Meaning of New ECB & BOJ Monetary Policy

Impossible Trinity and Emerging Markets

We often mention the Impossible trinity to evaluate how monetary policy effects on FX market. The Impossible trinity (also known as the Trilemma) states that it is impossible to have (1) A fixed foreign exchange rate, (2) Free capital movement, and (3) An independent monetary policy at the same time (Figure 1).

For example, a central bank loses monetary policy independency if one (1) fixes foreign exchange rate and (2) allows free capital movement. The central bank needs to follow other standard interest rate to reduce arbitrage opportunities and extreme capital outflow. Therefore, the central bank loses its intended monetary policy.

Figure 1: Components of the Impossible Trinity. Source: New York Times

China has been trying to overcome the Impossible trinity with the largest foreign exchange reserves. But I’d like to talk about emerging markets before addressing China. This week, there were two main events from the ECB President Mario Draghi and the BOJ Governor Haruhiko Kuroda. Both President Draghi and Governor Kuroda emphasized additional monetary easing.

The title of President Draghi’s speech on Feb. 4^th was ‘How central bank meet the challenge of low inflation.’ During the speech, he highlighted several issues.

1.   “…low inflation is increasingly being caused by structural factors in the global economy that cannot be addressed through domestic monetary stimulus.”
2.  ‘There is no reason why they should lead to a permanently lower inflation rate.’
3. ‘If we do not “surrender” to low inflation – and we certainly do not – …’

What he meant by ‘we do not surrender’ is the ECB will expand monetary policy longer than the traditional ‘medium-term.’ So, what does he mean by the new ‘medium-term’ in this case? President Draghi suggests that the central bank needs to boost inflation before expected inflation falls below actual inflation. Expected and actual inflation have an inverse relationship that lower expected inflation will eat up positive effects of monetary easing (Figure 2).

Figure 2: Fisher Effect explains relationship between expected and actual inflation

As inflation expectations fall, it pushes up real interest rates, producing an unwarranted monetary tightening. And the unexpected low inflation raises real debt burdens, which has a negative effect on aggregate demand due to the different propensities to consume and invest of borrowers and lenders. Output and inflation, then move again in the same direction – but this time downwards.

Same thing happened last December, when Federal Reserve Bank increased federal interest rate for the first time in a decade. Expected inflation had been declining and stagnated at 2.6% level. With that reason, President Draghi will easy ECB’s monetary policy for ‘medium-term.’ After his speech, however, euro (EUR) strengthened about 2.38% (Figure 3).

Figure 3: USD/EUR and USD/JPY graph from Feb. 1st to 5th. Source: Yahoo Finance

BOJ Governor Kuroda spoke in a similar tone: “there is no limit on monetary easing.’ With the President Draghi’s speech, Japanese Yen (JPY) strengthened 2.24%

Isn’t it weird? With more liquidity and additional monetary easing, in theory, EUR and JPY have to be depreciated. At first, we need to look at why they conduct additional monetary easing. We found that ECB is to fight against ‘medium-term’ disinflation. But how about BOJ?

According to the Economist in 2014, corporate cash holdings in Japan was about 44% of its GDP. It is larger than 11% of United States and 19% of Germany. It implies that the BOJ did not decrease its interest to negative area to boost investment. Even further, the BOJ would not conduct additional monetary easing in that perspective.

We can find the answer from the ‘Carry Trade.’

EUR and JPY Carry Trade 

Currency Carry Trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. It often carries large amount of debt.

There are two big downsides of carry trade: (1) Large amount of debt, and (2) Foreign exchange risk. In order to make profits from the carry trade, a trader needs to predict future spot exchange rate. It means that high volatility in FX market will be a burden for the carry trader.

Currency market in emerging nations weakened overall, but its volatility has been increased. In a high volatility environment, carry trade should reduce its size since it is exposed to high risk. Therefore, much of easy money in carry trade flow back to debt holders to payback principles. But illiquidity of JPY and EUR arises when those money flow back.

To solve the illiquidity issue, the ECB and BOJ announced another quantitative easing. By providing additional EUR and JPY, in theory, carry traders will have enough supply without appreciating domestic currency. Once the capitals from carry trade comes back to home country, they will look for safe asset such as 10-year Bund, 10-year Japanese bond and gold. This is the reason behind sudden spike in safe assets price.

Figure 4: Gold and silver futures price from Feb. 1st to 5th. Source: Yahoo Finance

Who will Gain and Lose?

On the first week of February, we can see an interesting spike or downfall in various financial markets on Wednesday 3 pm (EST). Emerging nations’ currencies (EMCs) such as rupiah and ringgit strengthened against USD while JPY and EUR continued its appreciation. Those EMCs continued to strengthen on Thursday and Friday; USD kept weakening.

Figure 5: USD index graph from Feb. 1st to 5th. Source: CNBC

On the other hand, EMCs did not have a noticeable spike on Wednesday. It showed a high volatility while overall exchange rates were steady. It means that capitals from carry trade can flow back ‘safely.’

Figure 6: JPY/MYR graph from Feb. 1st to 5th. Source: Yahoo Finance

Figure 7: EUR/MYR graph from Feb. 1st to 5th. Source: Yahoo Finance

The problem is emerging markets. While carry traders faded away, EMCs supposed to be weakened. Yet it appreciated against USD while stayed at the ‘steady’ level against EUR and JPY. It may imply central bank intervention to restraint capital outflow. Of course, we can confirm this fact later this month – when new foreign exchange reserve data comes out. We have to take a deep look of the proportion of foreign exchange reserves as well as the total amount of the reserve.

Conclusion

We have seen that much liquidity flew from European and Japanese quantitative easing to emerging markets in a form of carry trade. With recent increased volatility in financial markets, investors reduce their positions on the market and seek for safer assets. Central banks – BOJ and ECB – provide liquidity. Federal Reserve Bank have indirect benefits by weakening USD. It would help to boost oil price and potentially U.S. CPI and GDP in a long term.

However, we have to keep in mind that this scenario will work under several conditions:

1.  EUR/EMCs and JPY/EMCs should be stay steady to reduce carry trading positions
2. Central banks of emerging nations should have sufficient foreign exchange reserves

We have to closely monitor trading volume of EUR and JPY, and central banks’ movement for next few weeks to see further movement of FX markets.