Inflation Heralds a New Era of Central Bank Currency Stress

This content was published on February 18, 2022 – 12:03

(Bloomberg) – Once accused of lowering their currencies to spur growth, major central bankers are now looking to appreciate exchange rates to help combat the threat of inflation.

It’s been almost 11 years since Brazilian Finance Minister Guido Mantega accused rich countries of waging a “currency war” by cutting interest rates to pull their economies out of recession through cheaper currencies, making thereby driving up the exchange rates of countries like his.

Now, too much inflation has replaced too little growth as the primary concern for many economies. In this environment, a rising currency can help cool prices by making foreign goods cheaper.

According to Bloomberg Economics’ SHOK model, a 10% gain in the dollar on a trade-weighted basis in the second quarter would reduce inflation by about 0.4 percentage points in the following two quarters. The impact is a little greater in the euro zone in the event of a 10% rise in the euro on a similar basis.

While Federal Reserve Chairman Jerome Powell, European Central Bank President Christine Lagarde and others have avoided endorsing their currencies’ recent gains, neither have they disavowed them.

The result is strategists at Goldman Sachs Group Inc. and elsewhere on Wall Street declaring a “reverse currency war” is underway as policymakers find a tool to stifle inflation by bolstering interest rates. exchange.

“The big change is to stop thinking that currency appreciation is undesirable,” said George Cole, head of European rates strategy at Goldman Sachs. “It wouldn’t surprise me if we saw more and more G-10 central banks recognizing that a hard currency could be your friend during this tightening cycle.”

In a report to clients this week, Cole and his colleague Michael Cahill suggested that as the Fed seeks to tighten monetary policy more aggressively than expected, its counterparts will seek to follow in part to avoid a decline in the exchange rate. .

Goldman Sachs has estimated that major central banks would need to raise rates by around 10 basis points on average to offset a one percentage point change in their trade-weighted currency. This “new paradigm” of resistance to currency weakness should favor the euro, the Swedish krona and the Swiss franc.

Exchange rates could become a topic as central bank governors and Group of 20 finance ministers hold virtual and in-person meetings in Jakarta, with a statement expected on Friday. When officials last met in October, they said they would review price pressures that were “transient,” a word the Fed has since withdrawn.

Exchange rates have always been a hot topic among governments who don’t want to be accused of depreciating their currencies to fuel trade or falling foul of the US Treasury’s currency manipulators report. They don’t want a beggar’s run down either.

Swiss National Bank President Thomas Jordan noted in December that the strength of the franc, which has impacted the economy for years, has at least helped the country escape the spike in inflation seen in the euro area and the United States.

“We were able to prevent a sharper rise in inflation in Switzerland by allowing some nominal appreciation,” Jordan said at the time. “It makes imports cheaper.”

Polish central bank governor Adam Glapinski said he would welcome a stronger zloty to “support monetary tightening,” pointing to a change for the central bank that had previously intervened against the currency.

This is particularly important in small open economies such as Poland and Switzerland, given the importance of the exchange rate to inflation and growth prospects.

“It’s a key monetary policy lever,” said Aaron Hurd, portfolio manager at State Street Global Advisors. “So they are right to tolerate or encourage a stronger currency as part of their overall tightening cycle.”

Singapore, which uses its exchange rate as its primary monetary policy tool, unexpectedly tightened in January to join the global fight against accelerating inflation, sending its currency to its strongest since October.

Against the trend

For China, a stronger currency has helped offset high commodity prices that have played a role in soaring manufacturing costs. The yuan has been Asia’s second-best performing currency year-to-date, warding off a shrinking yield premium against US Treasuries, slower growth and repeated virus outbreaks.

This gives the central bank room to cut interest rates as it shifts its stance to support an economy suffering from a housing crisis.

Japan – where too little inflation remains the problem rather than too much – is the most notable case of the trend. Bank of Japan Governor Haruhiko Kuroda told policymakers this week that the weak yen has not raised import costs much.

The Japanese yen has been the worst performing Group of 10 currency since March 2020, losing 17% of its value on an inflation-adjusted basis against major trading partners, according to gauges from JPMorgan Chase & Co.

Admittedly, not all economies will benefit from an inflation buffer due to a stronger currency – much depends on the composition of their inflation basket and local dynamics, such as wage gains. A stronger currency would also do little to bring down inflation in economies that depend on domestic services for growth.

But for central banks that need to rein in prices, allowing their currency to strengthen is a crucial tool when combined with higher borrowing costs. It will be a topic of discussion at the G-20, said Priyanka Kishore of Oxford Economics.

“There will likely be discussions about the potential fallout from changing the hawkish tone of central banks in many major economies, especially as a weaker currency will be an additional source of imported inflation,” she said. declared.

(Updated yuan chart.)

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