What an Absence of High Inflation Means for Currencies

April 20, 2012

Economists and investors see different primary economic threats.  In the marketplace, a high level of fiscal deficit phobia continues.  The fear is that fiscal excess accommodated by low central bank interest rates will produce accelerating inflation.  Elevated commodity prices may constitute the foothills of that trend, and the pessimists also note that many emerging economies have begun to experience rising core inflation, too.  Economists by and large remain more worried that synchronized macroeconomic austerity around the world will cause already deficient growth in demand and production to become more so.  Annual growth in the volume of world trade, according to the IMF, will average only 4.8% in 2012-13, down from 5.8% in 2011 and 12.9% in 2010.  Real GDP in the advanced economies is projected to rise even less this year (1.4%) than in 2012 (1.6%) and to recover only to 2.0% in 2013.  Last year’s inflation rate of 2.7% for those economies is expected to slow to 1.9% in 2012 and 1.7% in 2011.

In a truly inflation-prone world, governments and central banks would be resisting currency weakness to contain import costs, but that isn’t happening among advanced or developing economies.  On the contrary, numerous authorities from Japan to Switzerland, Australia, New Zealand, and Brazil are speaking out in favor of less currency strength and threatening concrete steps if currency strength persists.  The Bank of Canada hints that it may resume tightening, but at the same time observes persistent strength in the loonie, which earlier influenced the decision to pause rate normalization. 

In the past when advanced nations with freely traded currencies had widely diverse rates of inflation, those with less internal price pressure also tended to have healthier current accounts, and those comparative advantages often were associated with currencies that trended higher.  It’s been a long time, however, since inflation spreads were a currency market driver in a direct sense.  Indirectly, the market player is apt to link the threat of inflationary pressure with a tightening bias in monetary policy and to assume that policy reaction will drive a currency upward.  This cause-and-effect sequence is alas much more common in theory than in fact.  Dramatic Fed tightening in 1994, for instance, was juxtaposed against equally remarkable dollar depreciation.

Central banks around the world have lately transmitted different messages about their policy intentions.  Many are playing the pro-growth card.  The Fed is predicting that a higher Federal funds rate before late 2014 is unlikely.  Plus, Fed Chairman Bernanke has left the door open to possible fresh quantitative relief in the second half of this year should U.S. growth or inflation undershoot expectations.  The Bank of Japan has dropped various hints of new stimulus to be announced after its meeting a week from today.  The Reserve Bank of Australia has encouraged speculation that it may ease in May.  New Zealand monetary authorities have opined that “sustained strength in the kiwi would reduce the need for future increases in the officials cash rate.”  BRIC monetary authorities have exhibited various dovish colors: the Brazilian Selic rate has been lowered 200 basis points already this year, the Reserve Bank of India just cut its key interest rate for the first time in three years, Russian rates are lower than six months ago, and China’s central bank could relax policy this coming week.  Other central banks that have provided additional stimulus since December can be found in Sweden, Turkey and The Philippines.  The Swiss National Bank’s policy remains committed to doing whatever is needed to keep the franc weaker than 1.2000 per euro.

The Bank of England expanded quantitative easing in February, but minutes from its April meeting voiced new concern about the inflation outlook and thus dampened prospects for an announcement next month of a further stimulus next month.  The European Central Bank doesn’t plan a third multiyear refinancing operation and effectively placed the burden for strengthening growth back on the governments. Canada’s more hawkish statement this past week contrasted with the dovish signals from the Reserve Bank of Australia and New Zealand.  Singapore is the sole Asian central bank to tighten in the past two months. 

Some currency movement over the past five weeks has conformed to contrasting monetary policy signals, but other situations have not.  Theory would suggest the wisdom of buying the currencies of Britain, Singapore, and Canada but selling yen, Swiss francs, Aussie dollars, and the Brazilian real. The Canadian dollar has strengthened since March 16 by slightly more than 2% against the Aussie dollar, where a rate cut in May looks more than plausible, but only about 0.5% versus the kiwi where only delayed tightening is in prospect. Sterling has strengthened some 4% against the euro from a low of 0.8505 per euro on February 24.  The euro has repeatedly received support above $1.3000, defying predictions that it is headed for the low 1.20s.  On the other hand, the yen and Swiss franc have retained a resilience that defies government guidance.  Dollar/yen fell about 2% this past week, and the Swissie has been hovering around the 1.2000 per euro target ceiling.

Without the simplistic conformity of currency action to a few basic rules of thumb, market behavior has settled into a choppy of a risk on-risk off metric, where momentum is only as old as the latest news headline regarding euro debt, corporate earnings, or any number of political tugs-of-war.  The ping-pong match of risk on, then off, then on again is no substitute for a real theme that might actually deliver cumulating directional movement.  In 1973 after the birth of floating dollar rates, the U.S. currency swooned over 20% from DEM 2.90 in early March to DEM 2.20 four months later yet managed to recover all those losses later in the year.  Likewise, the dollar recorded a 20-pfennig, 6%+ drop against the German currency between a Friday and following Monday in September 1984, and it also fell from JPY 264 to JPY 200 over the last eight months of 1980.  The scope for movements of such magnitude seem forever gone even in a world where the demise of the euro is one possible outcome.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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