Forecast for Japanese Yen

The Japanese Yen, has been appreciating against the Dollar and Euro for the past few years. It is currently 109 Yen to 1 dollar. In 1998 it was 130

However, on purchasing power parity standards, the Economist Big Mac index suggests the Yen is 27% undervalued against the dollar (and the dollar has been weak itself). It is approximately 50% under valued against Euro.

This is due to, the very low interest rates in Japan (close to 0%). It means foreign investors have an incentive to borrow in Japanese Yen and invest in countries with higher interest rates (e.g. ECB interest rates are 5.25%). This is known as the carry trade and has pushed the value of the Yen lower.

The very low interest rates have occurred because of the sluggish economic growth and deflation. If economic growth in Japan picked up, it would allow interest rates to rise and reduce carry trade. People might start holding Japanese Yen to invest in.

However, the Japanese economy has been hit by the global slowdown and rise in commodity prices. As a net importer of commodities like oil, rising prices have caused cost push inflation which have reduced consumer spending.

Thus although inflation has increased, it is the wrong kind of inflation. Interest rates are unlikely to rise as the economy slows down and probably enters into recession next year.

With this persistent economic weakness, the Japanese Yen may remain undervalued for longer.

However, I forecast that in the long term - end of 2009, 2010, the Japanese Yen will start to appreciate because the current cost push inflation is temporary and the economy has the potential to regain normal growth and normal interest rates - which would boost the value of the currency.