On 18th September 2026, the Bank of Japan raised interest rates to 1.25%, their highest level since 1995. Yet the yen fell rather than strengthened, briefly reaching around ¥158 to the dollar1. For a country attempting to contain inflation without derailing an already fragile recovery, this was an uncomfortable outcome. The conventional relationship between interest rates and exchange rates appeared to be breaking down precisely when policymakers needed it most.

The weakness of the yen is not a new problem. For years, Japan maintained exceptionally low interest rates to stimulate an economy struggling with sluggish growth and weak domestic demand. While the United States and other major economies raised borrowing costs to combat inflation, Japan moved much more cautiously. The resulting gap between Japanese and American interest rates made dollar-denominated assets comparatively attractive, encouraging investors to sell yen in favour of higher-yielding alternatives.

But the consequences have extended well beyond currency markets. Japan imports much of the energy and raw materials it consumes, meaning a weaker yen raises the domestic cost of goods priced in dollars. Oil, gas and imported food become more expensive even when their international prices remain unchanged. For Japanese households, already facing pressure on their purchasing power, currency depreciation has effectively acted as an additional tax on consumption.

Yet a weaker yen is not necessarily bad for everyone. Japanese exporters can benefit because their products become cheaper for overseas buyers, while profits earned abroad translate into more yen when brought home. Tourism can also become more attractive to foreign visitors. However, these gains are unevenly distributed. Large exporters may benefit from currency depreciation while smaller businesses, which rely on imported inputs, face rising costs. Households cannot easily escape higher food and energy prices simply because some Japanese companies are earning more overseas.

This is what makes Japan's position particularly difficult. The Bank of Japan must weigh the need to support the currency against the risk of raising borrowing costs too quickly. Higher interest rates could make yen-denominated assets more attractive, narrowing the gap with American returns and discouraging investors from selling the currency. But they would also increase borrowing costs for households and businesses, potentially weakening investment and consumption.

The problem is that even raising rates does not guarantee a stronger currency. Investors respond not only to the current interest rate but also to what they expect policymakers to do next. If markets believe American rates will remain comparatively high, or doubt Japan's willingness to tighten policy further, a modest Japanese rate increase may do little to change investment decisions. The yen's decline following September's rate rise illustrated precisely this problem1.

Japanese authorities have also turned to direct currency intervention, purchasing yen using foreign currency reserves in an attempt to slow its depreciation. But intervention cannot permanently reverse the forces driving a currency lower. It can make speculative bets against the yen more expensive and discourage disorderly movements, yet sustained weakness caused by differences in interest rates and global demand is harder to overcome2.

The pressure has become increasingly visible in the domestic economy. On 9th October, the government reiterated that it was monitoring exchange-rate movements and inflation closely3. Meanwhile, Japanese household spending fell by 3.1% year on year in August, marking its ninth consecutive monthly decline4. The figures underline the difficulty that policymakers face: a currency that may support exporters is simultaneously squeezing consumers and complicating the country's recovery.

There is a broader lesson here about the limits of monetary policy. Exchange rates are often discussed as though they respond mechanically to interest-rate decisions. In reality, they reflect expectations about future policy, relative economic performance and the willingness of global investors to hold a particular currency. A central bank can change the price of borrowing, but it cannot independently control how international markets interpret that decision.

Japan's experience also challenges the assumption that a weaker currency is an effective shortcut to economic growth. Depreciation can improve competitiveness, but its benefits depend on the structure of an economy and how quickly businesses can respond. When a country relies heavily on imported energy and raw materials, currency weakness can transfer income away from consumers and import-dependent firms before exporters have time to expand production.

Ultimately, Japan is not simply fighting a falling currency. It is confronting the consequences of trying to normalise monetary policy after years of exceptionally low interest rates, while protecting households from imported inflation and preserving a fragile economic recovery. These objectives are not always compatible. The yen's decline despite higher interest rates is therefore more than a currency-market anomaly. It is a reminder that policymakers cannot always engineer the economic outcomes they want by changing a single price. Sometimes, the cost of restoring confidence in a currency is borne by the very households that monetary policy is supposed to protect.

Footnotes

  1. Financial Times, Yen sinks after Bank of Japan raises rates to highest level since 1995 (opens in a new tab), 18th September 2026. 2

  2. Bank of Japan, What is foreign exchange intervention? Who decides and conducts foreign exchange intervention? (opens in a new tab).

  3. Reuters, Japan PM vows to keep watching yen, inflation moves carefully (opens in a new tab), 9th October 2026.

  4. Reuters, Japanese annual household spending drops for 9 straight months (opens in a new tab), 9th October 2026.