Goodbye Price Stability, Hello Exchange Rate Volatility

Yves here. This post makes a deceptively simple but important observation. Despite claims otherwise, central banks are giving top priority to interest rate stability, over that of other mandates they have been given explicitly, such as the health of the financial system, price stability, and full employment. This is further confirmation of the idea that central banks are desperate to keep asset prices aloft. For the ECB, the priority is to keep bond prices high to avoid exposing the insolvency of Eurobanks, and for the Fed, out of the need to keep the stock market high and keep goosing a not-very-impressive housing market recovery so as to keep the confidence fairy alive.

By Enric Yeldan, Dean of the faculty of Economics and Administrative Sciences at Yeldan University and executive directors at the International Development Economics Associates (IDEAs), New Delhi. Cross posted from Triple Crisis

Over the last six months, many developing emerging market economies had witnessed large, unforeseen, and unpredictable swings in their exchange rates. With rumors, and counter-rumors of likely tapering of the U.S. Federal Reserve’s Quantitative Easing (QE) programme, such swings resulted in abrupt depreciations by 16.7% in Indonesia, 7.3% in Thailand, 10.4% in Turkey, 9.3% in Brazil, 13.4% in India, and 8.8% in South Africa…

A recent policy brief by the Peterson Institute for International Economics provided Estimates of Fundamental Equilibrium Exchange Rates and revealed that many of these depreciations were, in fact, overshooting the fundamental equilibrium exchange rates that are consistent with the current account balances of these economies. Now it is found that Indonesia needs its currency to appreciate by 3.9%; Thailand, by 2.4%; the Philippines, by 3.8%; Malaysia, by 4.3%. Meanwhile, Turkey has to let its currency depreciate by 18.1%; South Africa, by 6.8%; Poland, by 4%; Brazil, by 3.4%. Table 1 below summarizes the relevant data.

Table 1


All these revelations point to an excessively volatile environment for exchange rates, the most important macroeconomic price for a national economy. These findings suggest that central banks (CBs) have now moved from the objective of price stability (and by extension exchange rate stability by way of interest rate volatility as the main instrument) over the period 2002-2008, to the new policy of exchange rate volatility to pursue interest rate stability. Interest rates all over are forced to the 0% lower bound in response to the pressures and whims of the global finance capital, a phenomenon to which Cömert and Yeldan (2008) referred as “interest rate smoothing.”

But all these lead to a dangerous game: volatility of exchange rates leads to volatility and excessive swings in national output, employment, and productivity.

The immediate policy concern, then, is to devise measures to manage/regulate “hot” forms of finance capital. It has to be underlined that long-term structural imbalances and external fragility arise, to a great extent, from the volatility of short-term capital flows against which central banks have taken a passive role to virtually stabilize interest rates, accommodating buoyant bond and equity prices through excessive exchange rate volatility.
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  1. Erinc Yeldan

    Many thanks for sharing a very important point. What we had been witnessing, indeed, is that the so-called “inflation targeting” CBs are actually trying to “smooth out interest rates” under pressure from the “markets”. A smooth, stable and preferably as low as possible interest rate path ensures the financial arbitrageurs high, stable and non-volatile gains with reduced uncertainty. So, the real objective of interest rate smoothing is being covered up under the officially stated lip services of dubious “targeting of inflation”. In the meantime, for the emerging developing market economşes, however, this means strong fluctuations of the exchange rate with pressures of uncertainty and loss in productivity.

  2. psychohistorian

    I read recently that the G7 central banks have institutionalized the swap arrangements that were used in 2008. I guess that means that the train is REALLY going to be off the track when that faith thing goes bye-bye.

    Is there a derivative strategy for central bank swaps, like any self respecting casino?

    Again I am thinking of the Rocking Horse Winner short story but this time I hear the plea being……”There must be more leverage!”.

