Monday, 28 January 2013

Currency Wars – Japan’s Central Bank Strikes Back

Japan ups the ante with policy makers eyeing monetary policy as a means to weaken their currency but where will it end…

Currency wars is not exactly the stuff of the latest blockbuster showing at the cinema but the issue is making headlines and setting pulses racing.  And it is the normal staid world of monetary policy that is the cause of the tensions.  In the face of weak economic growth, most central banks in developed countries tend to set interest rates close to zero and have had to resort to the unconventional tactic of quantitative easing or the buying of bonds to increase the money supply.  Creating more money in this way has an added effect of also reducing the value of the currency (see Where is all the money going? for more on quantitative easing) and a lower currency is helpful for exporters trying to sell their goods overseas.  With more quantitative easing acting to prompt more exporting, it is an easy way to help out businesses who may be suffering from sluggish demand in their domestic market.  So with quantitative easing all the rage, are central banks set to battle it out to see who can print the most money?

Central banks are not typically caught up in efforts to stimulate the economy.  Their role typically involves maintaining inflation near a target level.  However, the persistent stagnation in the global economy combined with high levels of debt in many countries has taken away governments’ abilities to revive the economy through increased spending or lower taxes.  As such, central banks have been enlisted to combat the worst economic slump since the Great Depression.  Quantitative easing was initially called into service as a boost to the economy but its effects on the currency markets have not gone unnoticed.

The latest salvo which has ramped up tensions was the Bank of Japan (the central bank in Japan) raising its inflation target from 1% to 2% following political pressure from the newly elected government in Japan.  It is not the action of the Japanese central bank that is causing concerns but that the Bank of Japan acted under a barrage of pressure from the government.  It is seen as crucial that central banks are allowed to operate for the good of the economy free from outside influences.  This independence from political pressure is the crux of the argument for central banks being entrusted with monetary policy (see More Power to Economists for more on why this is the case).

The flip side of the coin is that Japan has fallen victim to peculiarities of the currency markets following the onset of the global financial crisis in 2008.  Normally, the value of a currency would fall when the economy is doing poorly but the opposite has happened to the yen which surged in strength from above Y120 per US$ in 2007 to below Y80 per US$ in 2012.  So, as well as a recession in their home market and a drop in global demand for exports, Japanese business were under fire due to a strong currency resulting in the prices of goods exported from Japan becoming more expensive in foreign markets (for more detail, refer to Yen as Weathervane).  As a result, Japan posted its largest ever trade deficit in 2012 which is a sharp turnaround for a country known for its exporting prowess.

The new stance by the central bank in Japan had the desired effect with the yen dropping back above Y90 per $US but the plunge in the yen is based on market expectations of what could happen as the Bank of Japan has yet to do anything.  Furthermore, it is even unclear on what Japan’s central bank will do to work toward a “medium to long-term” goal of 2% inflation.  The Bank of Japan has not had any luck in lifting the country out of deflation and reaching its prior target of 1% inflation so it remains to be seen whether the shift in stance will have any effect.  An immediate change is the further politicization of central banks who have gradually been given more responsibility for the economy than was part of their initial remit.  The use of monetary policy as means of manipulating the currency is now in the sights of policymakers across the globe.  This poses the question - do other countries dare follow Japan’s lead?  There might be a sequel: ‘Currency Wars - Return of the Printing Presses’?

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