Monetary Conditions Remain Tight

Notwithstanding big declines in key central banks' interest rates, injection of funds into the financial system, and other bailout and stimulation packages, monetary conditions in the US remain tight. Effective monetary conditions are determined by real interest rates, real effective exchange rate, as well as asset prices. The huge declines in asset prices are clearly deflationary. The strong US dollar in recent months also contributes to tight monetary conditions. As of yesterday (December 1, 2008) the greenback has appreciated 7.6% against a benchmark basket of currencies since the beginning of the year. Low lending and borrowing activities also tend to reduce the money supply and aggregate spending. All in all, there is little evidence in support of possible re-ignition of inflation in the near or medium term.

It is unfortunate that central bankers do not seem to understand this. The failure of the ECB to cut interest rates in a timely fashion when the Euro was surging to as much as 1.6 USD against the Euro amid weak asset prices is a case in point. The Euro has since then declined significantly, now registering a 6.56% decline against the benchmark currency basket for this year to date. Among the major currencies, the Yen's strength is the most worrying. Its close to 26% appreciation against the benchmark basket against a backdrop of weak overseas demand is pointing to very dire exports performance. Given Japan's dependence on exports, this is indeed worrying.

If the world economy is to avoid a major recession, the key economies of US, Japan, and Germany need to grow. This would require a weaker Yen against the USD (say 100 Yen to the USD or weaker) and a weaker USD against the Euro (say 1.30 USD against the Euro), and much lower interest rates in Europe. Joint central bank action to bring exchange rates back to growth-sustaining levels will be necessary.

Comments

[Steven Hansen:]

"Among the major currencies, the Yen's strength is the most worrying. Its close to 26% appreciation against the benchmark basket against a backdrop of weak overseas demand is pointing to very dire exports performance. Given Japan's dependence on exports, this is indeed worrying."

and exactly how do you stop this from happening if the carry trade is unwinding? another point is that the bank of japan has been trying to keep the yen in a range around 105 for decades for export growth. from my view, the yen should be slightly under 100 for a fairer trade position with the usa,

the euro is a political currency. the ecb was tasked to prevent inflation - and they surely did that job well.

2008 Dec 02 04:56 AM