Interpreting Monetary Policy’s Impact on Exchange Rates (and Economic Activity)
Over a week ago, Bundesbank President Jen Weidmann warned against the politicization of Japanese monetary policy, as the BoJ was pressured for more expansionary policy.  Nouriel Roubini warned that a currency war could be self-defeating as each country’s laxer monetary policy merely resulted in higher commodity prices.  I have been wondering exactly how expansionary monetary policy can influence exchange rates in an era of unconventional monetary policy. And even if it can’t affect exchange rates, is that a reason for not pursuing expansionary policy.
Figure 1: Nominal value of US dollar (blue, left axis), and Fed funds rate (%) (red, right axis). NBER defined recession dates shaded gray. Source: Fed via FRED, NBER.
Exchange Rate Determination in a New Era
Several months ago, the Economist noted that the usual determinants of (advanced country) exchange rates no longer seemed to affect currency values in the traditional fashion ( Currencies: The weak shall inherit the earth, October 6, 2012):
…Other things being equal, the increase in money supply that a bout of quantitative easing brings should make that currency worth less to other people, and thus lower the exchange rate.
Ripple gets a raspberry
Other things, though, are not always or even often equal, as the history of currencies and unconventional monetary policy over the past few years makes clear. In Japan’s case, a drop in the value of the yen in response to the new round of QE would be against the run of play. Japan has conducted QE programmes at various times since 2001 and the yen is much stronger now than when it started.
Nor has QE’s effect on other currencies been what traders might at first have expected. The first American round was in late 2008; at the time the dollar was rising sharply (see chart). The dollar is regarded as the “safe haven” currency; investors flock to it when they are worried about the outlook for the global economy. Fears were at their greatest in late 2008 and early 2009 after the collapse of Lehman Brothers, an investment bank, in September 2008. The dollar then fell again once the worst of the crisis had passed.
David Bloom, a currency strategist at HSBC, a bank, draws a clear lesson from all this. “The implications of QE on currency are not uniform and are based on market perceptions rather than some mechanistic link.”
As the article points out, the most robust determinant of exchange rates has typically been short term interest differentials (in my view, it’s actually real interest differentials, as in the Dornbusch-Frankel model — see this survey). Now, it is asserted, it’s long term real bond yields. For more, see this recent WSJ article. (Also, it’s clear that risk is important, as discussed in this IMF working paper).
I think part of the confusion that some have over what should determine exchange rates (as well as inflation rates) arises from a misapprehension of what current unconventional measures are doing. In the pre-2007 period, lowering interest rates, ceteris paribus, implied faster money creation and hence faster inflation. Post-2008 (and payment of interest on reserves), that linkage is not so straightforward. Credit easing is altering some interest rates, but leaving yet others unchanged. Quantitative easing that results in large increases in bank reserves but leaves the money supply unchanged means that inflation expectations are largely unchanged. Extended policy rate guidance (committing to keeping rates low for a certain period, or made conditional on activity measures) does seem to alter the expected rate of inflation, but to the extent that these measures together induce higher output in the future relative to the no-unconventional policy counterfactual (see tables below), more positive expected future output gaps will tend to result in appreciated currency values in the future.
Chart 9 from Deutsche Bank, “QE3 to Boost Asset Values and Growth,” Global Economic Perspectives (Sep. 27, 2012) [not online]
Chart 11 from Deutsche Bank, “QE3 to Boost Asset Values and Growth,” Global Economic Perspectives (Sep. 27, 2012) [not online]
To the extent that expected future exchange rate values affect current exchange rates, it’s not surprising that one could get differing effects due to the implementation of these unconventional measures. The direction of effect depends on how the different measures affect output and inflation expectations at different horizons, among other things.
For instance, other estimates indicate US large scale asset purchase should depreciate the dollar. Christopher Neely notes that the announcement effect (depreciation) is consistent with a portfolio balance approach, but output is held fixed in his exposition, and asset demand does not depend on output, ruling out the mechanism I outline above. (See also Jim’s post on QE.)
Would One Still Want to Conduct Unconventional Measures Even If Exchange Rates Are Not Affected?
I think the answer is yes. Suppose Country A conducts expansionary monetary policy that (for the sake of argument) would result in a weaker exchange rate and a higher price level (say by 10%). Now suppose Country B seeks to prevent an appreciation of its own currency against Currency A; it could undertake a commensurate expansionary monetary expansion (that would result in a 10% price increase). In the end, the nominal exchange rate is unchanged, but the price level in both countries is higher. This might seem like a zero sum game – but I would say that in fact the world benefits if the price level is too low. That is, as Jeff Frieden and I have argued, higher inflation is going to be helpful in shrinking debt ratios and facilitating real wage adjustment. (That being said, the current measures (aside from extended guidance) do not seem likely to have large impact on inflation, except to the extent that output is increased and prices rise via the Phillips curve.)
Of course, if a central bank were to purchase foreign exchange (let’s say BoJ purchases US Treasurys), then there will be downward pressure on the currency’s value (in the old days, we would say if unsterilized, but I think these days, even if sterilized). Other countries might be forced to follow suit.
Then, one has to ask if countries, in an era of slack aggregate demand and high debt, might benefit from loosening monetary policy even further. Here’s one possible answer, from the experience of the Great Depression (courtesy of Barry Eichengreen).
Figure 5 from Eichengreen (1992).
Update, 11:45am Pacific, 1/29: Beate Reszat clarifies the degree to which recent government statements infringe upon BoJ independence, in the context of current legal and institutional arrangements.