  3. Fiver

    Not sure “volatility” is the right word to use when the Fed first forces the set-up of the board with its policy, then sweeps it due to a “mistaken signal” from Bernanke followed by a circus of Fed “corrections” and counter-corrections. Foreknowledge of this little “slip” would’ve paid considerably. Given this is the same Bernanke as featured in David Stockman’s linked-by-NC piece, just maybe that was a deliberate “mistake” in communication, and some very big winners lurk out there.

    Is that Malaysia I see with a better outcome, and did they use capital controls?

  4. craazyman

    what’s a structure and how can it be out of balance. it sounds like a building of some kind. but you can reach out and spray paint a building if you’re good at graffiti art. and usually there’s a rest room where you can pee in a structure. if a building is out of balance either it falls over or it looks funny, like the leaning tower of pisa. But even that somehow has stayed up for a long time. I guess you could call that balance. it looks like it’s gonna fall over any second, but if you stand there waiting you could be there for a while. why is that? none of this makes sense. do these people even know what they’re talking about or do they just make it up and type it out and then forget about it.

    1. psychohistorian

      You go into evolution with the textual white noise you have, not the textual white noise that might make a difference.

  5. financial matters

    It seems that a lot of hot money would stay here and that money invested in housing and the stock market could be re-directed if there were better incentives and better demand. These could direct this money to investment in increasing the value of the labor pool as well as re-distributing demand. All countries can take these steps to change financial investment into investment in education, health and research and promote domestic demand. Socially useful work should also be seen as productive and paid a decent wage which would then promote demand for locally produced products. Governments can afford to employ people. It can’t all be done with the central banks.

    1. MikeNY

      But so long as we maintiain the fiction that it *can* all be done by central banks, we don’t perturb the plutocrats, who of course are the prime beneficiaries of the fiction.

      The simple, plain-spoken truth is that the Fed’s asset-driven interest rate policy is reactionary, socially divisive, and immoral. It does nothing but redistribute wealth from the poor to the rich. And, in time, it is likely to cause a social explosion, the effects of which cannot be predicted.

  6. financial matters

    Low interest rates can cut both ways. Some people see them as making bonds less attractive thus driving money into assets such as the stock market and housing. Some people see low interest rates as promoting productive business investment.

    I think monetary policy can only go so far.

    Even more worrisome to me is the Fed taking on more responsibility such as trying to target GDP or money market rates or even actively buying stock indexes.

    How to Stop Financial Panics? Say Hello to Qualitative Easing


    by Jason Douglas

    “”In an interview, Mr. Farmer (a UCLA economics professor and the current holder of a research fellowship at the BOE) said he isn’t advocating government agencies buy individual stocks in such operations. Buying a stock index through a fund might be a less controversial approach, he said””

    1. Yves Smith Post author

      Um, I beg to differ. As we’ve discussed repeatedly in past posts, reducing the cost of money unless interest rates are notably high, seldom spurs business investment. Businesses invest on whether they see opportunity for growth in their markets. The cost of funding is merely one of many costs they need to assess in making the go/no go decision. Small business surveys of late consistently have shown that the reason small businesses aren’t expanding is overwhelmingly the lack of decent growth prospects, not the cost of funding.

      In what businesses in the cost of money a huge part of their total cost structure? The financial services industry. Thus making money cheap is a subsidy to Wall Street and not much if at all to Main Street.

      So the idea that lowering interest rates from already low levels will do much to stimulate business investment is Fed propaganda or self-delusion.

      1. financial matters

        I agree completely. As I’ve also mentioned I think Randy Wray is on target in describing what we have as a ‘demand trap’ rather than a ‘liquidity trap’.

        I just don’t see interest rates per se as the problem. I think this should be viewed as a fiscal issue. I think we get too bogged down in Fed machinations rather than trying to seriously target unemployment.

        1. NotTimothyGeithner

          Its a problem because the Fed’s actions boost asset prices which creates the perception of a growing economy in certain areas where the elite mingle. Combined with various myths to justify the wealthy existing at all (the rich have less value than anyone else if you think about it), the Fed’s actions prevent discussion on real problems because the Senator* can tell himself that he only needs six more months and everything will be peachy.

          Its very important to understand that the Fed by the character of the men** is not merely not achieving its goals but is actively helping a class become wealthier which should be taxed out of existence at the expense of the larger population.

          *Remember, these people are about as intelligent as the average MSM pundit. Al Franken developed a reputation as a wonk despite a comedy career because he is smarter than virtually anyone on capital hill.

          **I love how Democrats seemed shocked that a fine Republican like Bernanke would pursue atrocious policies. This is what really drives me up the wall about Democrats.

  7. Jim Haygood

    ‘All these revelations point to an excessively volatile environment for exchange rates, the most important macroeconomic price for a national economy.’

    They do. But excessive volatility has been a defining feature of the fiat currency era, which began in 1973 after the U.S. repudiated its obligation to anchor the global exchange system by converting dollars into gold.

    When currencies are irredeemable, their relative values display the same collective emotion-driven overshoots and undershoots that common stocks do. Through hedging and multiple plant locations, multinational corporations are better able to adapt to gratuitous currency volatility than local-scale businesses.

    Bretton Woods II, the accidental, post-U.S. default regime of irredeemable fiat currencies, has been 40 years of unmitigated disaster. Fiat currencies are the problem, not the solution. Jail the FOMC counterfeiters.

    1. Yata

      There were ample warnings, at the time of the QE programs, that CB intervention would heat up and fry the Asian markets. So i don’t know this may have been one of the Lagniappes of financial innovation. I mean if you are able to rig inter-bank rates and remove forex trading from regulatory oversight, haven’t you set up another facet of the the extend-and-pretend global wealth transfer?

      Please, someone briefly explain to me what capitalism actually is, because at this rate the common denominator, or the thread that ties all this together appears to be licensed and chartered theft.

      Holiday and New Year’s wishes to all.

      1. Fiver

        Yes, there were plenty of warnings, including from CB’s of the affected countries themselves, but it cannot be stated often enough that the US Fed (with support from its junior zombie CB’s at BoE and BoJ) is an Imperial institution vis a vis most of the world. No matter how often other countries expressed complete dismay at the prospect of further Fed “easing”, they could not dissuade Bernanke from repeatedly pulling the trigger – even though Bernanke and everyone else on the planet knew his actions were of benefit only to banks, their networks of speculators, and the already well-to-do who were able to re-finance their own huge household or investment debts while their equity assets approached escape velocity courtesy of relentless Wall Street ramping on fumes – and indeed stocks have left Earth orbit entirely. It is one thing for the US dollar to be the global reserve currency, and another thing for the Fed to be the completely corrupted heart of the US banking system. Put them together, though, and the effect is gigantic advantage for US finance capital, i.e., pure extraction.

      2. ilya

        The sense of volatility used in finance represents changes up and down in time. The fact described in article show that exchange rate of local currency drop with respect to dollars though $ was identified. Rumors about tapering can be heard quite a long period and was advertised recently. Currencies depreciation look better to see with connection to QE program rather than rumors about tapering. Dollars remain to be primary instrument on FX. If Fed in realization of the QE program buys bonds and then sells a massive amount of US bonds they can keep low interest rate. Volume of dollars in US market looks like increased significantly. What does it effect for third echelon of the world economy. Relative fraction of the local currency volume with respect to country USD-holding is decreasing. To support stability under QE pressure they should depreciate local currency with respect to dollar. If we recall that EU and Japan use similar policy we can understand troubles small countries. Depreciation currency automatically implies growth of the local interest rates. It follows from a primary relationship in finance known as Interest Rate Parity.
        Concerning a recent policy brief by the Peterson Institute for International Economics provided Estimates of Fundamental Equilibrium Exchange Rates it is not clear how equilibrium can be defined. It looks a subjective point. It is difficult to imagine that provided by the Institute rates will set a financial stability without providing exchange rate between primary currencies such as USD, EUR, YEN and some others.

