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

The long-held belief that “narrowing interest rate differentials lead to yen appreciation” has become invalid in the foreign exchange market. Since 2025, the U.S. has cut interest rates while Japan has raised them, reducing the policy rate gap between Japan and the U.S. to its lowest level in about three years. However, the yen remains around 155 yen per dollar, roughly unchanged from the beginning of the year. What is the key to understanding the “mystery” of the yen’s continued depreciation despite the narrowing interest rate gap?

The Bank of Japan will hold a monetary policy meeting on December 18–19 to discuss raising interest rates. Market forecasts suggest a 95% probability of a rate hike at the December meeting.

The U.S. Federal Reserve (Fed) decided to cut interest rates three consecutive times at the December meeting of the Federal Open Market Committee (FOMC). If the Bank of Japan decides to raise rates, the policy rate gap between Japan and the U.S. will narrow to its smallest level in about three years. Currently, the actual interest rate differential has shrunk to its lowest in about two and a half years. Generally, rising Japanese interest rates and falling U.S. rates lead to a narrowing of the interest rate differential, which tends to cause the yen to appreciate against the dollar.

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