Pretend you’re running a central bank and your primary job is to maintain a stable currency. Then assume that your long-term interest rates are around 1% and an important inflation measure is spiking to near 3%. What do you do?

Normally, you’d raise interest rates to one or two percentage points above the rate of inflation, producing positive real interest rates that encourage saving and discourage borrowing, thus slowing growth and bringing inflation back to a safe level.

But now assume that your federal government’s debt is 260% of GDP. Pushing interest rates up by another 2 percentage points will increase government interest costs by an intolerable 5% of GDP.

So you have two choices: Let your inflation run out of control (i.e., let your currency collapse) or protect your currency and bankrupt your government.

Well, here in the real world, that’s exactly the dilemma facing the Bank of Japan, and they don’t have any more answers than you did in the above hypothetical. Here’s an excerpt from a Wolf Richter report on the situation:

Services Inflation for Japanese Businesses Spikes by Most since 1991, Bank of Japan Gets Lots of Rate-Hike Ammo

The producer price index for services that Japanese businesses buy jumped by 0.82% in April from March, after a similar jump in March from April, according to data from the Bank of Japan. On an annualized basis, both those jumps amounted to just over 10%.

In the data that exclude the consumption tax hikes in the past, the April spike boosted the year-over-year increase to 2.9%, the worst jump going back to 1991.

The fiscal year for Japanese companies begins in April, and many of them adjust their prices at this time, and a big portion of the month-to-month price spikes in March and in April were a result of companies jacking up their prices on services they provide to other companies. They’re now passing on their wage increases.

The services that contributed the most to the year-over-year surge in prices were:

• Civil engineering and architectural services: +7.5%
• Other technical services: + 5.9%
• Training and development services: +6.7%
• Machinery repair and maintenance: +5.5%
• Waste and industrial-waste disposal: +5.1%
• Software development: +4.5%
• Commodities inspection, non-destructive testing, and surveyor certification services: +5.4%
• Leasing of computer and related equipment, communications equipment, motor vehicles, etc.: +5.3%
• Hotels: +22.3%
• Ocean freight: +16.7%
• Domestic air passenger transportation: +10.1%

Businesses that pay for these price increases in services will pass them on to their customers. Wages are a big factor in services inflation. The BOJ has been pointing at inflation in services as a sign that inflation has been spreading throughout the economy – and it has been.

The Bank of Japan has more than enough inflation-related reasons to hike its policy rates with substantial rate hikes, not minuscule-type hikes of the kind it performed in March from negative 0.1% to 0%. Its refusal-to-hike policy in the face of rising inflation has caused the yen to plunge to about ¥157 to $1 currently, as it’s ultimately the currency that ends up dealing with these kinds of monetary sins.

So the yen has to keep falling?

If the alternative is a bankrupt government followed by a plunging currency, it would seem that the best of a bad set of options is to raise interest rates only modestly (if at all) and let the yen go where it goes.

In other words, welcome to the eventual fate of all fiat currencies. And welcome to the solution: