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Aggressive central bank easing threatens currency wars

THE FINANCIAL MARKETS remain mostly optimistic, driven by confidence that the global outlook is improving and the central banks will persevere with aggressive monetary policies. Worries over the mediocre economic fundamentals are being shrugged off, once big disasters – e.g. euro break-up, US fiscal cliff or Chinese hard landing – are no longer imminent.

In spite of occasional corrections, recent gains in share prices remain largely intact. The S&P 500 Index rose above its pre-crisis 2007 level. Other equity markets also reached five-year highs. Setbacks are seen as justification for even bigger injections of central bank cash. The belief that boosting growth rather than containing inflation is now the overriding policy priority and will underpin market optimism for some time. But risks are rising. In the longer term, ballooning central bank balance sheets will heighten dangers of bubbles, financial distortions and inflation. A more immediate threat could be the outbreak of global currency and trade hostilities.

For many investors, the critical question is whether, in response to better economic conditions, 2013 will see a major “rotation” of portfolios from fixed-rate bonds to equities. Expectations of such a shift have been fuelled by the fact that government bond yields have risen markedly in recent months, and bond prices have correspondingly fallen. The yield on 10-year US treasuries, having fallen below 1.4% in July 2012, has risen recently above 2%. But, though the mood has changed, bond yields are still very low by the standards of recent decades. It is too early to conclude that the long bull market in bonds, which is some 30 years old in the US, has come to an end. If inflation is set to rise, bond yields will climb further and bondholders will incur big losses. But this is unlikely to happen as long as the central banks continue to create new money by purchasing massive quantities of bonds.

Hitting an inflation target is the primary policy aim of most central banks. In the case of the US Federal Reserve, there is an additional aim of increasing employment. With some notable exceptions, such as Switzerland, most Western central banks have avoided using exchange rate targets, since competitive devaluations are banned by international agreements. But the situation is changing. There is a greater realisation that one of the main aims of aggressive quantitative easing programmes is to weaken the respective currencies in order to boost exports. Though there is reluctance to acknowledge publicly that central banks are trying to manipulate their exchange rates, the problem is becoming more serious.

Trade tensions

In many countries, monetary policies are becoming more expansionary. If this trend intensifies, currency and trade tensions will almost certainly escalate. The new Japanese government led by Shinzo Abe, which wants to see aggressive pro-growth policies, has pressurised the Bank of Japan (BoJ) to double its inflation target from 1 to 2%, and to complement this with an open-ended commitment to buy assets from next year.

Further expansionary measures are expected when a new BoJ governor takes over. As a result, the yen has fallen sharply in recent months, by some 15% against the US dollar and some 20% against the euro. This has triggered adverse reactions, particularly from Asian countries such as China and South Korea. Frictions would worsen if, as seems possible, the yen weakens further.

The dollar’s appreciation against the yen masks the more important fact that the US currency has weakened sharply in recent months, particularly against the euro (by more than 10% since mid-July) but also on a trade-weighted basis. The euro’s recovery partly reflects the easing of earlier fears over a Greek exit and a eurozone break-up.

But the Fed’s aggressive policies – asset purchases totalling $85bn (£54bn) a month, the commitment to buy at this pace until US unemployment falls to 6.5%, and the added promise to maintain official rates at their current exceptionally low level of 0-0.25% until well into 2015 – not only fuelled the stock market boom but also helped to weaken the dollar.

US real economic performance is pedestrian, but remains stronger than that of the eurozone. Though GDP fell by a minimal 0.1% annualised in the fourth quarter of 2012, the housing market is strengthening. The US economy created 155,000 new jobs in January, and large upward revisions added a total of 127,000 jobs to earlier estimates for November and December, indicating that the GDP fall may have been a blip.

In full-year terms, US growth is estimated at about 2% for both 2012 and 2013. This is disappointing, but the eurozone economy declined in 2012 and will stagnate this year and the stronger euro will damage prospects. The US jobless rate, at 7.9%, is seen by the Fed as unacceptably high, but compares very favourably with the 11.7% eurozone rate.

UK GDP fell by 0.3% in the fourth quarter of 2012, worse than expected. If growth remains negative in the current quarter, due to bad weather, there will be unjustified talk of “triple-dip recession”, which will damage confidence. Since UK jobs growth remains strong, it is possible that the official GDP figures exaggerate the gloom. But growth is clearly too weak, and the challenge is to boost it while maintaining credibility by adhering to a realistic deficit-cutting plan.

The Monetary Policy Committee voted in recent months by a big majority to keep official rates at 0.5% and the quantitative easing programme at £375bn. But comments made by Mark Carney, the next Bank of England governor, have triggered speculation that the UK will tolerate higher inflation in the future in order to boost growth. These ideas are problematic. Inflation can ease the debt burden, but persistent above-target price increases in recent years have squeezed businesses and consumers and damaged UK growth.

David Kern, of Kern Consulting, is chief economist at the British Chambers of Commerce

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