All the talk over the past few weeks of currency wars and the great rotation is a sign of how far markets have moved on from concern over the great financial crisis.
Indeed, the spectre of a currency war is frightening–we had warned at the start of the crisis that it could, in tandem with possible mercantilist trade policies, plunge the world into a depression. Fortunately, with only a few exceptions, currency wars with protectionist trade measures have not happened so far. Talk of currency wars has picked up following Japanese policymakers’ belated realization that the ever-appreciating yen was going to perpetuate Japan’s dire economic situation and that it needed to adopt its own quantitative easing (QE) policies in an attempt to reinflate its economy.
In order to understand how QE and exchange-rate movements relate to one another, let us do a brief excursion into monetary theory. Exchange rates (relative prices between two economies) can vary as a function of relative productivity developments and relative prices. Adjustment can take place in nominal as well as real terms. Assuming no significant changes in relative productivity levels, a nominally constant exchange rate can make significant changes in the real value of a currency. For example, the yen, while having traded relatively range bound against the US dollar over the past five years, has appreciated significantly in real terms because of its approximately 3% annual lower inflation rate.
It is in this context that one needs to view the Japanese policy response to the QE policies of the Fed, ECB and BoE. The bid to inflate their economies is also an attempt at raising inflation expectations: Not only does this potentially encourage savers to spend more, but it also brings about a faster adjustment of real exchange rates relative to countries not engaging in QE (principally the emerging markets). Viewed in this light, the aggressive QE policies of most of the Organisation for Economic Co-operation and Development (OECD) have had the effect of bringing a much swifter real adjustment of exchange rates relative to the emerging markets than nominal exchange-rate movements would suggest. Protestation by OECD policymakers of currency wars and (nominal) currency appreciation (by e.g., China) is firmly directed at domestic audiences. Policymakers globally agree among themselves that real exchangerate adjustments are necessary to alleviate the global imbalances. Currency wars proper, with real damage to the global economy, cannot be excluded but currently are a distant threat only.
Talk of a great rotation out of bonds into equities is similarly misguided. With the threat of a global depression and a break-up of the eurozone receding, those capital markets participants (retail investors, corporations) that can, are responding to the inducement offered by the world’s main central banks. Alas, the bulk of capital markets participants (pension funds, insurance companies, banks) are firmly in the grips of financial repression. They, in addition to the central banks, will continue to pile on so-called risk-free assets with a prospective negative yield.