  8. susan the other

    the big danger would be for asset prices to start to fall and be impossible to salvage in a time when oil isn’t selling but its price is artificially set, and then oil prices would be beyond salvation and fall, then nobody could afford to produce alternative oil and then the whole plan would fall apart…such as it is, and everything would be in a deep depression… So fiat is all there is.

  9. don

    “The immediate policy concern, then, is to devise measures to manage/regulate “hot” forms of finance capital.”

    Once devised, I wonder who will adopt and implement such global “measures.”

    Perhaps the author will get around to that with the next article.

  10. Chauncey Gardiner

    Really trying to grok all this and the chains of proximate cause… without a great deal of success. :-)

    Have watched the Fed/BoJ tag team continuously ramp up their balance sheets and monetize their respective governments’ deficits in concert with the Primary Dealers and respective Treasury Depts/MoF to keep real interest rates negative, relentlessly elevate financial asset prices, and suppress price volatility in the financial markets. Gambit appears to be designed and intended to restore and support large Western financial intermediaries, reward debtors and speculators (including those with large derivatives exposures), spur debt-fueled domestic consumption in the U.S., and suppress the Japanese Yen, all at the expense of those who do not subscribe to the values reflected in these policies.

    Saw where the Bank of China injected Cash into the short-term interbank debt markets in Shanghai on Christmas Eve when few in the West were at their terminals. Reduced interest rates in the 1-week to 1-month maturities by over 2 percent. Fascinating display of raw financial power reminiscent of that displayed late last June, and seemingly designed to both control appreciation of China’s currency and inject liquidity into China’s troubled financial sector.

    … Ah, the tangled webs we weave and the unforeseen vulnerabilities of complex systems.

    1. Fiver

      Well, you have the most salient point in hand – that every action taken by the Fed to date has been driven by an appalling set of ethical values – so you must be doing something right.

  11. Fiver

    Apologies in advance for the length of this.

    First, I don’t think the Peterson Institute is going to put out anything unfriendly to a status quo wherein the Admin and Congress feign inability to act positively, leaving the Fed to do “all the heavy lifting”, meaning loading fleets of trucks with money destined for Wall Street banks and their associated speculator networks who, in exchange for record global looting opportunities (oops, I mean “profits”) have given the top 20% of income earners back more than the equally artificial asset “wealth” they’d lost in 2007/2009 – all to say the chart above, while depicting sizable capital outflows in some emerging/developing markets in response to 1 particular event, is misleading in a couple of ways.

    First, the entire “move” was in response to what most have termed a “botched” message from Bernanke, which was then walked back and forth for months before markets “concluded” interest rates will remain low and “easing” will be dead slow or reversible – in other words, the “move” was abortive, and the real damage from a wholesale withdrawal limited.

    Second, this focuses only on this 1 move. We’ve had several rounds of QE and each of them hit a somewhat different mix of economies, though the overall effects always hurt the weakest, poorest countries most, then “emerging” markets, then weaker “developed” markets as the price of oil, commodities and everything else in the dollar-payments system rose forcing repeated adjustments to these external shocks irrespective of whether the policy options available – or critically important, allowed – caused as much damage as the initial shock. The effects of QE on emerging or other markets need to be studied over the course of the whole program (assuming it ends).

    Third, an overlooked example of how dangerous such a huge, blunt sledge QE can be for other nations because it does not “recognize” that other economies are not unitary, rather they present a broad range of mixes and sizes of resource, agricultural, industrial, housing, communications, financial and other sectors, not to mention complex political verities. Thus “hot money” piles into a country in a differentiated fashion, with major implications for the recipient country.

    Canada was already in a housing bubble when the financial crisis hit. It was also already exhibiting a growing cleavage between small-population Western provinces riding a massive, somewhat irrational resource boom, and more populous Eastern provinces dependent on manufacturing/industry and the FIRE sector. The lion’s share of internal and foreign direct investment had for years gone into tar sands, mining, etc., while the East floated on household and government debt.

