Central banks don’t ‘control’ EUR/USD

Published: Jan 2013

The fact that EUR/USD is, at the time of writing this Market View, still in the 1.30 region is remarkable. After all, purchasing power parity (a yardstick many economists use to determine the equilibrium level for exchange rates) is normally estimated to be in the region of 1.10, so the euro is well above that level. How can that be if there are even doubts as to the survival of the European currency and the European economy is in a recession, while the US economy is growing?

Naturally, the US has a fairly high deficit on the current account, even if it is rather smaller than before. In the past that was often overshadowed by capital influx from abroad, which is something one would expect now, in view of the improved outlook for the US economy. Moreover, the US has the great advantage of:

  • A far more flexible labour market and economy, as well as a more favourable business climate.
  • The prospect of oil and gas production increasing enormously in the coming years.
  • Far less of a rise in unit labour costs over the past decade than in Europe.

The central bank’s approach

Taking all this into account, EUR/USD should logically be below, rather than above, 1.10. However, there appears to be one factor that is overshadowing all this: the central bank’s approach. When the credit crisis broke out, Ben Bernanke, Chairman of the Federal Reserve, immediately realised that, without large-scale government and central bank intervention, the US economy would fall into a deep depression. The Fed therefore initially lowered short-term interest rates to 0%, but when that failed to help sufficiently, it also actively suppressed long-term interest rates.

The central bank had already lowered interest rates so far, however, that investors could only earn a reasonable return by taking increasing risks. That resulted in narrowing credit spreads and rising stock prices. The Fed is now also attempting to boost the housing market and housing prices by lowering mortgage interest rates as far as possible.

The advantage of all this is that consumer balance sheets improve, so consumers can start borrowing more again. However, in view of the enormous debt mountain accumulated in the past, this is proving to be a slow process, particularly now that the government has to reduce budget deficits even before debts in the private sector have been reduced to any great degree. (Moreover, much of the reduction that has taken place so far is the result of bankruptcies. Many of those involved will therefore be unable to borrow any more for the time being.)

Inflation threatens

The great risk of this monetary tactic is that the enormous quantity of extra money will cause a high inflation risk as soon as credit activity picks up. That can only be avoided by promptly withdrawing the extra money from the system.

Chart 1: Based on PPP, the euro is overvalued vs the US dollar
Chart 1: Based on PPP, the euro is overvalued vs the US dollar

*PPP is based on the idea that in the absence of transaction costs, identical goods will have the same price in different markets.
Source: Thomson Reuters Datastream/ECR

Central banks often have the greatest difficulty in doing this in time, however, but they are also faced with the problem that once they remove money from the system, asset prices start falling. Losses on loans extended in the past then immediately mount, so banks start lending less and growth slows again. In other words: what this tactic amounts to is postponing the problems to the future. There is no point in doing that unless the government uses the time ‘bought’ to take structural measures for increasing the economy’s growth potential. The Fed views this fairly optimistically, though.

Most Fed members feel that if they are too late in withdrawing the money from the system and inflation rises, they are quite capable of fighting inflation. They are far more confident in doing that than in fighting deflation. They are not so concerned about the resulting fall in asset prices.

The European Central Bank (ECB) has other views – particularly when it comes to Germany. The Germans are terrified that once inflation starts rising, it will be almost impossible to stop.

Chart 2: Much looser monetary policy ECB does not match Germany’s anti-inflation stance
Chart 2: Much looser monetary policy ECB does not match Germany’s anti-inflation stance

Source: Thomson Reuters Datastream/ECR

They believe that this will hit asset prices – and therefore the economy – so hard that the central bank will not even begin to fight inflation. This has created the strange situation where, although the US economy is growing more rapidly and is in a better position than the economy in Europe, the Fed is prepared to loosen monetary policy much further than the ECB. The ECB is also far more concerned that if it opens the liquidity taps even further, politicians will only use that as an opportunity to postpone further structural measures that are generally unpopular. The net effect of further monetary loosening then becomes entirely negative. Finally, the fact that governments in Europe are more inclined than the US government to reduce budget deficits by hiking excise and consumer taxes also plays a role – they (temporarily) increase inflation.

Aggressive Fed policy

A situation has therefore arisen in which the Fed is following a more aggressive monetary policy than the ECB, while Europe is in a recession and the US is not. Moreover, fiscal policy is being tightened less in the US than in Europe.

That is the main reason why EUR/USD is at around 1.30 rather than below 1.10. It looks as if this situation will continue for the time being. There is one snag, though: if the Fed loosens monetary policy further – and therefore creates more money – that does not necessarily mean that the total money supply in the US will grow more rapidly.

After all, the extra money the central bank creates only represents a small percentage of the total money supply. The rest is created through credit activity. If credit activity declines, then the total money supply can still shrink or grow considerably more slowly despite the fact that the central bank is creating a great deal more money.

This is extremely important, as it is the difference between the growth of the total money supply in the US and Europe, in particular, that affects EUR/USD. In other words, if EUR/USD is still far above its purchasing power parity while the situation is worse in Europe, then that is chiefly because the total money supply is growing more rapidly in the US than in Europe. However, this is only possible when the US economy is picking up and borrowing increases.

There remain a number of major obstacles for US credit activity to expand more rapidly. The effects of ageing, uncertainty regarding future fiscal policy, stagnating real incomes and high unemployment will limit consumers’ and companies’ willingness to borrow more and therefore will remain subdued. If this will be the case and consumers even continue deleveraging, then the central bank can create as much money as its likes, but there will be little or no increase in the total money supply (the central bank cannot continue creating money indefinitely, either, due to the future inflation threat). The economy then remains weak and sentiment is therefore risk off. Stocks and EUR/USD will then fall, something we expect to happen in the course of this year.

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