With the seemingly innocuous observation that the euro-dollar rate ‘does matter’ for monetary policy, European Central Bank Chief Economist Philip Lane unleashed a bout of foreign exchange market turmoil, perceived by some as talking down the euro.
Whether that was the aim of Lane’s remarks is unknown. He was probably speaking as an economist, making the obvious point that currency movements are one channel for monetary policy transmission and a rising euro will add to the euro area’s strong deflationary pressures and squeeze growth.
But as many senior financial authorities have learned the hard way, publicly speaking about exchange rates may have unintended consequences. Markets may not appreciate that a comment is envisioned as an economic observation or a signal about the overall stance and direction of monetary policy. Rather, they may believe that the statement is an open mouth operation aimed at currency rates themselves, triggering volatility. Further, as evidenced in the single currency’s early years, when one authority spoke about exchange rates, it became licence for many to do so, sowing a cacophony of confusion.
In political and financial diplomatic circles, such remarks run the risk of being perceived as a means of boosting exports and redistributing global demand at others’ expense. That is why the G20 agreed to refrain from competitive devaluation and not target exchange rates for competitive purposes. It is also why the G7 agreed that fiscal and monetary policies should ‘remain oriented towards meeting our respective domestic objectives using domestic instruments’. Given chatter in recent years about currency wars, foreign exchange manipulation, and beggar-thy-neighbour protectionism, caution is warranted.
That is especially true for the euro area. It has run annual current account surpluses around 3% of GDP for the last five years. Much of this reflects excessive surpluses in Germany and the Netherlands. The International Monetary Fund has consistently found the euro undervalued.
Many analysts are nervously rubbing their hands, noting that the euro has risen sharply – more than 10% against the dollar since the euro’s March lows. But the alarm is unwarranted. One can just as easily observe that the euro is up only 4% against the dollar from its March highs.
The single currency’s trade weighted indices also suggest little reason for concern. The effective nominal euro is up less than 4% year-to-date and little more than 2% from its March highs.
In terms of the real effective euro index, the euro through Q1 2020 remained highly competitive and historically low.
If currency rates and movements are an essential part of monetary policy but talking about them runs the risk of upsetting markets, politicians and financial diplomacy, what should policy-makers do?
Under Presidents Bill Clinton, George W. Bush and Barack Obama, US authorities did their best not to speak about currencies. Doing so was the domain of the Treasury secretary. The secretary sought to avoid commenting, but when pressed would fall back on the standard mantra – ‘We have a strong dollar policy.’ What that meant was in the eye of the beholder, but ripples were few. This wise US verbal discipline has suffered enormously in the last four years.
ECB President Christine Lagarde and the central bank’s communications team may wish to consider developing their own mantra. It should be fairly easy for talented financial officials to comment on the overall stance of monetary policy without mentioning exchange rates. Governing council members could say, ‘Only the ECB president comments on currency policy.’ In turn, Lagarde could say, ‘No comment’, ‘The euro floats’, or, ‘Our policy is directed at fulfilling our mandate.’
This does not mean verbal (or actual) intervention should be taken off the table. There may be cases of significant market disorder, or times when authorities wish to use currency policy in conjunction with signalling a fundamental change in the stance of monetary policy.
European officials commented on the euro extensively when it plummeted in the fall of 2000 and a G7 communique and concerted intervention took place. US Treasury Secretary Hank Paulson and Federal Reserve Chair Ben Bernanke on rare occasions engaged in verbal intervention to try and steady currency markets during the 2008 financial crisis. Japanese officials years ago habitually expressed concern about excessive yen volatility, though their remarks only seemed to occur when the yen was rising, and created political uproar and protectionist pressure in the US. In contrast, in March 2011 at the time of the Fukushima disaster, there was an associated G7 statement and concerted intervention.
Amid a global economy characterised by extreme stress and facing sustained low growth, officials in the major finance ministries and central banks need to exercise caution in commenting on currency markets. Currency protectionism, especially in this day of populism, is an ever present and looming threat.
Mark Sobel is US Chairman of OMFIF.