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(Bloomberg) — Something’s stirring in the world’s fourth-biggest economy. After decades of growth slow enough to make deflation the central bank’s biggest worry, Japan’s prices and wages are rising. Its stock market, too. Even interest rates have gone up for the first time in 17 years — they’re actually slightly positive now.

It’s a hint of the return to normal the Bank of Japan has been trying to engineer after a quarter-century of unusual policies aimed at stoking inflation — and the stronger economy that usually comes with it — rather than crushing it. But the BOJ’s reaction to this change has been cautious, and the price of its slow pivot has been a weak yen.

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To keep the yen from dropping too sharply, Japan’s authorities appear to have taken action in global currency markets. (Officials don’t comment on interventions until data is out at the end of each month.) A more obvious solution would be to raise interest rates further — to literally make owning the yen pay better. But before doing that, the BOJ wants more proof that consumers and companies are ready to shed cozy, lackluster stability for riskier opportunities and potential growth. This economic liftoff could be bumpy.

1.  Why the Yen Is Weak

Japan Is Still DifferentThe main measure of the yen’s value is against the US dollar. The BOJ has finally joined the Federal Reserve in tightening monetary policy, but the US and Japan remain miles apart on interest rates. Japan’s 0.1% short-term rate — up from minus 0.1% — compares with the Fed’s 5.5%. Those rates set the baseline for bond yields and expected future asset returns in both countries. For global investors, US assets look far more attractive. That also means they want dollars more than yen.

BOJ Governor Kazuo Ueda would like to go slow on raising rates further. Inflation in Japan has run above the central bank’s target of 2% for more than two years, but that seems like a drop in the bucket compared with an average of only 0.1% in the first two decades of the century. Ueda wants an abundance of evidence to show that price growth is here to stay. Previous attempts to return to normality — including a move in 2000 that Ueda as a board member voted against — proved too rapid and buckled both the economy and prices.

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Traders Are Focused on the FedCurrency market traders are waiting for the Fed to move instead. A US rate cut is widely anticipated this year, and a standard move of a quarter of a percentage point down would be bigger than the 0.15-percentage-point hike that markets expect from the BOJ. All things being equal, looser US policy should weaken the dollar and boost the yen. The trouble is, US growth and prices have been stronger than expected this year, so rates may not drop as quickly or as soon as many had hoped. Those recalibrated market expectations helped drive a sharp drop in the yen in April.

2. How Life in Japan Is Changing

Inflation Is Losing Its StigmaThanks in part to the weak yen raising import costs and the global inflation snapback after Covid-19, all kinds of prices are going up for the first time in more than a generation. At first businesses tentatively announced price increases in national newspaper ads that were apologetic in tone. Now many of them are just getting on with it. Consumers who used to take their business elsewhere are finding they have to swallow rising costs. But as businesses and households emerge from their static price paradigm, small cracks are appearing in Japan’s edifice of economic stability.

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The Social Contract Is Being RevisedMany Japanese workers have enjoyed the security of lifetime employment. Companies squirreled away money for a rainy day instead of bumping up pay, enabling them to avoid layoffs when times got tough. Now workers whose wages have lagged behind inflation for the past two years are demanding higher pay. And with Japan’s declining population amplifying a shortage of labor, companies have to get more competitive on salaries for the first time in decades.

The higher wages will drive up personnel costs, putting further upward pressure on prices. That cycle is what the BOJ is looking for when it targets stable and positive inflation. It may favor the more flexible and talented workers in Japan while leaving the rest with less job security as companies revisit their commitments. But a yen that falls too sharply, adding more pressure from rising prices for imports and higher costs throughout supply chains, could make that adjustment more painful than the BOJ wants.

A Tale of Two TouristsIt’s good to be a visitor to Japan. The halving of the exchange rate against the dollar since 2012 has converted the country from an out-of-reach bucket list destination to a low-cost sightseeing and shopping spot for more than 3 million visitors a month. That influx is bringing money into the regions and helping hotels, restaurants and the service sector. The Japanese tourist abroad is having less fun: In terms of per capita dollar income, individuals in Japan are no better off than they were in 2002. That makes a Broadway show expensive.

