Yen's 40-year low driven by 2.5% M2 growth, not interest rates
As the yen slumps to a 40-year low despite interest rates hitting a 31-year high, collapsing broad money growth signals an impending reversal in Japanese bond yields.
The Japanese yen has slumped to a 40-year low, a striking divergence from the Bank of Japan’s policy rate, which recently hit a 31-year high of 1%. Since taking office in April 2023, Governor Kazuo Ueda has implemented five rate increases and ended yield curve control in March 2024. His strategy relies on a theory that rising wages, combined with higher energy and import costs, will lock in sustained 2% inflation.
A monetarist critique, articulated by economists Steve Hanke and John Greenwood, suggests investors are misreading the situation by focusing on interest rates. They argue that interest rates are merely a symptom of economic activity, while changes in the money supply are the true driver of nominal GDP growth. In Japan, low interest rates historically reflected tight money and weak economic activity, not accommodative policy.
The historical data supports this framework. From 2000 until the pandemic, Japanese broad money growth averaged a meager 2.6% annually. That resulted in just 0.3% average nominal GDP growth, consisting of 0.8% real GDP growth and a GDP deflator of -0.5%. This persistent stagnation occurred despite the central bank's large-scale quantitative easing programs.
The inflationary breakout during the pandemic was not driven by standard QE, but by the BOJ’s "Fund Provisioning" strategy. By offering interest-free loans to banks on the condition they lend to businesses, the central bank briefly pushed broad money growth to a peak of 9.6%. As monetarist models would predict, this surge ended deflation, triggering a stock market rally, a real GDP recovery, and inflation hitting 4%.
Those expansionary conditions have now vanished. Broad money growth has slumped back to 2.5%, essentially matching the sluggish pre-pandemic pace. This monetary contraction is happening alongside rising fiscal spending under Prime Minister Sanae Takaichi. Because Japan has experienced 35 years of low inflation, the lag between slowing money growth and its impact on nominal GDP is unusually long, masking the underlying slowdown.
For fixed-income investors, this lag creates a trap. Current Japanese bond yields are still rising because they track nominal GDP trends that reflect the pandemic-era money boom. However, with overall CPI inflation already slowing, yields must eventually fall to align with the current 2.5% money supply growth. Unless the BOJ accelerates M2 growth beyond 5%, the central bank's rate-hiking cycle will likely reverse as inflation continues to cool.
