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Changing Economic “Normal” Means Change for Foreign Exchange Risk

By Frances Coppola

A growing body of economic research and analysis points to the idea that the fundamental beliefs economists have held for decades about what constitutes “normal” economic behavior no longer hold. If that’s the case, businesses attempting to manage their foreign exchange (FX) risk face a period of instability where FX risk may remain magnified until the variables that constitute normal economics stabilize—or at least become better understood.

In this five-part series, financial journalist Frances Coppola, regularly featured in the Financial Times, The Economist, Forbes and a range of other financial industry publications, explores the global macro forces acting to change the values of economists’ classic measures. She discusses the tools the Federal Reserve used before the Great Recession of 2008 to help it decide what is the "right" level for interest rates, and explains how (and why) these tools appear to be failing today—and what it all means for businesses attempting to manage FX risk.

 

Part 1: Currency Risk Arises from Uncertainty of the Evolving Economy

 

The so-called “neutral rates” of inflation, unemployment and interest rates collectively determine the point at which the economy is running at full capacity and inflation is stable. When inflation is stable, the currency exchange rate also tends be stable, which is good news for businesses managing FX risk. But the neutral rates themselves are changing in unpredictable ways as the global economy evolves.

 

Part 2: Economists’ ‘Uncertainty Principle’ May Make Exchange Rate Risk More Unpredictable

 

The Fed uses the “neutral” rate of interest as a benchmark for its interest rate policy, which affects the dollar exchange rate. But the neutral rate seems to have fallen since the 1980s. Economists have many potential reasons for this, ranging from so-called “secular stagnation” to ageing populations saving more. But some say that the neutral interest rate itself is determined by Fed policy, while others doubt that the neutral interest rate even has an independent existence—all of which adds to dollar exchange rate uncertainty and FX risk management challenges.

 

Part 3: How the Unemployment Puzzle Could Affect the Dollar Exchange Rate

 

Since the 1960s, economists have believed that there is a trade-off between unemployment and inflation: typically, when unemployment is low, inflation is high, and vice versa. But now, unemployment is at historic lows, yet inflation has not taken off. Could this mean the relationship between unemployment and inflation has broken down, and what does this mean for interest rates, the dollar exchange rate, and companies managing their FX risk?

 

Part 4: Has the Relationship Among Money Supply, Inflation, and Exchange Rates Broken Down Forever?

 

Inflation is commonly believed to result when there is too much money chasing too few goods. High inflation tends to cause exchange rates to fall. But between 2008-14 the Fed put $4.6 trillion of new money into the economy, yet both inflation and the dollar exchange rate stayed on the floor. Why didn’t all this new money cause inflation—and what could happen to exchange rates now it is being withdrawn?

 

Part 5: Lower Long-Term Economic Growth May Affect the Dollar Exchange Rate

 

If the unpredictable evolution of what rates of inflation, unemployment and interest rates will enable an economy to run at “full capacity” isn’t confounding enough, the very notion of what constitutes full capacity may be subject to question. Many economists believe that the lower rates of global economic growth seen since the Great Recession may constitute a new, lower, normal for sustainable growth. And that could have ripple effects spreading into companies’ FX risk management thinking.

 

Frances Coppola - The Author

The Author

Frances Coppola

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.

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