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3. It’s a New World For Corporate Japan, Too

There’s Pain and ProfitThe weak yen has largely split companies into two camps. Big exporters or globally focused companies are raking in record profits when their overseas earnings are calculated in yen terms. Domestically focused firms reliant on imported materials are suffering a squeeze. The world’s biggest carmaker, Toyota Motor, video game maker Nintendo and Uniqlo apparel operator Fast Retailing are among the stocks that have returned Japanese equities to levels last seen during the nation’s heyday in the late 1980s, when Japan seemed on track to become the world’s largest economy.

But business groups are getting increasingly uncomfortable about the disconnect between overseas profits for some big players and the strain on the majority of companies at home. The head of the nation’s chamber of commerce is calling for the yen to be guided back up.

Reshoring and ‘Friend Shoring’ Make Sense NowA cheaper yen is giving Japanese manufacturers a reason to reconsider where they build factories after years of looking overseas. Domestic production in Japan has slipped by around a quarter since the global financial crisis, so a cheaper currency may stem that slide. The country is also becoming a more attractive destination for foreign businesses looking to set up production in a reasonably priced location in an allied economy. With an extra nudge from government subsidies, chipmakers including Taiwan Semiconductor Manufacturing Co. and Micron Technology Inc. are building capacity in Japan.

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4. The Yen in the Long Run

Keep an Eye on That DebtJapan already uses up a quarter of its annual budget to service debt equivalent to more than 250% of the size of the economy. This mountain of obligations suggests yen weakness is here to stay; raising interest rates too quickly would be too expensive for the government. Already the finance ministry sees debt-handling costs rising by a quarter in the next three years, to more than $225 billion annually. Still, the BOJ has some room to operate: More than half of the nation’s debt is owned by the central bank and most of the remainder by Japanese institutions or investors, so it’s more plausible to keep government bond yields low in Japan than in economies reliant on foreign investors.

Demographics Are RelentlessAlmost 30% of people in Japan are at least 65 years old, and the share is growing all the time. Fewer and fewer people, then, are working to support a larger segment of the population on pensions or needing health care. That puts further strain on the nation’s finances and limits the prospects for economic growth — another factor that could hold down the yen.

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Disasters and Geopolitics Play a RoleThe tsunami that wiped out the Fukushima nuclear power plant in 2011 frightened the nation and prompted a shift toward other sources of energy, including coal and liquefied natural gas. That change weighs on the currency because buyers have to sell yen when they purchase those imported commodities. With North Korea’s provocations and China’s increasing assertiveness over Taiwan and the South China Sea, Japan is also looking like a somewhat less secure place to park money for safekeeping than it used to be. A Bloomberg survey in May showed 78% of respondents feel the yen is no longer a haven currency.

5. Meet the Traders

So far we’ve discussed the big macro factors affecting the yen. But on a daily basis, foreign currencies are moved by traders and investors making bets in the $7.5 trillion-a-day global market. The Japan bet everyone loves is called the carry trade. Because rates in Japan are so low, investors can borrow cash cheaply there, then convert it to other currencies and lend — or hold bonds — at other countries’ much higher rates.

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The yen-dollar carry trade is the classic: Borrow yen for almost nothing, and lend dollars at more than 5%. But there are spicier plays in riskier emerging-market currencies. Yen-funded carry trades against eight emerging-market currencies have netted almost 60% gains since the start of 2022.

That’s helped make selling the yen a hot bet. Speculative hedge funds and asset managers recently ratcheted up short positions against the yen to a record level. And they aren’t just betting against the yen versus greenbacks or emerging-market currencies. The euro is stronger than it’s ever been against the yen, whereas Australia’s and New Zealand’s dollars are at multiyear highs. The success of yen short trades can create a vicious cycle: The more popular such strategies get, the more people have to borrow yen to sell the currency.

6. What’s the Fallout Beyond Japan

The weakness of the yen isn’t only a Japan story. It matters for Japan’s global trading partners — including the US, whose consumers like cheaper goods, but which also worries that a too-strong dollar could make its companies less competitive. More important, further plunges in the yen could concern Japan’s neighbors. Exporting rivals South Korea, Taiwan and especially China might feel pressure to let their own currencies slide to keep their prices competitive on global markets. Although most market observers think an all-out Asian currency war is unlikely, the risk of competitive devaluation can’t be ruled out.Carson covers currencies from Singapore. In Tokyo, Fujioka reports on the Bank of Japan, and Jackson leads coverage of Japan’s economy and government.

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