JACKSON HOLE, WYOMING – To consider the actions taken by the world's major central banks in the past month is to invite an essential question: when – and where – will all this monetary easing end?
At the end of July, the Bank of Japan announced that it would maintain its current negative interest rates and bond-buying program. At the same time, the BOJ pledged that it would nearly double its annual purchases of equity-traded funds, from ¥3.3 trillion ($32.9 billion) to ¥6 trillion. And yet the announcement of a monetary-policy package that in a different era would have been considered inconceivably accommodative, actually disappointed financial markets. To the chagrin of Japanese policymakers, the yen strengthened against major currencies.
Then, in early August, the Bank of England cut borrowing costs, boosted its quantitative easing (QE), and committed an extra £100 billion ($131 billion) to encourage banks to lend. Responding to the pound's significant depreciation against the US dollar and other currencies following the United Kingdom's vote in June to leave the European Union, the BoE indicated the move was a pre-emptive effort to mitigate the recessionary pull of Brexit. In response to the new monetary stimulus, the London stock market surged and the UK pound slid further.
In the same week, the Reserve Bank of Australia cut its benchmark interest rate to a record-low 1.5%. The minutes of that meeting suggest that the cut was primarily aimed at heading off currency appreciation in anticipation of further interest-rate cuts and QE around the world. Members cited a "reasonable likelihood of further stimulus by a number of the major central banks."
In a similar vein, the Reserve Bank of New Zealand cut its policy rate 25 basis points, to 2%, to counter deflationary forces and restrain the appreciation of the New Zealand dollar. In this case, the interest-rate cut took place against a backdrop of solid economic growth and a hot housing market.
The world has been here before, only the names have changed. In his classic 1944 book International Currency Experience, Ragnar Nurkse argued that reflationary policies following the collapse of the gold standard of the 1920s operated by lowering currencies' foreign exchange value, with the 1931 devaluation of the British pound unleashing a spate of competitive devaluations worldwide.
While it is commonly believed that the devaluations were intended to "beggar thy neighbor," Nurkse pointed out that they were often accompanied by expansionary monetary policy, which benefited world trade. The rationale for favoring weak currencies was that a competitive exchange rate would prevent a further contraction in domestic output and prices (deflation). The aim was to substitute external demand, in the form of an improvement in net exports, for deficient domestic demand.
We no longer live in a world dominated, as Nurkse's was, by fixed exchange rates. The term "devaluation" is not appropriate when describing currency fluctuations within a system of floating exchange rates. Yet the recent spate of central bank actions and their timing (notwithstanding considerable diversity in terms of domestic economic conditions) suggests that interest-rate cuts and nonconventional forms of easing, if not competitive, are certainly contagious.
This observation is not intended to imply that the general direction of monetary-policy accommodation is inappropriate. The prospect of deflation is a threat to prosperity and financial stability, particularly for countries with low growth and high levels of public and private debt.
But the contagious nature of the rate cuts does raise the question of whether domestic monetary policies have once again become more interdependent. It would seem that among many of the world's largest central banks, no one wants to be the one with the strong currency. This, at least, is reminiscent of Nurkse's era.
Where does this leave other major central banks? Top Chinese officials have recently begun to call for the People's Bank of China to cut interest rates and lower reserve requirements.
As for the United States, the Federal Reserve faces competing pressures. Strong recent job growth, including long-awaited gains in middle-wage employment, is a positive sign for the US labor market, and wage growth and so-called core inflation are firming. At the same time, employment gains have not translated into proportionately higher output, as productivity remains depressed, while inflation expectations remain subdued.
Although the links between economic fundamentals and currency movements are elusive, it seems plausible to expect that a more hawkish path for the Fed would mean living with a stronger US dollar. But will it?
The deterioration in US net exports already trimmed about 0.8 percentage points from real GDP growth in the first quarter of 2016 (largely at the expense of manufacturing). Indeed, the US current-account deficit is widening once again just as Germany's current-account surplus is expected to hit a high of about 8.5% of GDP this year (about three times China's ratio).
All of this, together with the wave of central bank accommodation worldwide (and prospects for more of the same), would seem to tilt the balance toward a more gradualist Fed approach to unwinding QE. In other words, when it comes to global monetary easing, the buck may not stop at the Fed. With so much depreciation worldwide, why would the US want the dubious honor of a strong dollar?
Carmen Reinhart is Professor of the International Financial System at Harvard University's Kennedy School of Government.
© Project Syndicate 1995–2016