Euro, Yen Taking Heat from QE2

Euro, Yen Taking Heat from QE2

* With China and a number of important emerging market countries unwilling to allow their currencies to appreciate substantially, the euro has again been absorbing the pressure.
* The Bank of England faces the same problem as the Fed; that is, it is very hard to judge whether more QE will help to improve the economy's performance, other than via the impact on the price of risk assets.
* In the absence of a positive surprise from the G-20 on the ability to promote coordinated adjustment, it appears that current market trends may continue for some time.

This article was originally published on www.forbes.com on November 9, 2010.

Jean-Claude Trichet, president of the European Central Bank (ECB), was very polite at the ECB's November press conference when asked about QE2 – the Federal Reserve's second round of quantitative easing – and the implications for the euro exchange rate.

"I have no indication that would change my trust in the fact that the Federal Reserve chairman and the secretary of the Treasury, not to speak of the president of the U.S., are not playing the strategy or tactics of a weak dollar. I have no reason not to trust them," he said.

Trichet, a French national, was speaking in his second language, but the garbled syntax and double negatives hint at the strain. The U.S. central bank is starting a new round of government bond purchases aimed at lowering interest rates and boosting asset prices. But part of the mechanics and logic of QE2 is the attempt to weaken the U.S. dollar in hope of boosting U.S. exports.

The potential impacts of QE2 on the American economy and the chances of success are hard to judge. But the effects in terms of the international spillover are clear.

With China and a number of important emerging market countries unwilling to allow their currencies to appreciate substantially, the euro has again been absorbing the pressure. The Japanese yen has also appreciated even though the Bank of Japan has intervened in the currency markets and it continues with its own quantitative easing program.

In London the Bank of England this week decided that it would not start another round of government bond purchases – for now, at least. The Bank of England faces the same problem as the Fed; that is, it is very hard to judge whether more QE will help to improve the economy's performance, other than via the impact on the price of risk assets. It has an additional challenge in that inflation remains above target, owing to a number of factors, including the direct impact of the increase in indirect taxes on U.K. inflation. However, one factor that may force the Bank of England to engage in more quantitative easing is the danger of the British pound appreciating. Being a floating currency in a world of many more-or-less fixed currencies is not comfortable, particularly when the economy's fundamentals suggest that exchange rate depreciation is required.

A number of emerging market countries have been rather less polite than Trichet in terms of criticizing the Federal Reserve's QE2, as well as signaling that they will increase use of capital controls to try and prevent the liquidity the Fed is creating from seeping into their markets. Emerging market countries have been recipients of large capital flows as global investors have searched for higher yields than those available in the U.S. and other OECD countries. These are potentially destabilizing, particularly for countries that are already worried about inflation pressures.

Of course it takes two to tango. China and some other countries may import U.S. monetary policy owing to their exchange rate pegs to the dollar. But the U.S. is not asking China to manage its exchange rate versus the dollar. Quite the opposite. The U.S. faces structural as well as cyclical problems and the fact that the U.S. dollar has not been allowed to weaken versus important Asian currencies is one factor frustrating structural adjustment in the U.S.

The leaders of the G-20 group of leading industrial and emerging market nations meet in Korea this week. While the group may agree on a polite statement there is little indication that there will be any real agreement on policies to facilitate the reduction of global current account imbalances. In the absence of a positive surprise from the G-20 on the ability to promote coordinated adjustment, it appears that current market trends may continue for some time, in terms of the Fed's efforts to re-inflate its domestic economy and the efforts of other countries to counter or withstand the spillover effects. But this does not look like a sustainable equilibrium. The danger is that the cracks will widen for all to see and fear.

There could be a loss of support for the Fed's activism domestically, just as there has been for fiscal activism. International investors may decide that they do not want to finance the U.S.'s current account deficits at prevailing interest rates, a challenge to the Fed's strategy. At some point, emerging market countries may decide that the potential benefits of large scale currency interventions are outweighed by the costs, and therefore allow their currencies to appreciate rather than trying to frustrate the process of global rebalancing. If not, creeping protectionism remains a serious threat.

The ECB may not be engaging in interventions aimed at the euro exchange rate. But at some point the Europeans may be forced to stand up for themselves, owing to the strains for the eurozone that stem from the current conjunction of the Fed's QE2 and emerging market opposition to exchange rate adjustments. The ECB may not be engaging in large-scale QE, but nonetheless it is working across a number of fronts to prop up weaker European sovereigns and banking systems – as well as intervening directly in the eurozone sovereign bond markets given the growing pressures on Ireland and Portugal. This is a very difficult task given the domestic economic challenges and coordination issues within the eurozone. The eurozone economy, like the U.S., faces a growth problem. The euro's appreciation does not help.