If policymakers in the eurozone and Japan hoped to engineer a weaker currency by their aggressive expansion of monetary policy, they must be watching the latest moves in currency markets with dismay. Despite fresh rounds of quantitative easing and radical experiments with negative interest rates — usually associated with a weaker exchange rate — the euro and yen have rallied. Threats of official intervention from Tokyo did nothing to prevent the yen climbing last week to a 17-month high against the dollar.
Interpreting the vagaries of foreign exchange markets is a risky business. One popular conclusion, though, has been that these moves betray the helplessness of central banks, for whom a weak currency would be an invaluable tool. Investors think the European Central Bank and Bank of Japan are nearing the limits of monetary policy and no longer believe they will be able to revive growth and fight off deflation.
There is some truth in these fears. The yen’s current level is hardly a ringing endorsement of Abenomics. Nonetheless, the perverse behaviour of foreign exchange markets does not necessarily reflect despair over the state of the global economy. Yen and euro strength is at least in part a consequence of the recent change in stance by the US Federal Reserve, which has signalled that it is in no hurry to proceed with a second rise in interest rates.
This has triggered weakness in the dollar, now back at last October’s level against a basket of major currencies. This makes the job of the ECB and BoJ harder but will be a great relief to policymakers in many emerging markets. It helps oil exporters that were struggling to keep currency pegs in place — especially as a weaker US currency tends to support commodity prices. It takes the pressure off countries that built up huge volumes of dollar-denominated debt thanks to the excesses encouraged by quantitative easing.
Above all, it has already helped China avert a sharp devaluation in the renminbi — addressing one of the biggest fears that fuelled the turbulence in global markets at the start of the year. The Chinese currency has bounced back from January’s lows, with data from March showing the first rise in the country’s foreign exchange reserves in five months.
One theory among investors has been that policymakers reached a tacit understanding on the advantages of a weaker dollar at February’s G20 meeting — an echo of the 1985 Plaza accord. This seems improbable, given repeated pledges to avoid any targeting of exchange rates. The Fed’s internal deliberations, however, show a growing appreciation of the risks that global financial turbulence and a global slowdown pose to the US recovery.
Moreover, central banks in advanced economies need to give increasing weight to the effects of their actions on emerging economies. The International Monetary Fund warned this week that “spillovers” from China to global financial markets would grow considerably over the next few years.
The Federal Reserve cannot ignore the reality that its actions will have global consequences. The possibility of a shock Chinese devaluation or a debt crisis that might bring down governments in emerging markets is a more alarming prospect than the ever-present risks of sluggish growth in developed economies.
At present, a policy stance that helps moderate strength in the dollar is in the best interests of the US and of the global economy. Insofar as any conclusion can be drawn from unpredictable short term moves in exchange rates, it is that the eurozone and Japan are suffering collateral damage.