Markets Insight
December 18, 2012 4:35 pm
A new recipe for currency friction
Central banks outline intentions for looser monetary policy
Growth now firmly trumps inflation in the central banking lexicon. What was already pretty clear is beyond dispute following the Federal Reserve’s new commitment to keep interest rates close to zero until US unemployment falls below 6.5 per cent.
The readiness of Mark Carney, currently governor of the Bank of Canada, to consider targeting nominal gross domestic product when he takes over from Sir Mervyn King at the Bank of England next year further underlines the point. And where central bankers are failing to rise adequately to the growth challenge politicians now threaten to move in on their act – witness the determination of Shinzo Abe, Japanese prime minister-to-be, to impose a higher inflation target on the supposedly independent Bank of Japan.
Of this trio of growth promoters, Mr Abe has much the toughest job because expectations of deflation in Japan are so entrenched. In the US, by contrast, there is scope for a virtuous circle. Fed chairman Ben Bernanke’s announcement of an explicit unemployment target coincides with a promising turn in the negotiations over the so-called fiscal cliff. If Barack Obama can strike a budgetary deal and secure its passage through Congress the turnround in the US housing market will solidify and US business will put surplus cash to work in new domestic investment.
The US thus looks set to provide a firm base for global growth in 2013. Yet it is important to recognise that this growthmanship takes unprecedented monetary experimentation to a new and higher level. That means the law of unintended consequences will cast a shadow. A commitment to keep the cost of borrowing low for a prolonged period is a wonderful incentive for increased risk taking in the markets, which could lead to bubbles. Admittedly the Volcker rule and other regulatory restraints will curb the banks’ urge to speculate. But there are plenty of non-banks ready and able to seize the opportunity. My suspicion is that the impact will be felt chiefly outside the US.
For a start, extremely loose monetary policy is a recipe for prolonged currency weakness. With the eurozone crisis under better control since the European Central Bank revealed its potential outright monetary purchases programme, the dollar has less of a role as a haven, while managers of official reserves remain anxious to diversify away from the US currency. The dollar thus looks the perfect funding vehicle for carry trades, whereby investors borrow in low interest rate, weak currency countries in the developed world to invest in currencies and commodities in higher growth countries.
This monetary spillover is a recipe for renewed currency friction since it will put powerful upward pressure on emerging market currencies. That takes us straight back to Guido Mantega, finance minister of Brazil, who has repeatedly complained of currency wars. And it seems inevitable that more emerging markets will resort to rigorous capital controls to mitigate the damage of volatile inflows.
What adds piquancy to this mix is that the International Monetary Fund has just gone through a not quite Damascene conversion on this issue. After a long internal debate it has developed a new “institutional view” which recognises that liberalisation before developing countries have reached a certain level of financial and institutional development is highly risky. So the IMF accepts that there is a case in certain circumstances for regulating cross-border capital flows to address the problem of volatile inflows and outflows. An important plank of what used to be called the Washington Consensus has thus been subjected to symbolic revisionism. Capital flow management measures, a new, sanitised IMF phrase for capital controls, are seen as acceptable even if only as a complement to other economic measures and a last resort.
This is a healthy if belated step in a sensible direction. The theoretical case for the liberalisation of capital controls has always looked weaker than that for free trade. By contrast, the pragmatic case for managing capital flows has looked compelling in the light of recent financial crises. China, with a heavily controlled capital account, saw little financial backwash from the crisis in 2008-9, while the resort to capital controls by Malaysia in the 1997-8 Asian crisis proved largely beneficial.
None of this should be taken to imply that ultra-loose monetary policy will have no unintended consequences in the developed world. As central banks engage in further bond buying and commercial banks are encouraged to stock up on more bonds, their balance sheets become increasingly vulnerable to a spike in bond market yields, with potential systemic consequences. Ending the great monetary experiment will be no picnic.
Copyright The Financial Times Limited 2012
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