FX International Payments
By Frances Coppola
In the last decade, the U.S. Dollar has been on a rollercoaster ride against the Euro. The USD exchange rate collapsed in the financial crisis of 2008. Since then, it has gradually risen:
This is a pretty bumpy ride. What is driving these fluctuations? How much of this is due to U.S. exchange rate policy? Is the Federal Reserve (Fed) allowing the European Central Bank (ECB) to drive the currency exchange rate? Or perhaps neither central bank is really in control. Perhaps the relationship between the currencies is entirely determined by economic conditions.
To start with, let’s look at the economics. The U.S. suffered a deep recession in 2008-9 (grey area on the chart). GDP fell by 8 percent, and unemployment rose to 10 percent. Since then, unemployment has gradually fallen to about 5 percent, while GDP is now growing at about 2 percent per annum. The U.S.’s story is one of slow but sustained recovery.
Conversely, the Euro area weathered the financial crisis pretty well, losing only 3 percent of its output, though unemployment rose to over 10 percent. But less than two years later, the European debt crisis struck. By 2012, the Euro area was back in recession. The unemployment rate soared, reaching 12 percent in 2013. Three years later, unemployment is still above 10 percent and GDP growth is barely above zero. The European story is one of stagnation and lost output.
These starkly divergent economic stories perhaps explain the upwards trend of USD exchange rates. The U.S. economy is performing better than the Euro area economy, so it is a more attractive place for investors. Investors opting for the dollar rather than the Euro put upwards pressure on the dollar rate.
But the different economic fortunes of the two currency areas don’t explain the fluctuations. These are more likely due to central bank policy.
Neither the Fed nor the ECB has directly manipulated the U.S. exchange rate. But interest rate policy influences the exchange rate – and the interest rate policies of the two central banks have been very different.
The Fed has a “dual mandate”, which means that its interest rate policy must reflect not only expected inflation, but output and employment too. So the Fed used monetary policy to counter high unemployment and disappointing GDP growth. It cut the Fed Funds rate to nearly zero and did three rounds of quantitative easing (QE), in which it bought government bonds in return for newly created money. Investors expected QE to cause inflation, which made the dollar less attractive than the Euro. So as each round of QE was announced, the dollar rate fell. The three rounds of QE can be clearly identified on the chart above.
Conversely, the ECB has a single mandate: its sole concern is price stability. So when the oil price rose in 2011, causing inflationary pressures, it raised interest rates. Higher interest rates attract investors looking for return, so capital flowed into the Euro area, putting upwards pressure on the Euro and causing the dollar rate to fall. But borrowing costs rose for Euro area countries. Some economists think that the ECB’s high interest rate policy caused the European debt crisis.1
Until 2014, Euro area interest rates were persistently above US rates and there was no QE. So although the underlying trend of the dollar rate was upwards, the ECB’s tighter monetary policy tended to push the Euro up. This is an alternative explanation of the volatility evident in the chart.
The dollar rose sharply against the Euro during 2014, when the Fed signalled its intention to end QE and the ECB signalled its intention to start it. The QE “baton” was passed across the Atlantic, and the USD exchange rate responded accordingly.
But the Euro has not appreciably weakened since the start of ECB QE in January 2015. If anything, it has strengthened. Reasons given by analysts include: worries about the US economy,2 Federal Reserve chief Janet Yellen suggesting that interest rates might remain lower for longer,3 the effect of China selling its U.S. Treasury reserves,4 the fact that the Euro is regarded as a safe haven by nervous investors,5 and the balance of trade between the two currency areas.
Perhaps the most worrying explanation of the Euro’s strength is that central banks may be running out of firepower. ECB chief Mario Draghi appeared to suggest this in March, when he indicated that interest rates could go no lower.6 And in a paper released March 2016, the Bank for International Settlements concluded:7
Underlying some of the turbulence of the past few months was a growing perception in financial markets that central banks might be running out of effective policy options. Markets pushed out further into the future their expectations of a resumption of gradual normalisation by the Fed. And as the Bank of Japan (BoJ) and ECB signalled their willingness to extend accommodation, markets showed greater concerns about the unintended consequences of negative policy rates. In the background, growth remained disappointing and inflation stubbornly below targets. With other policies not taking up the baton following the financial crisis, the burden on central banks has been steadily growing, making their task increasingly challenging.
Markets watch the Fed and the ECB for signals and react accordingly: they evaluate economic performance and question government policies. The rollercoaster ride of the US dollar versus the Euro reflects the uncertainty and risk of FX trading in a stormy global economic environment.
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.