Brad Setser on the US's Unusual Japanese Yen Intervention

Episode Summary

Executive Summary: The episode examines the sharp weakening of the Japanese yen, East Asian currency dynamics, and the unusual U.S.-Japan intervention that used euros and the Fed’s FEMA repo facility. Brad Setser argues the yen is overshot, intervention can work if paired with BOJ rate hikes, and Japan’s fiscal position is stronger than commonly believed.

Main Topics: Why the yen weakened and why intervention happened (Priority: 5/5): The hosts and Brad Setser discuss why the yen fell to historically weak levels, why U.S. Treasury Secretary Scott Bessent intervened, and why Japan’s central bank did not simply raise rates sooner. East Asian currency weakness beyond Japan (Priority: 5/5): Setser explains that Korea, Taiwan, and other East Asian economies are seeing large trade surpluses yet weak currencies due to capital flows, hedging behavior, and portfolio constraints rather than simple trade fundamentals. The mechanics and novelty of the intervention (Priority: 5/5): The conversation focuses on the U.S. selling euros, Japan’s Ministry of Finance selling dollars, and the use of the Fed’s FEMA repo facility to mobilize dollars without immediate Treasury sales. Fair value, valuation models, and why classical FX tools struggle (Priority: 4/5): They assess Big Mac parity, behavioral equilibrium exchange-rate models, and current-account based measures, concluding that these tools remain useful analytically but have weak predictive power when financial flows dominate. Can intervention work without BOJ support? (Priority: 5/5): Setser argues intervention is most likely to succeed if the Bank of Japan raises rates and if market expectations shift; otherwise, the yen could be retested near key levels like 160. Japan’s fiscal position and debt dynamics (Priority: 4/5): The discussion challenges the idea that Japan is in imminent fiscal-dominance trouble, stressing its improving primary balance, large foreign asset base, and the fact that net debt dynamics are less alarming than headline debt ratios suggest.

Key Arguments: The yen’s weakness is not just a speculative story; it reflects a mix of rate differentials, hedging flows, and massive institutional foreign-asset positions. Intervention is more credible when it aligns with BOJ policy; if the BOJ raises rates, the yen’s path can improve materially. East Asian currencies are weak despite large surpluses because financial flows and portfolio hedging have overwhelmed trade fundamentals. The U.S. is concerned not only with trade competitiveness but also with avoiding disorderly pressure on Treasury markets. Using the FEMA repo facility allows Japan to obtain dollars without dumping Treasuries immediately, reducing market disruption. Classical valuation models still indicate the yen is undervalued, but they do not predict timing well in a flow-driven market. Japan’s fiscal position is better than many assume because the primary balance is near zero and the government also earns income on foreign assets. The yen’s overshoot matters because once expectations shift, a reversal can be rapid if policy and flows turn together.

Data Points: JPY level vs. dollar: ~155-156 - Current yen exchange rate discussed as weaker than before intervention. JPY level at intervention concern: 160 - A key psychological and market-defense level for the Ministry of Finance. BOJ short-term policy rate: 1% - Setser says the Bank of Japan has been slow to raise rates despite inflation above this level. Japan current account surplus: 5% of GDP - Setser notes Japan remains in surplus, driven mainly by investment income. Japan reserves: ~$1.2 trillion - Approximate foreign-exchange reserve stock held by Japan. Japan government pension fund foreign assets: $900B+ - Large foreign asset position that contributes to Japan’s external balance. Japan GDP: $4 trillion - Used to illustrate the scale of Japan’s foreign asset holdings relative to GDP. Japan foreign asset position: ~50% of GDP - Setser’s estimate of combined government foreign assets relative to GDP. Korea current account surplus: $100B+ rising to $300B-$400B - Setser describes a massive increase in Korea’s external surplus. Taiwan current account surplus: 15%-30% of GDP range - Setser says Taiwan’s surplus is extremely large and may double. Taiwan dollar move: Weaker than last year - Attributed to prudential-regulation changes and reduced hedging by insurers. Japanese 30-year yield: ~4% - Host notes the shift from near-zero yields to around 4% as rates normalized. Japanese 30-year yield in 2016: 0.05% - Illustrates the extreme change in long-end Japanese rates. U.S. short-term rates: 3.25%-3.5% - Compared with Japan’s 1% policy rate. ESF liquid FX and cash: ~$20B each - Treasury’s Exchange Stabilization Fund is too small on its own for unlimited defense. ESF SDR holdings: ~$160B-$170B - Additional firepower, but still not unlimited and more politically unusual to use.

Pivotal Quotes: "The irony of the guy working for Soros and Stanley Druck and Miller, who broke the Bank of England back in 92, pretending that you can do FX intervention alone and lastingly defend a currency is just amazing." — Adam Posen (quoted by host): Referenced as skepticism about whether unilateral intervention can sustainably support the yen. "I think it will be enough if the Bank of Japan is going to raise rates and maybe raise rates several times." — Brad Setser: Setser’s core view on what makes intervention likely to succeed. "Japan is selling dollars it bought between 80 and 100, depending on when they bought them, at somewhere around 160." — Brad Setser: Closing point on how intervention can reduce gross debt and improve Japan’s balance-sheet position.

Implications: Listeners should watch BOJ policy and Japan’s flow dynamics, not just the headline yen level. If the BOJ tightens and market expectations shift, yen strength could persist; if not, intervention may only buy time. The episode also suggests Japan’s fiscal risks are less dire than conventional narratives imply.