Could we please have collaborative currency policy instead of (or at least alongside) combative trade policy?

This morning I saw a news story on Bloomberg quoting Janet Yellen as saying that intervention in foreign exchange markets should be rare, a comment that immediately triggered one of my more long-standing bugbears/quixotic efforts of tilting at windmills. I’ve done versions of the below post elsewhere, here, in a piece entitled Make Multilateral Intervention Great Again AND here, in a piece called Highway To The Target Zone. Since you are entitled to dad jokes as subscribers, I will note that at some point in the later Trump administration I had a tweet saying that while his foreign exchange policy suggested Highway To The Target Zone, his technology policy suggested Huawei To The Danger Zone. Alas, I was right about only one of those things.

Anyway, this is just to underscore my longer standing credentials as someone who has repeatedly questioned whether the combination of open capital accounts and freely floating exchange rates is stabilizing. The first “MIGA” piece on Tumblr linked above in turn has lots of links to other ruminations on the subject; if you are so inclined, there is a rat hole available to go down. So in a sense, this is all old hat, but it thought it worth doing again especially because this substack has so many followers in the trade policy arena thanks to Sam Lowe recommending it (Thank you Sam, and Congratulations).

As to where I’m coming from, some of you may already know that I’ve spent many years in or around foreign exchange markets as strategist, trader, or freelance macrobloviator,  I’ve felt for a while that there is a simple, obvious fact about FX markets that may nevertheless, IMO, be under appreciated in trade circles, particularly when it comes to broader economic and financial policies.

And here is the fact. It is typically the case that when a central bank moves interest rates in order to move an economy closer to internal balance (i.e., raises rates to counter inflation above target, or lowers interest rates to raise inflation up to target), traders will typically react by pushing the currency in a direction that could take the economy further away from external balance (i.e., move a trade deficit in the direction of a deeper deficit or a trade surplus in the direction of a wider surplus).

There are many factors that affect markets and what I am going to describe is probably more true of “normal” swings in the cycle than of full-blown risk-aversion due to concerns about exceptionally sharp slowdowns, catastrophic credit events, or other such calamities. But in normal times, traders will typically react to a country lowering interest rates by selling (and consequently) weakening the currency, making exports more competitive and imports more expensive, thus increasing the trade surplus/reducing the trade deficit. They will react to higher interest rates by buying (and consequently strengthening) the currency, making exports less competitive and imports cheaper, thus increasing trade deficits/reducing the trade surplus.

Why do traders do this? —the reason is the increased attraction of holding a currency that pays higher interest rates (or the reduced attraction of a currency that now pays lower interest rates). Indeed, traders can (and do) combine the trade—selling (or borrowing) a currency with lower rates to buy (or invest in) the currency with higher rates. This is known as a carry trade; leading to another one from the dad joke archives about how traders surfing exchange rates and the steepness of yield curves and volatility curves are looking forward the US Supreme Court formalizing a Constitutional Right To Carry.

Now, insofar as domestic inflation is influenced by the level (or rate of change) of demand in an economy, one can see the problem here. Low inflation can be a corollary of lower domestic demand (versus domestic supply), but if the archetypical traders’ response to such an outcome is to weaken the currency, the effect will be to make essential imports more expensive in-country and make the country’s exports more attractive outside it. The opposite will happen if high inflation is accompanied by high levels of imports (not unlikely since both can be the effects of “hot” demand). In this case the exchange rate effects of central bank hikes will likely make the country’s exports even more expensive abroad and imports even cheaper within it. So to repeat what I was saying earlier—THE EFFORTS OF CENTRAL BANKS TO RETURN AN ECONOMY TO INTERNAL BALANCE VIA INTEREST RATE POLICY WILL VERY OFTEN RESULT IN EXCHANGE RATE DEVELOPMENTS THAT TAKE THAT ECONOMY FURTHER AWAY FROM EXTERNAL BALANCE.

