Yen weakness is usually attributed to the interest rate gap with the US; as long as the Federal Reserve (Fed) maintains higher rates than the Bank of Japan (BoJ), carry trades keep the Japanese currency under pressure. While true, this explanation is incomplete. Exchange rates reflect not only interest rates but also inflation and central banks’ willingness to respond to it.
Viewed through that lens, the key question is not the inflation differential itself, but which central bank is furthest from its own Taylor rule, or put differently, which is more complacent. Since March 2026, that distinction has shifted. The Fed has remained on hold as oil-driven inflation moved above target, making it the more complacent of the two. The question for Simply put, therefore, is not whether Japanese inflation will rise, but how much of that inflation the yen will be forced to absorb.
Read more: Higher real yields and the reaction function of central banks
How currencies price inflation: the theory
The purchasing power parity puzzle (PPP) is a good starting point. Deviations from PPP are large and persistent over short horizons, yet the relationship reasserts itself over the long run, as documented in Rogoff (1996)1 and refined by Imbs, et al. (2005)2. A second area of research ties exchange rates to expected fundamentals rather than current ones: Engel and West (2005)3 showed how currencies work as a financial asset, pricing the expected values of their fundamental factors, including future rate expectations (those rate expectations are closely tied to expectations of future policy rates).
This is where monetary policy rules enter. John Taylor’s research4 introduced a simple way to gauge whether a central bank is ahead or behind its objectives – notably inflation. Combining the two areas yields the hypothesis tested here: if exchange rates price expected policy, then the effect of inflation on a currency should depend on whether the respective central bank is expected to fight that inflation or tolerate it. Time to look at the data.
Two central banks, one yardstick
Figure 1 compares Fed and BoJ policy rates to their respective estimates of the classic Taylor rule. Two facts stand out and they are not symmetric:
- Behaviour: Figure 1 shows the Fed’s long-run response to inflation is close to one-to-one, the classic Taylor prescription, while the BoJ’s is a fraction of that, regardless of the specification. One reaction function closes inflation gaps; the other mostly waits them out. This is consistent with the Japanese search for an exit from Japan’s long zero-inflation period
- Position: The distance between the observed rate and the rule measures complacency or how far a central bank stands from its own norm – and this distance changes. Throughout most of 2023-2025, the Fed sat closer to its rule than the BoJ: rates had been raised into restrictive territory while Japanese policy stayed below a rule that asked for little. In March 2026, this ranking flipped.
Oil prices, lifted by the Iran conflict, raised US inflation back above 3% while the Fed continued to hold rates; the BoJ, meanwhile, kept tightening into an inflation rate drifting back toward target. By this yardstick, and for the first time since late 2022, the Fed is now the more complacent of the two central banks.
FIG 1. Fed policy rate vs Taylor rule and BoJ policy rate vs Taylor rule5
Complacency is a switch, not a factor
Does this policy gap constitute an independent driver of the exchange rate? Tested directly, no. Relative prices and the rate differential explain 44% of the variation in the level of USD/JPY since 1995. Adding the spread of Taylor deviations lifts that figure by a single point, and once both the exchange rate and the spread are stripped of the effects of relative prices and the rate differential, the residual link is statistically indistinguishable from zero.
Whatever information the Taylor spread carries, PPP and the carry already price it. The role of complacency is subtler, and the chart in Figure 2 isolates this: it conditions the sensitivity of the exchange rate to inflation itself. When the Fed is less complacent than the BoJ, the USD/JPY’s sensitivity to relative inflation is mildly positive: higher US inflation raises expectations of Fed tightening, supporting the dollar. When the Fed is the more complacent central bank, the relationship reverses. The sensitivity becomes negative and several times larger, as inflation that is not credibly challenged is treated as currency debasement. In that regime, markets enforce the PPP adjustment far more aggressively. The near-zero average masks the combination of two distinct and well-represented regimes. Inflation itself does not determine a currency’s path; the central bank’s response to it does.
FIG 2. USD/JPY inflation beta by central-bank complacency6
Oil, inflation and the yen
The current framework points to a clear conclusion. An oil shock is global, but its inflationary impact is not evenly distributed. Japan imports almost all of its energy and pays for it with a currency that has already weakened, while the US is a net energy producer. As a result, higher oil prices are likely to firm Japanese inflation more than US inflation, narrowing the US-Japan inflation gap from the Japanese side.
Under normal conditions, such a relative inflation shock would only have a limited impact on the yen because the long-run relationship between inflation differentials and exchange rates is weak. However, this is not a normal regime. With the Fed accommodating above-target inflation, markets are attaching greater weight to inflation differentials than usual. That makes the yen more sensitive to a rise in Japanese inflation, even if the BoJ continues to tighten policy.
Read also: Why are long-term bond yields rising?
The key point is that the strength of this channel depends less on the BoJ than on the Fed. When markets perceive Fed policy as falling behind inflation, relative inflation shocks have a larger effect on USD/JPY.
A second asymmetry reinforces the story. Higher energy prices feed into persistent inflation only when businesses cannot offset rising costs through productivity gains. With productivity growth currently stronger in the US and largely stagnant in Japan, the same increase in oil prices is likely to generate more persistent inflation pressure in Japan than in the US.
Simply put, rising Japanese inflation combined with a complacent Fed creates a negative backdrop for the yen. While stronger productivity growth can help the US absorb an energy shock without generating persistent inflation, Japan has less capacity to offset those pressures.
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Preference Centre
Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Our growth nowcaster strengthened significantly this week, with both the US and eurozone signals rising above the 50% threshold
- Our inflation indicator declined marginally, while remaining in the high and rising regime
- Our global monetary policy nowcaster increased this week, driven primarily by the eurozone, due to improving employment data.
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
