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Why is the yen so strong?

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Kim Kyung-Hoon/Reuters

(Read caption) A man places Japanese yen on a counter to exchange for U.S. dollars at an exchange booth in Tokyo, Sept. 16. The Japanese prime minister signaled that Japan was ready to keep intervening to curb gains in the yen, as a deterioration in manufacturing confidence underscored the threat of a strong currency to the fragile economic recovery.

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After having had a "hands off" approach since 2004, the Japanese government intervened in the currency markets again today following new record highs for the yen against the U.S. dollar. Even though they didn't specify the amount, the yen still dropped some 2% after the announcement.

There are two causes for the strong yen. The first is the persistent deflation in the Japanese economy. While British consumer prices rose by roughly 3% and while they rose by 1-2% in the United States and the Euro area, they fell by roughly 1% in Japan.

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Deflation first of all causes the relative purchasing power of the yen to gradually rise, and secondly given the fact that most central banks have near zero short term nominal interest rates, real interest rates are in fact higher in Japan than in most other countries.

The second reason is the increased safe haven demand caused by the European debt panic and the slowdown in the U.S. economy.

As long as these factors persist, it will be difficult for the Japanese government to really reverse the trend. The Swiss central bank has spent enormous sums to stop the franc from appreciating yet failed to do more than slow the gains.

UPDATE: Tim Duy discusses an interesting aspect of the "safe haven" factor that I mentioned, namely that much of that buying is made by the Chinese central bank. It would be interesting to see to what extent the Swiss franc's appreciation is caused by purchases by China and other governments.

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