underappreciated policy tension into sharper focus: 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.
Figure 1. The yen has strengthened
Dollar-yen exchange rate
Source: LSEG Workspace
Tighter policy would sustain yen gains
It is no secret that the yen’s weakness is largely due to Japan’s wide interest rate differential with the US. The latest rally has eased immediate depreciation pressure, but faster monetary tightening would help make the yen’s appreciation more durable. With inflation close to, if not already at, target, the case for withdrawing monetary accommodation is increasingly clear.
Trend inflation and inflation expectation measures are broadly around 2%, the output gap is positive and labour shortages are contributing to wage raises. Upside risks have also intensified, as high energy prices and yen weakness lift import costs, which rose 29% year on year in August. Yet the BoJ’s 1% policy rate remains accommodative and markets expect only a gradual tightening cycle.
The market-implied terminal rate sits at the upper end of the 1% to 2.5% range of neutral-rate estimates cited by the Bank. Even so, the slow path towards it appears overly cautious for an economy in which underlying inflation is approaching target and upside risks have intensified.
The danger of a yen overshoot
For the BoJ, policy normalisation is a double-edged sword. Tighten too slowly and lingering yen weakness will sustain inflationary pressure; move too quickly and the yen could overshoot, disrupting the Japanese economy and global markets.
A sharp appreciation would squeeze exporters’ profit margins and weaken their capacity to raise wages and prices. This risk is not merely hypothetical. Following the 1985 Plaza Accord, under which major economies agreed to devalue the dollar, the yen roughly doubled in value by 1988. Kenneth Rogoff, former International Monetary Fund chief economist, identifies the appreciation as a catalyst for the slowdown that preceded Japan’s 1990s financial crisis.
Decades later, the episode still helps explain policy-makers’ aversion to excessive yen appreciation. During the 2024 carry unwind, for example, the BoJ tempered expectations of further tightening to steady the yen. Evidently, the possibility of excessive yen appreciation continues to constrain the pace of policy normalisation.
Irrespective of what triggered the current appreciation, it is a reminder that the currency’s medium-term upside risks persist. Beyond the possibility of further intervention and shifts in speculative positioning, rising domestic rates could create two additional sources of yen demand. As the interest-rate differential narrows, hedging foreign assets becomes cheaper. Given Japan’s vast overseas holdings, even a modest increase in hedge ratios could generate significant yen-buying flows. Higher domestic bond yields could simultaneously encourage investors to repatriate capital. These flows could add to appreciation pressures and increase the risk of an overshoot.
The BoJ’s delicate balancing act
The BoJ is widely expected to raise rates by 25 basis points at its next monetary policy meeting on 17-18 September. Failure to deliver could reverse some of the yen’s gains and revive doubts about the Bank’s commitment to control inflation. Conversely, guidance pointing to consecutive increases could intensify appreciation pressures.
The Bank should navigate these risks by emphasising a faster but flexible approach. Hajime Takata, the board’s most hawkish member, described 2026 as a ‘regime change’ requiring nimbler, data-dependent rate increases. This would mark a shift from the current pace of two hikes per year. Governor Kazuo Ueda should echo that message at his post-meeting press conference without committing the Bank to a fixed schedule.
Markets currently price around 40bps of tightening by year-end. A 25bp hike in September, accompanied by guidance that keeps the door open for another move before year-end, would signal the BoJ’s willingness to accelerate normalisation. This measured approach would preserve flexibility while limiting the risk of a yen overshoot.
Tighter policy would help contain inflation and put the yen on a firmer footing. However, the BoJ must ensure that a necessary correction does not go too far. Moving faster while preserving flexibility over subsequent hikes would help strike that balance. The yen has spent years weakening under the weight of monetary divergence; as that divergence narrows, policy-makers should not assume the reversal will be gradual.
Christos Panourgias is an Economist at OMFIF.
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