Within the last 24 hours, G-7 officials issued a currency statement, “clarified” it and then criticised the clarification! Here, in summary terms, are three possible reasons for this muddle, as well as what it may mean for investors.
Let us start with the context.
Yesterday’s statement was a response to increasing global concerns about “currency wars.” It stressed that members’ policy approach “remains oriented towards meeting … domestic objectives using domestic instruments.” And to make things totally explicit, officials added that exchange rates are not being “targeted.”
So why have reactions been so confused?
First, the statement’s impact was immediately blunted by officials’ attempt at a forced analytical distinction between direct and indirect influences on exchange rates. Simply put, the G-7’s stab at economic diplomacy collided with economic reality.
Yes officials may not be directly manipulating their currencies; and yes, they do not have specific targets in mind (unlike the traditional FX intervention triggered by the trade tensions of old).
But undoubtedly they are indirectly influencing their exchange rates, and in a meaningful manner. They are doing so through the aggressive choice of monetary policy and the manner it is being pursued – particularly the ever-deepening experimental combination of floored policy interest rates, bold forward policy guidance and, of course, unprecedented use of their balance sheets.
Second, the G-7 itself is far from united on the issue.
Some countries, like the U.S., are advocating a broader adoption of “reflationary national policies” around the world. Essentially, they believe that the income effects will dominate the prices effects. Others, such as Germany, worry about the inflationary implications and related financial fragilities of such policies.
Third, domestic and regional political realities translate into overly constrained macro policy approaches, placing an excessive burden on monetary policy, and thereby increasing the likelihood of collateral damage and unintended consequences (or what Federal Reserve Chairman Bernanke calls “costs and risks).
Given all this, it is not surprising that the G-7 statement did very little to dampen currency movements. I also doubt that the other likely short-term objective – that of pre-empting currency disagreements at Friday’s G-20 meeting – will be fully successful.
For these reasons, investors should:
- expect currency volatility to continue,
- look for policy interest rate convergence to spread throughout the world (read: more emerging economies) as a larger number of central banks succumb to the Fed’s approach, and
- expect equity investors to separate even more into two major camps when it comes to characterising the future impact of unusual monetary policy activism: between those who have unfaltering blind faith in the effectiveness of central banks, and those who respect central banks but recognise that their policies’ are becoming increasingly ineffective and that collateral risks/unintended consequences will mount.
Then there is the really complex, longer-term question – and one that I tried to address on Monday in a Financial Times column: The longer this regime of unusual central bank activism continues, the greater the bar bell in macro expected outcomes.
The Fed-led global shift to expansionary monetary policy could help transition major economies from “supported growth” to “genuine growth.” But it could also stress the global system to such an extent that it could cause significant fragmentation and breakage.
Neither historical experience nor analytical studies points convincingly to how the systemic effects will ultimately tip. In the meantime, look for more official statements that – almost inevitably – will likely fall somewhere between confused and incoherent.