The rally in dollar/yen this year to over 150 left the yen at its weakest level against the dollar for over 30 years.

The rally in dollar/yen this year to over 150 left the yen at its weakest level against the dollar for over 30 years. But even this understates the true extent of the yen’s fall. But does it follow that forecasters are understating the extent to which it could recover against the dollar next year and beyond?

Why do we make this claim that the yen is actually much weaker than the moves in the dollar/yen this year would have us believe? Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said it is because the true measure of a currency’s value is to be found in its real (inflation-adjusted) trade-weighted index, not its nominal level against one currency (the dollar). Coincidentally, the real value of the dollar has not been this high since the mid-1980s. In other words, if we want to measure the true gain in Japanese competitiveness relative to the US, we should not go back to 1990, when dollar/yen was last above 150, but to the mid-1980s, or even as far back as the 1970s.

From this, we could argue that the yen has a huge amount of ground to make up, and hence we should be thinking in terms of the dollar/yen falling dramatically over the next few years, perhaps to 100 again or even lower. However, we might want to show some caution here. The reason for this relates to the usefulness of these measures of currency overvaluation and undervaluation.

As far as we can tell, many analysts would argue that currencies as undervalued as the yen against the dollar will rebound in time. This scenario basically envisages that Japan has gained so much competitiveness against the US through the fall in the nominal exchange rate and its superior inflation performance that trade balances will adjust and lift the yen over time.

Predominantly, this purchasing power parity (PPP) theory envisages that the direction of causation goes from inflation to currencies with persistently high inflation that tend to weaken over the long haul, while currencies where inflation is low will recover if they spend time being undervalued.

However, Mr. Steve Barrow thinks that any causation probably tends to go the other way around. Specifically, countries with persistent currency strength adapt to the loss of competitiveness caused by a persistently good inflation performance.

Likewise, countries with persistent currency weakness tend to lean more on the competitiveness gained by presiding over relatively high inflation. In other words, the exchange rate plays a large role in dictating inflation. In Japan, Mr. Steve Barrow thinks he sees this because, up until recently, the yen has been a strong currency, and that’s been ingrained in the psyche of consumers and firms such that inflation expectations stay very low—perhaps too low.

In Mr. Steve Barrow’s view, it is no coincidence that countries that have traditionally seen significant currency strength in the past, like Japan and Switzerland, have seen a far more modest rise in inflation than other countries over the past year or so. With this in mind, he is very wary of the idea that undervalued currencies will "naturally" correct themselves in the way that traditional PPP-type analysis would suggest. However, there is a caveat, and this relates to FX intervention.

If the currency concerned becomes so undervalued or overvalued that it provokes FX intervention, as we saw from the BoJ earlier in the year, then the extent of this currency misalignment may be of some significance. It might have taken a while, but the yen-buying intervention by the BoJ earlier this year does seem to have helped turn the dollar/yen around.

But will the BoJ continue to intervene from here? And, if it does not, will the dollar and yen continue to fall?Mr. Steve Barrow said the answers to these two questions are "no" and "possibly not." Of course, much depends here on the general sentiment towards the dollar, and, as this is becoming more bearish, it seems, the outlook does appear to be for the dollar/yen to fall further. But will it quickly correct the undervaluation that has built up over the past year, or so? Probably not.