Currency Wars Heat Up as Growth Chills
As global growth mostly stagnates, governments are increasingly focusing on monetary policy as a last resort to prop up ailing economies. As discussed in our September Cross Asset Monthly, available exclusively to Strategy clients, the Fed recently signaled a refocusing away from eventual exit strategies toward the possibility of more intervention in the ailing U.S. economy. The Fed’s shift is unsurprising as the U.S. economy continues to stutter and approaches a stall speed: RGE has downgraded its U.S. growth forecast for 2011 from 2.1% to 1.5%, well below the consensus average of 2.5%.
RGE expects the Fed to announce additional policy stimulus at its meeting in November, most likely in the form of large-scale purchases of Treasurys. Embarking on another round of quantitative easing (QE)—presumably with the expectation of weakening the dollar and thereby subtracting from other countries’ growth—is in line with Japan’s recent (and less than successful) attempt to weaken the yen. Last week, the Bank of Japan (BoJ) cut interest rates to zero, and it has been making plans to buy various assets including government and corporate bonds.
There’s more to come as it’s likely that the BoJ will make another attempt to weaken the yen, given the negative impact of a stronger currency on the country’s already dismal growth outlook. However, for yen interventions to succeed in the longer term, they should be supported by other policies. It remains to be seen whether the latest round of QE in Japan will be sufficient in this respect, especially if China even marginally increases its JGB holdings further.
While the Fed and the BoJ joined some emerging market countries in the rush to debase their currencies, the ECB is sticking to a more hawkish policy stance—at least for the time being. One possible reason is that headline CPI in the eurozone has been trending up since July 2009, and core inflation also edged up in the summer of 2010. In addition to responding to the currently diverging inflation dynamics, the ECB also is acting in line with the belief that its policy stance is too accommodative for larger EMU economies (such as Germany) that are growing faster than the debt-ridden periphery.
In contrast, the Fed has expressed clear concern about underlying deflationary pressures in the U.S., stating that inflation is below levels associated with “maximum employment and price stability.” Indeed, both core and headline CPI in the U.S. have been trending down in 2010. Given that the U.S. is a bit ahead of the eurozone in the current cycle, the ECB is likely to remain more hawkish than the Fed for now. However, we believe that such hawkishness will depress the eurozone’s growth prospects going forward, causing the return of deflationary pressures and leading to yet another behind-the-curve policy response from the ECB. Between the Fed’s QE2, the ECB’s stubbornness and a new round of currency wars as countries fight each other for export growth, the path out of the recession remains unclear.