Week in FX Europe – EUR’s Kiss Of Death From Ben
by Dean Popplewell, OANDA
OK, sorry about the bad translingual joke. But I thought it might be interesting to try doing a bit of deductive analysis on the sudden 7 percent plunge in the Nikkei.
One important thing to bear in mind, when it comes to big financial market moves, is that there may be no fundamental explanation at all. I’m old enough to remember the 1987 stock crash, which was followed by many theories about which policy move might have been responsible. As it happened, however, Robert Shiller managed to do a real-time survey as the market was plunging, and found essentially nobody mentioning any of the reasons later given for the selling wave. Instead, everyone said that they were selling because … prices were falling.
Still, to the extent that there is some fundamental story, what clues would we look for? And the answer, surely, is to ask what was happening in other markets, especially bonds and currencies.
Let me give you three different stories, each of which could explain a Nikkei plunge:
1. Fears about weak Japanese and Asian growth.
2. Fears about Japanese debt– the bond vigilantes have finally arrived.
3. Fears about the resolution of the Bank of Japan, its willingness to persist in very expansionary monetary policy for a long time.
All of these imply a fall in stocks; but they have different implications for bond and currency markets.
Story 1 should mean a fall in Japanese interest rates, since weaker growth should imply looser money for longer. Indeed, the recent runup in Japanese stocks and interest rates have gone hand in hand, suggesting that what we’ve been seeing is basically rising optimism. (Many of us have used similar arguments to wave away the claims that debt fears are driving occasional upticks in US rates). But in this case Japanese interest rates went basically nowhere.
Story 2 should have seen bond rates rising sharply, which they didn’t. Also, it should have meant a weakening in the yen — which actually rose significantly. So, not the bond vigilantes.
What about story 3? The impact of expected future monetary policy on long-term interest rates is ambiguous — rates might rise because they expect the BoJ to tighten, or fall because they fear that it will fail to end deflation. But worry about the BoJ’s resolve should have a clear impact on the yen, which should strengthen — which it did.
So to the extent that this wasn’t just markets doing their occasional panic thing, it looks like a sudden outbreak of concern about whether the Bank of Japan has really changed as much as it seems.
These are good days for someone who teaches macroeconomics, because it is easy to find articles that misrepresent the basic concepts we teach in class – this always motivates our students who now feel that they can make better arguments than those writing in the financial press.
Bill Gross, founder and co-chief investment of Pimco is back in the Financial Times. This time he is not trying to explain why higher interest rates are good for investment and growth, but instead he is trying to help investors make decisions on foreign exchange markets. His argument is that the traditional theories of exchange rates (Purchasing Power Parity = Big Mac Index) do not matter much today, what matters is the behavior of central banks when it comes to quantitative easing.
The first thing that is odd in the article is that he misses the connection between the different theories he discusses. Someone making an argument that quantitative easing leads to inflation and a depreciation of a currency is implicitly using Purchasing Power Parity as an argument to talk about exchange rates. That argument is standard in any macroeconomics textbook.
What is not standard and where, in my view, he is not being accurate is the way he describes quantitative easing and its implications on exchange rates. First, there is the constant reference to “money being printed”. This is wrong. Most of the increases in the monetary base (the size of the balance sheet of central banks) do not correspond to increases in the amount of currency in circulation but to increases in the deposits that commercial banks hold at the central bank (reserves). This increase in the monetary base do not always lead to an increase in the money supply or inflation. Or you can put it in a different way: the increase in liquidity is matching the demand for liquidity by the financial system. If demand and supply are balanced, prices do not change (exchange rates do not change).
When it comes to the exchange rate he cites Japan as an example where his theory is working (the Yen has depreciated because of quantitative easing). Correct, but only up to a point: it is not because the balance sheet of the central bank is increasing, it is because there is the perception that the central bank is finally committed to deliver high inflation and if this is the case, PPP tells us that a currency will get weaker.
His advice: to pick winners and losers (in terms of currencies) by looking at the size of the central bank balance sheet. Way too simplistic and possibly wrong. It sounds more as one additional attempt to criticize central banks for what they have been doing (QE). If anyone had followed that advice during the crisis years, they would have gotten their bets on currencies wrong several times (same for those who followed his earlier advice that inflation was around the corner and interest rates would increase fast).
Yes, monetary policy matters for the exchange rate because it affects all nominal variables: prices, inflation and the nominal exchange rate. But mislabeling quantitative easing as “printing money” and call it a sure bet to increase inflation in future years has proven to be wrong enough times in the last years that one would think that the argument would not be repeated again. But I should not complain, I have to teach a few more sessions on monetary policy in about three weeks, so these articles are making my search for interesting readings much easier.
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