Macro and Markets

For those interested in policy coordination and exchange rate policy, last week was both entertaining and informative.  U.S. Treasury official Lael Brainard’s G-20 background briefing last Monday, interpreted by some as signaling a green light to Japan for further yen depreciation in support of growth, was followed by statements that seemed to repudiate, support, then reinterpret the statement. The result was significant volatility in foreign exchange markets.  I suspect that was the opposite of what was intended.  Beyond the noise, events last week signal a policy environment where countries have great latitude to take measures that have significant effects on exchange rates.  “Currency wars” is hyperbole, but it’s capturing something real. On the surface, policy appears unchanged.  The G-7 statement on Tuesday reiterated established policy–a commitment to market determined exchange rates, a call to not target specific rates, and a willingness to act when there are excessive volatility and disorderly movements:   We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate. --Statement by G-7 Finance Ministers and Central Bank Governors, February 12, 2013.   The G-7 doesn’t always issue statements, so it was reasonable to assume that this time: (1) there was concern that the yen’s depreciation had gone far enough, for now, and that Japan shouldn’t use the bully pulpit to further talk down the currency or use foreign currency instruments to intervene; (2) concern that discussion about “currency wars” was building momentum; and (3) a desire to put down a marker that exchange rate policy coordination is primarily the domain of the G-7, not the G-20 (with U.S.-China exchange rate issues handled bilaterally). In this regard, it succeeded.  The key paragraph from the G-20 communique, along with comments from participants, signaled a tamping down of the debate:   5.  We reaffirm our commitment to cooperate for achieving a lasting reduction in global imbalances, and pursue structural reforms affecting domestic savings and improving productivity. We reiterate our commitments to move more rapidly toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments and in this regard, work more closely with one another so we can grow together. We reiterate that excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open. --G-20 communique, February 16, 2013.   But context matters.  In a world where the major countries are enacting unorthodox policies to spur their economies, where the new Washington consensus allows for a greater role for capital controls and other macro-prudential measures, and where the United States arguably has less leverage on countries’ policies, these words take on different meaning.  My take is that, looking ahead, any country that can make a domestic case for measures that weaken the exchange rate can do so without concern for sanction from the G-7.  The country shouldn’t talk down the currency, or use a foreign currency instrument that specifically targets exchange rates, but otherwise the door is more open than it has been for some time. Of course, the lines on what is acceptable are fuzzy and will be debated.  When monetary operating systems differ, one country’s unorthodox monetary policy is another’s exchange rate intervention.  For example, it appears unacceptable in any circumstance for Japan to buy foreign currency bonds for yen, while at the same time it’s ok for countries to buy mortgage backed securities in their own currency.  Also, while fixing exchange rates is not allowed, China’s commitment to incremental, managed yuan appreciation remains acceptable. If we do have a new policy, it may be first seen in capital controls in emerging markets to stem hot money inflows.   Large scale Quantitative Easing (QE) programs, though motivated by domestic considerations, have the result that some of the newly created money will flow overseas.  This is particularly true when QE creates an expectation of currency depreciation. As these flows make their way to emerging markets, we should expect them to react.  Speculation revolves around Korea and Taiwan, given both stated hot money concerns and the importance of their trade relationship with Japan.  The hot-money story was well captured by Mexican Central Bank Governor Augustin Carstens in Singapore earlier this month (as reported by the Wall Street Journal): "Today my fear is that a perfect storm might be forming as the result of massive capital flows to some emerging-market economies and some strong performing advanced economies," Mr. Carstens said in his speech. "This could lead to bubbles characterized by asset mispricing. [Countries could] then face a reversal in flows as the major advanced economies start exiting their accommodative monetary policy stance." Carstens called for more work on when macroprudential policies should be used to address these concerns.  Carstens has strong market credentials so when he warns of a problem, his words catch attention. It may be that, within the G-20, current monetary policies are broadly appropriate for domestic considerations, and there is little reason in the near term to expect an outbreak of competitive depreciation.  But if pressures continue to build, it may become clearer that the debate over exchange rates has entered a new phase.  

Jeremy Stein’s speech  today–“Overheating in Credit Markets:  Origins, Measurement, and Policy Responses”–provides valuable insight on the issue of credit bubbles that could result as a consequence of current Federal Reserve policy.  As such, it speaks to the upcoming debate over the Fed’s exit strategy.  It’s a must read. Stein’s review of credit markets suggest “we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.”  Even so, that by itself is not a reason for policy to react–in Stein’s view, its when bad credit decisions are combined with excessive maturity transformation that troubles occur. One important contribution of the paper is the tour he takes through credit markets, trying to measure reach-for-yield and maturity extension behavior.  This includes major markets (e.g., high-yield corporate bonds and syndicated-leverage loans), the instruments that fund them (including money market/collateral markets) and other indicators of maturity transformation.  The evidence is mixed, but my read is that, if trends continue, eventually these patterns will become a source of concern.  At a minimum, it points to indicators  that should be followed and that are likely to make their way into Fed discussions. Finally, Stein reviews the debate over whether monetary policy, rather than supervisory/regulatory policy, should be used to deflate bubbles.  His conclusion is that while monetary policy may not be the best tool for the job, it has the important advantage of broad market effect, “reaching into corners” that supervision and regulation cannot. That could be true even if the dual mandate pointed towards a continuation of current accommodative policies.  When you have multiple instruments, you can pursue multiple objectives.  That’s a powerful statement.