What Divergent Monetary Policy Biases Suggest…. Or So We’re Told
June 12, 2014
Students are taught that unsynchronized monetary policies promote currency volatility. For bored currency market watchers, it ought to be heartening to see significant divergences among the major central bank policy biases for the first time since the European Central Bank raised interest rates in July 2008. Now it is the ECB whose stance is most skewed toward additional accommodation. The ECB last week cut each of its key interest rates and became the first central bank to test a negative rate. Targeted longer-term refinancing operations were unveiled to encourage greater bank lending, and more serious consideration of quantitative stimulus was implied. In the meantime, the Fed is engaged in a controlled, gradual phase-out of its quantitative easing. The Bank of Japan is in the second year of aggressive asset buying to grow its balance sheet, and the Bank of England has shifted its policy bias from more stimulus to readying for normalization. Officials at the Reserve Bank of Australia thinks it prudent and appropriate to retain the record low 2.5% interest rate, while their New Zealand counterparts have hiked their Cash Rate three times since March. The Swiss National Bank leadership has subordinated domestic interest rate policy to an exchange rate target that since September 2011 has prevented the franc from strengthening beyond 1.2000 francs per euro.
Alas, currencies have hardly responded to the shifting monetary policy biases. Take the euro, for instance. The common European currency has only dipped 0.5% against the dollar since the day before last week’s ECB policy changes, and it shows a 0.8% net advance over the past half-year. That’s an awful start as a tool to lift inflation back toward target, which lies more than a full percentage point above the current level. President Draghi has estimated that a 9% trade-weighted euro decline would boost inflation just 0.4-0.5 percentage points, and trade-weighted movement generally runs below movement in EUR/USD. Other factors being the same, the euro would need to weaken about twice as much in the future as it has strengthened over the past two years to restore inflation to acceptable levels.
In addition to EUR/USD, net dollar changes since the end of 2013 amount to less than 3% against the yen, Swissie, sterling and yuan. The dollar has recorded identical 5.3% year-to-date losses against the Australian and New Zealand dollars since December 31 in spite of the different policy stances of the Australian and New Zealand central banks.
The correlation between monetary policy stances and currency movements is not mechanically automatic. It never was. For one thing, interest rates are but one of many determinants of foreign exchange rate values. For another, monetary policies are evaluated by investors relative to what is believed to be most appropriate. Officials at the ECB just took a number of steps to promote faster growth in bank lending and to guard against deflation and falling expected inflation. Such action should have been done quarters, if not years, ago. The governing council still hasn’t undertaken quantitative easing, rejecting the medicine that officials at the Fed, Bank of England, and Bank of Japan took some time ago. Going back to the Trichet era, ECB authorities have argued that they understood better than other central bankers the limitations of monetary policy, that the euro economy is more inflation-prone than others where policy stimulus had been greater, and that the possibility of Euroland slipping into a deflationary state is vastly over-rated. Moreover, President Draghi and his cohorts have acquired a reputation of throwing verbal policy guidance at the market but dragging their feet on actual policy accommodation. Only now will weekly refinancing operations not be sterilized, and the hint of using quantitative easing if and when required had been offered several times before last Thursday.
The seeds of the ECB’s reluctance to stimulate are now being sown. That central bank caught a bad break from having such a predisposition at a time of very subdued global inflation, but the excuse that other countries also have low inflation lacks validity. Euroland’s 0.5% on-year rise in consumer prices is well below Japan’s 3.4%, China’s 2.5%, America’s 2.0% or Britain’s 1.8%. Euro area inflation has plunged from 1.4% in the year to May 2013, and the drop is not an energy story. Energy inflation actually rose from -0.2% to zero. Non-energy consumer price inflation fell to 0.6% from 1.6%, aided by extensive disinflation in the cost of both services and non-energy industrial goods. Within the euro area, Greece, Cyprus, Slovakia and Portugal already are experiencing deflation. Since its harder to end deflation than to reduce inflation, it’s at least as likely that deflation in these countries will spread to other members with positive, but low, inflation, than to see a dynamic working in the opposite direction.
Keep in mind, too, that the monetary policy gaps among advanced economies is in fact less than the divergence in stated medium-term policy bias. Every advanced economy central bank is running a very accommodative policy. At the soonest, it will be close to another year before the Federal Reserve funds rate is increased. Inflation differentials are not as wide as they’ve been in the more distant past, nor are the discrepancies in economic growth large enough to power sharp, unidirectional swings in key dollar rates. In the first calendar year of floating dollar rates, which didn’t commence until March, the mark managed to rise some 70 pfennigs, more than 30%, but subsequently reverse that entire upswing. A dozen years later, the dollar lost half its value in less than three years against the yen and mark. That kind of volatility is a distant and almost forgotten memory.
Copyright 2014, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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