2026 Reports

Interest Rate Differentials, Exchange Rates, and Inflation: A Bayesian State-Space Approach to Regime-Dependent Pass-Through in Japan

Kobayashi, Minoru

This paper examines how interest rate differentials shape exchange rate dynamics and inflation in Japan within a unified Bayesian time-varying parameter state-space framework. Focusing on Japan relative to the United States since 2016, we distinguish between short-term policy rate differentials and long-term differentials derived from inflation-indexed bond yields, capturing market-based inflation expectations.

We document a pronounced asymmetry between short-term and long-term interest rate differentials. Long-term differentials exhibit a stable relationship with exchange rate movements, whereby a widening differential is associated with yen depreciation, consistent with standard theory. In contrast, short-term differentials display a weaker and often unstable relationship, implying yen appreciation for most of the sample period but becoming temporarily positive during the 2022 episode of monetary policy divergence.

We further show that exchange rate pass-through to inflation is highly time-varying and closely linked to the underlying drivers of exchange rate movements. Pass-through strengthens when exchange rate movements are driven by widening long-term differentials, particularly during periods of monetary policy divergence, while remaining limited in stable periods. Overall, the results indicate that inflation dynamics in Japan are governed by the transmission of interest rate differentials through exchange rates and a regime-dependent pass-through mechanism. The findings highlight the central role of long-term expectations and global financial conditions in shaping exchange rate determination and inflation dynamics. The analysis carries important implications for the evaluation of monetary policy under prolonged low interest rate environments, where transmission mechanisms exhibit significant regime-dependent variation.

Keywords: Exchange Rate Pass-Through; Inflation Expectations; Monetary Policy Divergence; State-Space Model; Japan