Currency Truce, Not War

Citi GPS Opinion

15 Feb 2018 15:32:20 ET – Recent weeks have seen renewed interest in and concern potential ‘currency wars’ — short-hand for competitive depreciations, competitive non- appreciations, and other exchange-rate related beggar-thy-neighbor policies. Currency wars were the talk of the town in the aftermath of the Great Financial Crisis when many advanced economies (AEs) engaged in very expansionary monetary policies and many emerging markets (and a few AEs as well) were resisting the appreciation of their exchange rates by intervening heavily in foreign exchange (FX) markets. In 2012-16, such exchange rate interventions became less common (outside Switzerland) and the rhetoric less martial, but monetary policy across developed markets remained unusually focused on addressing external effects and exchange rates.

The recent revival of interest in currency wars has its origin — like so many current topics of conversation — in the United States. For instance, candidate Trump famously promised to brand China a currency manipulator on his first day in office, Treasury Secretary Steven Mnuchin unusually stated that a “weaker dollar was good for the U.S.” during a visit to the 2018 World Economic Forum and the dollar has depreciated by 8% on a trade-weighted basis since January 2017. In addition, the U.S.’s renewed appetite for using trade remedies and some of the international elements of its recently passed tax reform have further pointed to a growing U.S. focus on its slice of the global pie, even as the President has insisted that ‘America First’ does not mean ‘America Alone.’ Meanwhile, several European Central Bank (ECB) officials have in return criticized the clear references of U.S. officials to the currency, appealing to existing G20 agreements and conventions they appear to violate.

Despite these frictions, we do not expect currencies to turn into a major source of international tensions in the foreseeable future. This is mainly because the macroeconomic situation today is very different from what it was for most of the time following the Great Financial Crisis. Global growth is currently running at around 3.5% at market exchange rates, closer to some of the better pre-crisis years than the more recent past. Global growth is also, according to some metrics, the most broad-based in decades. Global unemployment stands at 5% compared to 8% in 2010. The more balanced nature of global growth and aggregate demand implies that there is less need to try to import demand from abroad.

Equally, during much of 2012-16, inflation was falling and fears of deflation appeared to take hold. With fiscal policy often inert at best, and domestic demand insufficiently responsive to monetary stimulus, central bankers were pinning their hopes on importing inflation from abroad, only to find that the lack of inflation was global. Although inflation mostly still remains subdued, fears of deflation have receded, underlying inflation and wage growth appear to be rising, if slowly, and several central banks have started to normalize monetary policy, with more to follow quite soon.
Overall, therefore, we argue that monetary policy is becoming less, rather than more, sensitive to and focused on the exchange rate and external effects. It is therefore no surprise that, for instance, the Swiss National Bank (SNB) and the Czech National Bank have recently loosened the exchange rate fixation of their monetary policy. In China, the renminbi gradually begins to look a bit more like the managed float Chinese officials prematurely declared it to be in 2005. Even in the U.S., despite the confusing official rhetoric, the combination of expansionary fiscal policy and consistently (if gradually) tighter monetary policy hardly fits the textbook recipe to weaken a currency.

Indeed, at various points in previous years we noted that central banks were becoming increasingly sensitive to FX rates, sometimes after bruising experiences (e.g., for the Riksbank). We predicted that such sensitivity would lead to more expansionary monetary policy globally and to more easing or less/later tightening by several individual central banks, including the U.S. Fed in 2015/16 and the ECB or Bank of Japan (BoJ) more recently — akin to a modern day ‘fear of floating.’ Similarly, we think that, as domestic inflation pressures build, it is significant that central banks will now gradually abandon their extreme FX sensitivity and manage to offset potential drags from FX appreciations. Of course, the growing number of central banks in tightening mode suggests that tightening should no longer be as closely associated with FX appreciation.

In our view, the reduced emphases on currencies and external support is — or would be — a welcomed development, as it would suggest some normalization of economic affairs and would reduce the scope for international (economic) tensions in an increasingly fractured world.

But there are a few caveats.

First, we think that the move away from the extreme FX sensitivity of central banks will continue to be gradual. For now, we observe that central banks in economies where inflation has long disappointed, notably the BoJ and the ECB, remain quite alert, perhaps excessively so, to the risk that a stronger currency could throw a spanner in the wheels of their incipient increases in underlying inflation. Idiosyncratic reasons suggest that these central banks will continue to be very cautious in removing accommodation, including in their assessment of FX risks, as they rightly perceive themselves to be better equipped to deal with upside surprises in inflation than downside ones. Their caution in turn will hold back several other central banks, including the Riksbank and the SNB, from tightening much earlier.

Second, our expectation that we will not see widespread tensions on currencies is — sadly — not the result of a more cooperative international environment. Even though ‘America First’ has not (yet?) led to a breakdown of the established international economic and political order, the lack of U.S. participation, let alone leadership, in multilateral initiatives (including on climate change, global trade, and diplomacy) is a serious setback for the international community. The threat of higher protectionism and growing international tensions is real and it will likely have tangible adverse consequences, even if they would only manifest themselves over time.

Third, we stress that the absence of currency tensions may be cyclical: it is closely linked to the return of growth and some rise in inflation, as noted above. The growing fractures in international relations one observes, including among erstwhile allies, suggest that the next downturn could yet see a return to the currency battlefield.