Thursday, 21 November 2013

Monetary Policy – via the currency market

With the banking system clogged up, the European Central Bank is looking for other ways to make monetary policy work

Unconventional - this is a term currently used to describe many new elements of monetary policy such as quantitative easing.  It could also be employed in relation to the manner in which monetary policy works nowadays.  The European Central Bank (ECB) cut interest rates in November 2013 due to concerns about deflation (for more info, see previous blog) but the effects are not expected to work through the banking sector as would normally be the case.  Instead, the unspoken target of the policy change was the value of the euro.  This is stuff that you won’t find in any economics textbook, so how does it work and why is the ECB having to rely on such disingenuous tactics for its policies?

The normal result of a cut in interest rates would be a boost to the economy through an increase in lending with lower borrowing costs convincing more households and businesses to take out loans.  The extra spending that this generates would spur on the economy.  But this policy route is not working at the moment as demand for new loans is weak irrespective of how low interest rates are.  The fall in inflation has prompted growing concerns about deflation and the ECB felt the need for further action to signal its intent to prevent this.

Accordingly, the ECB is targeting another avenue (without stating it outright) to achieve the desired results – the currency market.  Europe has been burdened with a currency which reached a two-year high against the US dollar in October.  This is relevant to the fight against deflation in two ways – a stronger currency hurts the economy by making exports more expensive (and harder to sell overseas) as well as reducing the prices of imports (which adds to downward pressure on prices).  A reversal of this trend, that is, a weaker currency, would then work in Europe’s favour and is one of the few levers available to the ECB.

A lower interest rate helps to drag down the value of a currency by reducing the benefits of holding cash in that currency and providing an extra incentive to sell.  This effect is further magnified by the large amount of cash sloshing around in the global financial system at present.   But it is not so easy - some other central banks (namely the Bank of Japan) are keen on achieving the same results through similar policies and not all countries can have weak currencies.  This has resulted in the coining of the term "currency wars" as countries battle to drive down the value of their currencies.  It all sounds rather dramatic but it is evidence of how things in the system of finance are far from normal.

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