Mark Manger wrote:

Keep in mind that we're both 90% in agreement that this [fixed-rate for the yen] would only buy time for Japan, and that we disagree on whether it could work at all.
I agree that the 90% agreement on susbtance is what counts. I also think--and perhaps you do as well--they we'll never be able to settle our argument in the real world since it is politically impossible for Tokyo to adopt your proposal, due to opposition both at home and in important foreign capitals.

Still, it remains a useful intellectual exercise--at least for me--since I run across it all the time. As often happens with SSJ, I was forced to do a little useful research in order to deal with your arguments.
So, thanks.

I think there is a crucial factor in the ability to carry out this fixed rate currency policy: what rate does the central bank set? Is it one that is in the neighborhood of fundamental value, or is it way too undervalued? Or even overvalued? It would be a lot easier for the BOJ to defend a ceiling of Y80/$ than Y100/$. The Swiss National Bank action was more akin to adopting a ceiling of, say, Y75 or even Y70. Just because the SNB succeeded in defending a ceiling at an OVERvalued level doesn't mean the BOJ can defend a ceiling at an UNDERvalued level.

CAUTION: The rest of this may bore people not really interested in the ins and outs of currency and monetary policy.

CAUTION 2: This is in the nature of thinking out loud.

We know from experience that ordinary intervention works best when markets have substantially overshot or undershot fundamental values--and when they keep doing so due to "momentum investment" and herd instinct.
Then, intervention is a useful shot across the bow that can lead traders to stop in its tracks and help the market self-correct. By contrast, intervenion, even on the massive size conducted by Tokyo in 2003-04 and again in 2011, tends to fail when it is trying to impose a value too far away from fundamentals, or at least market perception of them.

With that in mind, let's look at the ceiling imposd by the Swiss National Bank vis-a-vis the Euro. This was imposed at a time when the Swiss franc had been pushed up to values far above anything resembling fundamentals. According to OECD estimates of Real Effective Exchange Rates, i.e. exchange rates adjusted for changes in the price differentials with a country's major trading partners, over the quarter century from 1986-2010, the "real" Swiss franc, had spent 95% of its time fluctuating in a range no more than 8% above or below its quarter-century average. But, due to speculation during the Euro-debt crisis, the real Swiss franc shot up during the July-September 2011 quarter to an unprecedented 20%-30% above its long-term average (20% as measured in consumer prices; and 30% as measured using unit labor costs).

Back in the second quarter of 2010, when the OECD put the real SF at its long-term average, the SF traded at an average of 1.25/Euro. At its peak on August 10, the SF equaled 1.03 (as with the yen, the lower the number, the stronger the currency). It then weakened over the following six weeks to 1.205 on Sept. 19. The SNB put the ceiling at 1.20. In other words, by the time, the SNB put on the ceiling, the nominal SF had already WEAKENED14% from its peak, and it had spent only three months stronger than 1.20. By November, it weakened another 3% to 124. But from January 2012 onward, the SF appreciated again to 120 and stayed there. 1.20/Euro is a pretty high level. At that level, the real SF was 10% above its long-term average as measured by consumer prices and 20% above its long-term average as measured by unit labor costs. This is sharply higher price-adusted level than any ever seen between 1986 and
2010 except for brief spell in 1995. 1.20/Euro is higher than any nominal level prior to June 2011. It is 27% stronger than the average 1.53 seen during 2000-2010. It's not as hard to keep the currency from rising higher when you have set a ceiling that is already so far above long-term real and nominal averages. The 1.20 level may have acted as a ceiling as well as a floor. The SNB was NOT challenging fundamentals. It was not pursuing a beggar-thy-neighbor cheap rate. It was not trying to fix a rate that the market thought was unsustainable. It was just telling
speculators: we'll let you seek a safe haven from the Euro-debt crisis and sharply overvalue the SF, but only to a certain degree. By the way, now that fears of the Eurodebt crisis are receding, the nominal SF has weakened to 1.24/Euro..

Now, contrast all this to the yen. Even at its highest nominal level in 2012, the real (price-adjusted) yen was a few percent BELOW its quarter-century average by the OECD's consumer price measure and 14% BELOW its quarter-centuiry average using the OECD unit labor cost measure. Using the Bank of Japan measure (consumer prices), the yen at 90/$ is 15% BELOW its quarter-century average. During 1986-2012, the real yen has spent two-thirds of its time no more than 10% above or below its long-term average. So, suppose the BOJ set a rate at Y100/$. That would be so far below its longterm real value, and such a challenge to its competitors, that, sooner or later, I believe it would be highly likely to invite speculators to challenge it.
If, in a move more like the SNB's, the BOJ put a ceiling at Y75 or Y80, it would have a greater chance of success--at least for a while.

To sum up: just because the SNB succeeded in defending a ceiling at an OVERvalued level doesn't mean the BOJ can defend a ceiling at an UNDERvalued level.

Richard Katz
The Oriental Economist Report