Currency appreciation

By deciding to increase its bond-buying yet again, the Bank of Sweden took an initiative that shed light on the reasoning behind the policies currently implemented by Western central banks. With the stated objective of reaching an inflation target, they are all trying to prevent their currency from appreciating excessively. Why else, with real estate prices now at worrying levels and growth in economic activity doing well, would the Riksbank want to shore up domestic demand even further? This decision, accompanied by its Governor's statement on the possibility of another key rate cut (already at -0.35%), had but one objective: preventing the krona from climbing against the euro.

Are the ECB's recent announcements following the same logic? Isn't the almost non-existent rise in consumer prices enough to justify our central bank doing "whatever it takes" to raise inflation? In taking this course of action, it is doing exactly what it has been mandated to do. If we look a little closer, however, things start to get fuzzy. Would someone who knew nothing about the recent history of the euro zone be able to understand why - after already nearly doubling the size of its balance sheet - our central bank is thinking of going even further? After all, core inflation, a measure of the inflationary pressures generated by our economy, currently stands at 1% instead of … the 1.5% of 10 years ago. Clearly, the ECB's real goal for months now has been to do "whatever it can" to stimulate European growth! But how is it achieving this goal?

By crushing the entire yield curve with its bond-buying programme, it has succeeded in driving the cost of credit down across the board. And yet credit has not really bounced back. If our economic environment is doing better, we mainly have lower oil prices to thank: by reducing the rise in consumer prices, the oil price decline has buoyed household purchasing power and placed household consumption firmly in the driver's seat of our recovery. But at the same time, our exports have been driven and our imports slowed by the euro's steep depreciation, which began over a year ago: for the most part, this has been how the ECB's new QE phase (announced in 2014 and now under way) has affected activity. And through its impacts on foreign exchange, any subsequent expansion of the programme is very likely to continue having this effect.

For the central banks to be trying if not to depreciate their currencies then at least to avoid their appreciation is worrying. It shows that the deflationary forces emanating from the emerging regions are powerful and that even the less and less conventional monetary policies conducted in developed countries are struggling to counter them. In the euro zone especially, growth in domestic demand is not strong enough for us to allow the euro's appreciation to steer some of this demand to the rest of the world. Only the Fed seems ready to take this risk right now. At least that's what the statement issued after the latest FOMC suggested. By explicitly placing the fed funds lift-off on the agenda of its next meeting, the FOMC seems to be saying the economy should be able to handle the appreciation of the dollar that could follow. That makes its decision in December a very important one. If the Fed decides not to begin normalising its key rates, it will send a clear message to the rest of the world: the US economy, against whose currency nearly all others have depreciated, cannot absorb added deflationary pressures from the rest of the world, as a further appreciation of the dollar would imply. That kind of message would be worrying indeed!

Anton Brender
Chief Economist