By Frances Coppola
Central banks around the world are talking about ending QE, raising interest rates, and reducing the size of their balance sheets. It is hard to predict the effect this will have on exchange rates. When only one major central bank raises interest rates and unwinds QE, the exchange rate of the currency it issues is likely to rise. But when several major central banks tighten monetary policy concurrently, exchange rate movements can cancel each other out.
However, since the U.S. dollar is by far the most widely used currency worldwide, the Fed's tightening could increase exchange rate volatility as U.S. dollars become scarcer. For international businesses, this could increase FX risks and raise the cost of foreign currency borrowing.
But there is one central bank that is not joining the tightening party. Bank of Japan (BoJ) Governor Haruhiko Kuroda recently announced that the BoJ would continue QE.1
Japan's economy is gradually emerging from a two-decade-long slump. Although still low, GDP growth has been consistently above zero since 2013.2 Unemployment is very low, at 2.8 percent.3 However, inflation remains far below the BoJ's 2 percent target, at 0.7 percent per annum,4 and wage growth is subdued at only 0.9 percent per annum.5 The yen's exchange rate, which strengthened after the 2008 financial crisis as the pre-crisis carry trades unwound, has not weakened sufficiently to have a noticeable impact on inflation.6 This is what concerns Kuroda.
The BoJ has a single mandate, which is to achieve price stability. In 2013, it set a target for inflation of 2 percent per annum, and issued strong forward guidance that policymakers would do whatever it takes to meet that target.7 Since then, the BoJ has introduced a range of measures to raise inflation, including a large QE program, interest rate targeting8 and negative interest rates.9 The Japanese government has also attempted to reflate the Japanese economy with large fiscal stimulus programs funded by issuing bonds,10 most of which were bought by the BoJ as part of its QE.11 The BoJ's asset holdings have swelled to over 500 trillion yen, largely comprising Japanese government bonds,12 and Japan's government debt is the highest in the world in terms of GDP (234 percent of GDP).13
Now, some doubt whether the BoJ is capable of raising inflation to its 2 percent target. In a recent academic paper, the economist Mark Gertler showed that when inflation remains persistently below target for a long time, people can start to believe it will remain low despite forward guidance that inflation will rise.14 He warned that bringing inflation up to target would not be easy for Japan, not least because inflation is low in other countries too.15 "Despite the best efforts of a central bank, global factors that moderate inflation may frustrate efforts to reflate," he says. He recommends that the BoJ "continue aggressive monetary policy and hope for some luck."16
The International Monetary Fund (IMF), too, warned earlier this year that the outlook for the Japanese economy was weakening and said it expected inflation to remain very low. It advised the Japanese government to maintain fiscal stimulus and the BoJ to keep monetary policy "accommodative".17
Governor Kuroda's decision to continue QE and keep interest rates low while other major central banks are tightening policy could result in a lower yen exchange rate, especially if carry trades emerge to exploit widening interest rate differences. Return of a substantial yen-USD carry trade, for example, could reduce the yen's exchange rate to its pre-crisis level. This would help to spur Japanese inflation. However, it would also tend to increase Japan's historically large current account surplus, and could depress U.S. inflation, creating a conundrum for the Fed.
However, Governor Kuroda's hope of treading a different path from the Fed and European Central Bank (ECB) could fail to materialize. There are some signs that the Fed is getting cold feet about monetary tightening, as U.S. inflation remains below target.18 On the other side of the Atlantic, ECB central bankers have recently stressed that interest rates will remain very low for the foreseeable future,19 and that although they expect net asset purchases to be tapered off in 2018 they have no plans to reduce the ECB's balance sheet.20 Economists worried by the U.K.'s increasingly gloomy economic outlook recently warned the Bank of England not to raise interest rates.21
If the other central banks back off from policy normalization, then significant yen exchange rate weakening could be less likely. The yen's exchange rate could even rise if the economic outlook in other countries turns gloomy and uncertainty rises, since international investors tend to treat the yen as a "safe haven" from economic storms.
Concurrent monetary policy tightening by major central banks could cause the yen's exchange rate to weaken. However, because inflation is low in most advanced countries at the moment, there is growing uncertainty over the future path of monetary policy, and the direction of exchange rate movements is consequently hard to predict. Businesses may wish to consider appropriate hedging strategies to mitigate raised FX risks.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Kuroda says BoJ to keep easy policy, tread different path from Fed, ECB” – Reuters; http://www.reuters.com/article/us-imf-g20-boj/kuroda-says-boj-to-keep-easy-policy-tread-different-path-from-fed-ecb-idUSKBN1CH2XR
2. “Gross domestic product for Japan,” FRED Economic Data; https://fred.stlouisfed.org/series/JPNNGDP#0
3. “Labor force survey summary results for August 2017,” Japan Statistics; http://www.stat.go.jp/english/data/roudou/results/month/index.htm
4. “Consumer price index August 2017,” Japan Statistics; http://www.stat.go.jp/english/data/cpi/1581.htm
5. “Japan,” Organization for Economic Co-operation and Development; https://data.oecd.org/japan.htm
6. “Japan/US FX rate,” FRED Economic Data; https://fred.stlouisfed.org/series/EXJPUS
7. “Joint Statement of the Government and the Bank of Japan on Overcoming Deflation and Achieving Sustainable Economic Growth,” Bank of Japan; https://www.boj.or.jp/en/announcements/release_2013/k130122c.pdf
8. “The latest from the Bank of Japan,” Brookings Institution; https://www.brookings.edu/blog/ben-bernanke/2016/09/21/the-latest-from-the-bank-of-japan/
9. “Japan introduces negative interest rate in surprise move,” BBC; http://www.bbc.co.uk/news/business-35436187
10. “Japan launches $45bn stimulus package,” Financial Times; https://www.ft.com/content/857bd6ee-588a-11e6-8d05-4eaa66292c32
11. “Outright purchases of Japanese government bonds,” Bank of Japan; https://www.boj.or.jp/en/mopo/measures/mkt_ope/ope_f/index.htm/
12. “Bank of Japan accounts, October 10, 2017,” Bank of Japan; https://www.boj.or.jp/en/statistics/boj/other/acmai/release/2017/ac171010.htm/
13. “General government debt,” Organization for Economic Co-operation and Development; https://data.oecd.org/gga/general-government-debt.htm
14. “Rethinking the power of forward guidance: lessons from Japan,” Bank of Japan; http://www.imes.boj.or.jp/research/papers/english/17-E-08.pdf
15. “Inflation (CPI),” Organization for Economic Co-operation and Development; https://data.oecd.org/price/inflation-cpi.htm
16. “Rethinking the power of forward guidance: lessons from Japan,” Bank of Japan; http://www.imes.boj.or.jp/research/papers/english/17-E-08.pdf
17. “IMF advises Japan to maintain fiscal stimulus,” Markets Insider; http://markets.businessinsider.com/news/interestrates/IMF-Advises-Japan-To-Continue-Fiscal-Stimulus-1002102636
18. “Fed policymakers signal caution on inflation, rate hikes,” Reuters; https://www.reuters.com/article/us-usa-fed/fed-policymakers-signal-caution-on-inflation-rate-hikes-idUSKCN1BG2TT
19. “Maintaining price stability with unconventional monetary policy measures,” European Central Bank; https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp171002.en.html
20. “Between low interest rates and bond purchases – has ECB monetary policy reached a dead end?” Sabine Lautenshlaeger, European Central Bank; https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp171009_1.en.html
21. “Raising rates in November would be a mistake,” City AM; http://www.cityam.com/273936/raising-rates-november-mistake-these-economists-have-warned