    When the crisis hit, Canadian banks were bailed out to the tune of $114 billion (roughly approximating TARP in relative size) when the federal housing agency took all mortgage exposure off banks books. Absent this move 1 or 2 major Canadian banks would’ve gone under. Other programs (eg, for commercial paper) injected further tens of billions. The Bank of Canada also lowered interest rates in tandem with Bernanke to historic lows, just above US rates, and kept them there, and kept them there, and kept them there.

    Well, what would one expect with that policy and massive Fed easy-bucks chasing financial profits globally? Exactly. The Canadian $ has been strong for the last 5 years (until very recently, as “hot money” wobbles with the danger becoming apparent above and beyond the end of QE) based on exactly the same mix – goosed high commodity prices which kept the Cnd $ (and stock prices ) high, hurting the East’s industrial exports, massive foreign and domestic investment in tar sands and mining (gold, potash et al) reinforcing that dynamic, and what is now a truly gargantuan housing bubble with its attendant “employment” numbers which make Canada appear far more solid than it really is. A wise Canadian Government would’ve acted well before the last financial crisis to offset at least the internal investment flows into globally over-priced commodities (over-priced in good measure due to the Fed’s prior money hose “problem solving”). In the event, the Government was about as stupid as it gets, betting the farm on tar sands oil with no obvious thought whatever given for the consequences in FIRE – perhaps in the belief Canadian taxpayers won’t mind they will one way or another eat hundreds of billions more in mortgages originated in the past 5 years – most of them mortgages for a lot more house than normal interest rates or the actual incomes of the buyers would’ve allowed. How to replace all those FIRE and disappearing manufacturing jobs with something more sustainable is of course the same “that’s another question” that faces the bulk of the US.

    Note however, that for the Bank of Canada’s ex-Goldman Mark Carney, without forceful action by the essentially “hands off” neocon/neoliberal Harper Government to restore balance in the economy, the outcome was determined. Eastern industries needed cheap money to have any hope in hell of competing with their US counterparts, as did the bloated FIRE and provincial government sectors, which would’ve been impossible without all that “future oil production” as ultimate collateral (that vs the Fed’s being backed ultimately by the Pentagon). The idea that Carney was a “star” in the banking world is a very sad joke, as he in fact did nothing. He simply followed Bernanke’s lead knowing the Canadian Government was mesmerized by oil (and a chance to rub elbows with big oil power) and generally hostile to what was in fact the popular majority of voters who happened to inhabit the East. Carney’s chief advisor at the BoC, another Goldman man, now sits ensconced at the helm of Canada’s federal housing mortgage agency – doubtless poised to pull the trigger when the moment is ripe. Someone with Canada’s interests in view at the BoC would’ve sounded the alarm immediately in 2009, and kicked and screamed (as Bernanke should have done in his bailiwick) until the Government responded to the Fed-induced too-high oil/commodity/gold price mirage by channeling investment into real, productive activities on a more diversified, country-wide basis. As is, Canada has convinced itself it is “the exception” and can absorb the mammoth distortions induced by the last 5 years of the Fed. Fat chance of that. It is unfortunately too late, as this Fed-chick is coming home to roost before the next election in 2015.

  12. H. Alexander Ivey

    “But all these lead to a dangerous game: volatility of exchange rates leads to volatility and excessive swings in national output, employment, and productivity.”

    An excellent post, but I quibble with the above quote. We are not getting to that future of swings in output, employment, and productivity, we are fully in it and will remain so for the forseeable future. Maybe it is just me, but too often economists state with certainty what is not true or not certain, but state with ambiguity what is certain (esp. if it would offend the powers that be…).

    1. NotTimothyGeithner

      Economists are no different than the modern priest. They are paid tribute for their meaningless chants and bask in glories of new temples built on the back of the real economy. For the political class, they offer a bulwark against demands for real change. How are they any different from the classes of priests* who have protected corrupt regimes from time immortal? “The invisible hand of the markets.”

      *Not to be confused with a local parish priest; although they can easily move across to the other side.

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