Is this a problem and if so why? Let me start with the economic part first, because I think it is fascinating and also somewhat under appreciated. Now there is a nostrum I hear sometimes (the technical term is intertemporal smoothing) that this will all turn out fine because traders and entrepreneurs “know” that currencies experiencing appreciation now as a result of increases will eventually depreciate. This in turn will lead to galaxy-brained forward-looking agents using this transitory period of currency strength to import capital (either financial or physical) from overseas in order to invest in the country’s tradeable sector, being perfectly positioned to benefit from the period of currency depreciation that will (inevitably) arrive. As you might surmise from my use of the term “galaxy-brained” this rarely happens, with the most likely sink for funds sourced overseas during a period of domestic currency strength being the non-tradeable sector. We have seen this happen a few times over the years in both emerging and developed markets, a fact that has occasioned posts from me here and here (the latter — a counterfactual on Eurozone crisis without the Euro is an absolute banger IMHO). Oh, and I even had a  limerick on the subject in the (online) house organ of the Globalist Nomenklatura (a curia I personally yearn to belong to, but was alas thwarted when I lost in the second round of the Neoliberal Shill contest).

But obviously, the economics are not all that matters. Trade imbalances have always been political, and they have become ever more so in recent years. Now one might surmise amid all the complaints about mercantilist policies, particularly in East Asia, that finance ministries and central banks in countries with exceptionally weak currencies right now might be chortling to themselves at having hoodwinked the US yet again. Except that that’s not what happening. China is clearly unhappy at current levels of the Renminbi, worrying that it might lead to accelerate capital outflows. The Japanese finance ministry has been complaining bitterly for close to a year now about yen weakness, out of concern that it hits domestic real incomes. Conversely, at least one influential person in American political life has expressed concerns that the dollar is too strong against the yen and the renminbi. And even in the Biden administration, although there might be little inclination to intervene in foreign exchange markets, there is little doubt that currency developments that exacerbate trade imbalances will increase the pressure on US manufacturing and raise worries about the political consequences in the geographic fulcrum of US political power—the upper midwest and western PA.

Which brings me the title of this piece. We live in a world where trade policies have become increasingly combative—not just between the US and China, most obviously, but also to some extent between the US and Japan, and potentially between the US and the EU, as implied in recent speeches by Mario Draghi and Emmanuel Macron. There might be little we can do about this, but one thing that might be worth trying is COLLABORATIVE EXCHANGE RATE POLICY that seeks to soothe rather than irritate tempers on trade, most obviously when official sectors on both sides of the currency pair have reasons to be annoyed about what is happening.

What I am saying here is something that most participants in foreign exchange market know—market driven exchange rates are very often driven by large flows of portfolio capital rather than by trade (im)balances; that trade imbalances can be exacerbated by such flows; that exchange rates typically spend long stretches of time in overshooting territory relative to whatever notional “equilibrium rate” one ascribes to them; and that extended periods of overshoots have (often deleterious) consequences for decisions in the real world. Given all this, I would suggest there might be opportunities to use these (increasingly rare) moments of agreement across countries to act jointly in foreign exchange markets, perhaps as a prelude to acting jointly in other things.

Will it work? I think it’s worth a try, certainly better than either allowing markets alone to do the job (snide insider tweet here), or to have the “weak” side — the country trying prevent depreciation—from going it alone. I would also suggest that, if we do it, we give the job to the entities that have gotten used to running extraordinarily large balance sheets—central banks rather than treasuries. After all, over the last several years, we have come to see major central banks move away from using just their short-term benchmark interest rate as a tool to guide markets, embarking instead on massive programs of balance sheet expansion as tools to guide market expectations and control term and credit risk premia.

And since they have come to terms with needing to influence duration and credit risk at critical moments by acting on the composition of domestic assets on their balance sheets, they expand their remit to influence the exchange rate at critical moments by acting on the domestic v. foreign asset composition of their balance sheets. As for the protest that this is not their job, here is a link to something related I wrote years ago on how we should junk the idea that only the Treasury should talk (or do anythying) about the dollar. As for complaints that this would constitute malign interference in global financial markets, I would ask, “Have you been paying any attention to what governments have been doing in global goods markets recently?”   And as to the question, what would the Fed buy, I would answer —JGBs; lots of joint-and-several paper issued by the EU, whose most influential national governments might be reassured that such a buyer exists; and, yes, CGBs—because that’s a great way to tell China that its central government needs to engage in fiscal expansion/backstopping aimed at stabilizing domestic sentiment and supporting domestic consumption.

A man can dream…..

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