Japan may not have managed to shift the Yen/$ rate significantly with its recent intervention, but it has sparked hopes of another round of QE globally as central banks engage in a 'race to the bottom' in currency terms (boosting gold and silver as 'hard asset' hedges in the process). Japan's real effective trade weighted exchange rate is actually close to its long-term average because of its relatively high real interest rates given persistent local deflation. With China now emerging as a key marginal buyer (even threatening to use its $2.4trn reserve war chest to deliberately sabotage the Japanese economy in the recent maritime border spat), managing the yen down to what Japanese exporters consider bearable levels is likely to require a prolonged campaign of large-scale, unsterilized intervention.
Since the Japanese move, the dollar has fallen sharply against the euro on expectations of further dollar supply from the Fed to further expand its balance sheet (not that the Europeans want a strong euro either). The yen intervention thus looks like the trigger for renewed central bank monetary expansion, adding to the picture of a gradually improving liquidity backdrop for markets and suggesting further strength in equities, commodities and other risk assets in late 2010, in a reversal of the liquidity contraction that began in late Q1 and presaged the sharp selloff subsequently. By creating more of their own currency to sell, many countries are effectively now loosening policy in a form of indirect easing.
Adding to the QE frenzy, the Fed has now stated publicly that US inflation is below the level ‘consistent with its mandate’, a strikingly bold proclamation it never made even during the last (misplaced) deflation scare in 2003, which led to a lower for longer rates policy that helped fuel the housing bubble later in the decade. As can be seen in the chart (click to enlarge), overlaying the US CPI path since 2007 versus Japan’s from 1990 does indicate a strong and ominous correlation. As explained previously, I don’t subscribe to that parallel but the clear implication is that the Fed now sees its mission in terms of using monetary policy to induce a rise in US inflation, an interpretation that sent the dollar tumbling and precious metals soaring (notably silver hitting 30 year highs). The bigger issue is the risk of the frayed patchwork of fixed, managed and floating exchange rates that has held global capital markets together since the 1970s (including the formal euro zone and informal dollar blocs) being ripped asunder over the next couple of years.
The burden of adjustment is falling disproportionately on developing countries with open capital markets like Brazil and Indonesia which have seen soaring currencies (up 35% and 24% respectively since late 2008) and portfolio inflows while China hides behind capital controls. With an NBC/WSJ poll this week indicating
that 69% of Americans now believe that free trade agreements with other countries have cost jobs in the US against just 18% believing they have created them ahead of critical mid-term Congressional elections,
the risk is rising that a so-called ‘currency war’ characterised by systematic market intervention (and in Asia alone this week South Korea, India, Malaysia, Taiwan, the Philippines and Singapore have been busy ‘guiding’ their dollar cross rates)
evolves into a trade war. (click to enlarge)
With another flood of QE cash about to be unleashed (both directly via asset purchases and indirectly via unsterilized currency intervention), the prospects of a substantial EM asset bubble developing are high. The downside is that the same foreign capital inflows will exacerbate underlying inflationary pressures (both from supply side bottlenecks and commodity prices, notably food) and make tighter monetary policy even more urgent. It is that scenario which will make capital controls an increasingly attractive option for countries like Brazil.
The key economist to understand in making sense of the 2008 credit led crash and subsequent halting recovery is the little known but prescient Hyman Minsky, who I've highlighted many times. Minsky’s theory was that eras of financial stability set the stage for future crisis, because they encourage a wide variety of economic actors to take on ever-larger quantities of debt and engage in ever-more-risky speculation until a 'Ponzi Finance' economy emerged. As long as asset prices keep rising, driven by debt-fueled purchases, all looks well. But sooner or later there is a “Minsky moment” when all the players realize (or are forced by creditors to realize) that asset prices won’t rise forever, and that borrowers have taken on too much debt. The resulting stampede to deleverage is most destructive in the financial sector, where everyone’s attempt to pay off debt by selling assets all at the same time can lead to a vicious circle of plunging prices and rising distress. At the 2007 peak, US consumers were consumer $1.60 for every dollar of income they generated. The US economy remains hamstrung, still crippled by a private sector debt overhang and the crucial role of the banking system in credit creation remains constrained. The simultaneous and rational efforts of so many people to pay down debt at the same time are keeping the economy depressed. In the shock of a 'Minsky moment', budget deficits are an essential economic blood transfusion after an horrific accident. Indeed, the surge in budget deficits around the world between 2007-2009 was at least as important as the financial sector rescue in keeping the US real estate implosion from triggering a second depression but they can't be extended much further as aggregate public and private debt burdens have reached new records in the US and UK, which leaves central bankers as our unlikely superheroes saving the day.
Meanwhile, US policymakers are struggling to address foreign government directed capital flows which they suddenly realize have geopolitical implications, as the Japanese have found out in squaring up to China. Many influential US commentators now think that nothing short of trade sanctions seems likely to stop China suppressing its exchange rate (and domestic consumption) by accumulating endless international reserves, whether these take the form of US or increasingly Japanese and European paper assets. China’s efforts to diversify even its $25-30bn monthly trade surplus, let alone its $2.5trn in existing reserves, are likely to distort many more markets than the yen in coming months.
The inability of policymakers in China and the developed world to deal with the inadequacies of our current global financial architecture will ultimately trigger a violently disruptive adjustment when the system can no longer be sustained, and that moment is approaching over the next couple of years as either the US/China symbiosis ends and/or the euro zone shrinks back to a coherent core. In the meantime, a growing danger is that politicians worldwide fall back in frustration on trade barriers and capital flow restrictions to restore their control over macro policy levers.The G20 Summit in November may be the last chance to achieve a multilateral consensus rather than a descent into ‘beggar thy neighbour’ competitive currency devaluations, which would ultimately be bad news for everyone except precious metal miners.
This is one economic cloud that literally has a silver lining for hard asset investors, but I've always maintained that the path to ultimate inflation by mid decade lay via another deflation scare and the policy response to it. If money printing was being applied to directly reduce the debt burden of households, it might have the desired impact of shortening the adjustment process and boosting consumer 'animal spirits' but by being pumped into financial markets via further asset purchases the risk is that it will ultimately reduce Western living standards further by indirectly boosting already strong EM demand to levels risking a 2008 style inflation outbreak across Asia and Latin America.
That would result in higher input and import price inflation for US and European consumers already faced with stagnant real incomes and rising taxes, which would undermine, not boost, growth prospects. It's that immutable Law of Unintended Consequences in action again, the bane of every central banker's neat econometric models.
Disclosure: None
