The mystery of the yen's continued depreciation despite narrowing interest rate gap between Japan and the US

The conclusion that “a narrowing interest rate differential leads to yen appreciation” in the foreign exchange market has become invalid. Since 2025, with the U.S. lowering interest rates and Japan raising them, the policy interest rate differential between the U.S. and Japan has shrunk to its lowest level in about three years, yet the yen’s exchange rate has remained around 155 yen per dollar, essentially unchanged since the beginning of the year. Where is the key to unraveling the “mystery” of the yen’s continued depreciation despite the narrowing interest rate differential?

The Bank of Japan will hold a monetary policy meeting on December 18-19 to discuss raising its policy interest rate. The market predicts a 95% chance of a rate hike at the December meeting.

The Federal Reserve Board (FRB) will decide on three consecutive rate cuts at the Federal Open Market Committee (FOMC) meeting in December. If the Bank of Japan decides to raise rates, the policy interest rate differential between the U.S. and Japan will fall to its smallest level in about three years. Currently, the actual interest rate differential has narrowed to its lowest level in about two and a half years. Generally speaking, an increase in Japanese interest rates and a decrease in U.S. interest rates leading to a narrowing of the interest rate differential should result in yen appreciation against the dollar.

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