Japan did what economic intuition says should strengthen a currency. On September 18, the Bank of Japan (BOJ) raised its policy rate by 25 basis points to 1.25 percent, its highest level in 31 years. Yet the yen weakened rather than strengthened.
The apparent contradiction offers a useful lesson. Interest rates matter for exchange rates, but currencies do not respond mechanically to whether a central bank raises or cuts rates. They respond to what investors had expected, what they now expect to happen next, and how attractive domestic assets look compared with alternatives elsewhere.
That distinction matters particularly for emerging market central banks such as Bank Indonesia. If policy rates alone determined currencies, stabilizing the rupiah would require little more than adjusting one number. In reality, Bank Indonesia uses a much broader set of instruments. Bank Indonesia has kept its policy rate unchanged while simultaneously using foreign-exchange intervention, rupiah securities, and hedging instruments to support currency stability.
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The textbook mechanism is straightforward. When interest rates rise, domestic financial assets may become more attractive. Higher expected returns can encourage capital inflows, increase demand for the domestic currency, and ultimately support its value.
The mechanism is not wrong. It is simply incomplete. The BOJ’s September increase was widely anticipated. Investors had already had time to adjust bond positions, currency exposures, and expectations before the decision arrived. As a result, much of the information contained in the rate increase had already been reflected in financial prices.
What came afterwards mattered more. Two of the BOJ’s nine board members opposed the increase, while investors found limited assurance that aggressive tightening would follow. At the same time, the US Federal Reserve had also tightened monetary policy, and markets continued to assess the possibility of further increases in US rates. The relative attractiveness of dollar assets therefore remained important.
The lesson is simple. Markets price the path, not merely the point. A central bank can raise rates and still deliver what financial markets interpret as a dovish surprise. If investors expect an increase of 50 basis points but receive only 25 basis points, monetary policy has technically become tighter. Yet compared with what investors had already anticipated, the decision is less restrictive than expected. Foreign exchange markets often react to that gap between expectation and reality.
Interest Rates Are Relative Prices
There is another complication. Investors rarely ask whether one country’s interest rate is high in isolation. What matters is whether expected returns in that country are becoming more attractive relative to opportunities elsewhere.
Japan’s rate rising from 1 percent to 1.25 percent may have very different implications depending on what is happening to US or European yields. Inflation expectations also matter because nominal returns can be eroded by rising prices. Hedging costs, growth prospects, and perceived risks further influence the actual return received by international investors. This means that exchange rates are influenced by the expected return on domestic assets relative to foreign assets after accounting for inflation and risk.
A country can therefore raise interest rates while its currency remains under pressure if foreign yields rise faster, inflation expectations deteriorate, or investors demand a larger risk premium. Currencies are prices of expectations.
Indonesia Shows Why One Instrument Is Not Enough
Indonesia provides the other side of the story. Bank Indonesia has kept its policy rate unchanged while continuing to place rupiah stability among its policy priorities. Yet an unchanged BI rate does not mean that the central bank is inactive in the foreign exchange market.
Bank Indonesia uses several channels simultaneously. It conducts interventions through offshore non-deliverable forward markets as well as domestic spot and domestic non-deliverable forward transactions. It also uses Bank Indonesia Rupiah Securities to influence the attractiveness of rupiah assets and support portfolio flows. Hedging facilities can further reduce some of the currency risks faced by investors.
There is an important economic logic behind this policy mix. Consider a situation in which pressure on the rupiah comes from rising US yields and a stronger dollar rather than from excessive demand within Indonesia. Bank Indonesia could respond by increasing its policy rate. A higher interest rate might make rupiah assets more attractive and support the exchange rate. But such a decision would not affect foreign investors alone.
Higher domestic interest rates can eventually influence funding costs, lending rates, investment decisions, and household borrowing. A manufacturer considering the expansion of a factory, a household planning to buy a home, or a small business depending on bank financing could end up bearing part of the adjustment cost.
That creates a difficult question for every emerging market central bank. How much domestic economic activity should bear the cost of responding to an exchange rate shock that originated abroad?
Sharing the Burden
This does not mean that foreign exchange intervention, monetary securities, or hedging instruments can replace the policy rate without cost. Foreign exchange intervention cannot permanently reverse economic fundamentals. Monetary instruments that offer attractive returns can affect liquidity and broader financial conditions. Hedging facilities reduce particular risks, but they cannot eliminate concerns about inflation, fiscal conditions, or the underlying strength of an economy.
If persistent currency depreciation eventually threatens inflation expectations, the policy rate may still have to respond. The policy rate influences aggregate demand, inflation expectations, and the overall stance of monetary policy. Foreign exchange operations can deal more directly with liquidity and excessive volatility in currency markets. Monetary instruments can influence incentives for portfolio allocation. Hedging facilities can reduce the exchange rate risk faced by international investors.
Using several instruments allows a central bank to distribute the burden of adjustment rather than forcing every problem through a single interest rate. That distinction matters because excessive reliance on the policy rate can create second-order consequences. Repeatedly raising interest rates primarily to support the currency can eventually weaken credit growth and investment. Yet allowing persistent depreciation to continue unchecked can increase imported inflation and destabilize expectations. The policy challenge is finding a combination of instruments that reduces the economic cost of preserving both.
The Price of Expectations
Japan’s experience shows why a rate hike does not automatically strengthen a currency. What matters is whether the decision changes market expectations about future returns, inflation, and risk.
The same lesson matters for emerging economies such as Indonesia. Exchange rate stability cannot rely on the policy rate alone. It depends on how interest rate policy, foreign exchange operations, market instruments, and communication work together to shape expectations and maintain confidence. In the end, currencies respond not only to what central banks do today but also to what markets believe those decisions mean for tomorrow.
