Asset management

24 September 2012

Economist Insights Loose or lose
The introduction of open-ended QE by the Federal Reserve has led to devaluation of the US dollar. The US is a relatively closed economy so the trade benefits for the US economy from such devaluation are limited. For other more open economies, the exchange rate impact of monetary policy can be significantly more important. Hence it is no surprise that many central banks have announced or are expected to announce policy loosening in the coming months. While the decline in USD relative to their own currencies might not be the official reason, it is likely to be a strong incentive. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management

Gianluca Moretti Fixed Income Economist UBS Global Asset Management

When the Federal Reserve introduced open-ended quantitative easing (QE), it did so with the intention of signalling its commitment to do whatever is necessary and of pushing investors out of safe assets into risky assets. It did not expand QE with the aim of depreciating the US dollar (USD), but this was always going to be one of the effects. When the Fed pushes yields down through QE, it decreases the relative attractiveness of US fixed income assets compared to similar assets in other countries. This will lead some investors to sell their US fixed income assets and buy those similar assets elsewhere. This transaction means that they are selling USD in order to buy foreign currency and this puts downward pressure on USD. Another way of thinking about it is simply that when the Fed prints money it increases the supply of USD. For a given level of demand, increasing the supply of dollars relative to the supply of other currencies is going to reduce the value of USD. A drop in the dollar is useful for US exporters because it makes their products cheaper for foreigners, and also beneficial to domestic producers because the price of goods from foreign competitors goes up in USD terms. Whenever the Fed has started a programme of QE we have seen USD depreciate. The nominal effective exchange rate (NEER) index for the US, which is a weighted average of exchange rates based upon the relative importance of each currency for trade, shows a consistent message (see chart). When the Fed is printing money the NEER falls; when the Fed stops it rises.

Looser and looser Nominal effective exchange rate index for USD (1999=100) 100 95 90 85 80 75 70 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Sep 08 09 09 09 09 10 10 10 10 11 11 11 11 12 12 12 12 QE programmes
Source: Bank of England

US nominal effective exchange rate

This trade benefit is of limited importance to the US because the US is actually a pretty closed economy – imports and exports as a share of GDP are fairly low simply because the economy is so big that the US has plenty of scope to trade with itself. Hence the Fed views the exchange rate impact as being of secondary importance compared to the other channels for QE to affect the economy. For other countries that are smaller and more open (such as the UK or Australia), or for countries that rely heavily on exports (such as Japan, China and Germany), the exchange rate impact of monetary policy can be the single most important impact. No wonder the central bankers in many of

these countries are being forced into action to compensate for the decline in USD relative to their own currencies. If they do not want to lose value of their currency relative to USD they will need to make their monetary policy looser. The first to loosen in response has been the Bank of Japan (BoJ), which was pretty much forced into expanding its own quantitative easing programme simply to keep pace with the Fed. The BoJ has been worried about the strength of the Japanese yen (JPY) for some time now and had been warning that it would need to intervene if JPY appreciated further. The BoJ did not go all the way towards open-ended QE, but it has effectively drawn a line in the sand for JPY which is a limited version of open-ended QE. If the BoJ wants to be credible in its commitment to preventing JPY appreciation, it may be forced into ever larger quantitative easing. To get an idea, simply look at how much the Swiss National Bank has had to increase its balance sheet to prevent the Swiss franc (CHF) appreciating. The answer is 350%. Other countries may have to follow suit. The Bank of England (BoE) could move as soon as November, when its current programme of QE comes to an end. While the recent Funding for Lending scheme should incentivise banks to lend more money, a further expansion of QE could help to stimulate some demand for credit. On the other side of the globe, we have heard rumbling from the Reserve Bank of Australia that it thinks the Australian dollar is too strong. The euro continued to appreciate after the Fed’s announcement, even though the European Central Bank (ECB) had earlier promised unlimited intervention in sovereign debt. This is because from a market perspective the announcement of the Outright Monetary Transactions (OMT) had more to do with significantly reducing the risks of a euro break-up than easing its monetary policy stance. Although the OMT might look like QE, it is unlikely that the ECB will use it in the same expansionary way as the Fed and BoE have used their QE programmes. A significant increase in the ECB’s exposure to sovereign debt, similar to that of the BoE and Fed, would likely cause severe political resistance. Therefore, the ECB may be more inclined to continue to use “less controversial” measures to loosen monetary policy, such as the LTRO, easing collateral rules and interest rate cuts. And this time, because of the potential intervention of the OMT, these measures could potentially be much more effective than in the past in feeding through the economy.

The US is the main trading partner for Europe, so a substantial devaluation of USD could potentially hurt the ongoing process in part of the Eurozone to regain its competitiveness. The more USD depreciates, the more the adjustment process will weigh on the real economy and the more likely it is that the ECB will have to take action. The biggest impacts of the US open-ended QE will be reserved for those countries that have pegged their currency to USD. When you peg against another currency you effectively have to adopt that country’s monetary policy – when the US increases the supply of its currency you have to as well. The renminbi had actually been depreciating earlier this year but that reversed as the market started to price in further QE and the appreciation has accelerated since then. Given the huge amount of spare capacity in the US, the Fed does not have much of a concern about inflation. Emerging markets that have very little or no spare capacity, such as China, could easily run into inflation problems if they try to match the Fed. This is in stark contrast to countries like Japan which would actually love to have some inflation. In the past, we have seen complaints from some emerging markets about QE from the Fed. This has ranged from direct complaints about the currency to the impact on commodity prices. The simple fact is that the Fed sets policy for its domestic economy, and leaves the rest of the world to sort itself out. If other countries choose to peg their currency to the Fed then that is their own choice and they will need to bear the consequences. In short, we may be looking at something approaching a limited currency war as all the central banks try to keep step with the Fed. The Fed may have started this conflict unintentionally, but it makes little difference to the rest of the world. May the loosest policy win.

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