Economics Essay 48: Central Banks and Exchange Rates

Discuss the extent to which it is desirable for a central bank to use foreign currency reserves to support its exchange rate.

Central banks use foreign currency reserves as a tool to manage their exchange rates and support their domestic currencies. By intervening in the foreign exchange market, central banks buy or sell currencies, utilizing their reserves to influence the supply and demand dynamics. This intervention can help stabilize or influence the exchange rate.

The use of reserves by central banks for exchange rate support has both benefits and drawbacks. On the positive side, it can contribute to exchange rate stability, providing certainty for businesses engaged in international trade and reducing exchange rate risk. Stable exchange rates can also attract foreign investment, promote price stability, and foster confidence in the domestic economy.

Central banks also utilize reserves to intervene during periods of excessive volatility or speculative attacks. By buying or selling currencies, they can mitigate disruptions to the economy and financial markets. Additionally, reserves can be used to support international trade by ensuring competitive exchange rates, making a country's exports more affordable and attractive in foreign markets.

However, the use of reserves for exchange rate support has limitations. Depletion of reserves over time can leave a country vulnerable to external shocks and reduce its ability to respond to future crises. Holding reserves also incurs an opportunity cost as these resources could have been invested in other productive areas. Furthermore, continuous intervention in the foreign exchange market can create a moral hazard and undermine market dynamics if market participants become overly reliant on central bank support.

In considering the desirability of using reserves for exchange rate support, central banks need to carefully manage their reserves, communicate their policies clearly, and take a comprehensive approach to economic development. While maintaining exchange rate stability is important, central banks should also prioritize long-term economic growth, sustainable development, and policy credibility.

In conclusion, central banks utilize foreign currency reserves by intervening in the foreign exchange market to manage exchange rates and support their domestic currencies. The use of reserves can contribute to exchange rate stability, trade support, and policy autonomy. However, careful reserve management is necessary to strike a balance between short-term stability and long-term economic development. Prudent policies, effective communication, and a comprehensive approach to economic management are essential to ensure that the use of reserves for exchange rate support is beneficial to the overall economy.

A political backlash against monetary policy is looming

Martin Sandbu in The FT

Three weeks ago, Sanna Marin, Finland’s prime minister, retweeted a link to an article by a Finnish academic together with the following quote: “There is something seriously wrong with the prevailing ideas of monetary policy when central banks protect their credibility by driving economies into recession.” 

Defenders of those prevailing ideas predictably pushed back, warning against second-guessing independent central banks or not valuing their credibility. But defensiveness is the wrong response. Not just because Marin didn’t actually criticise any central bank actions. But, more profoundly, because avoiding a debate over whether our macroeconomic regime is fit for purpose is more perilous than having one. 

Comparisons with the 1970s often fail to notice one important lesson of that decade: a macroeconomic regime that cannot justify itself will be toppled, first intellectually, then politically. It was from the ashes of 1970s monetary chaos that theories were born justifying independent central banks with a mandate to keep inflation low. Before the century was out, independent inflation-targeting was de rigueur in most advanced economies. 

Forty years on, a new intellectual and political reckoning would be less surprising than the absence of one. The “great moderation” produced by the 1980s monetary revolution has in many countries long been accompanied by stagnant wages for the low paid. The glacial recovery from the global financial crisis prompted the world’s two biggest central banks to revise their policy framework during the pandemic. In 2020 and 2021, the Federal Reserve and the European Central Bank vowed to tolerate a period of higher inflation if employment had further to rise or there would be little room to loosen policy in case of a downturn. But this new attitude fell at the first hurdle. 

With cost of living crises biting and recessions looming in key advanced economies, what are the odds of avoiding a more profound reckoning for much longer? Marin is not the only national leader expressing unease about central banks. French president Emmanuel Macron recently worried aloud about “experts and European monetary policymakers telling us we must crush European demand to contain inflation better”. 

Precisely because central bankers are independent, it falls to political leaders to tell their citizens why it is right to meet Russian energy blackmail with actions to clamp down further on incomes and jobs. They would be remiss if they did not question whether this is the best we can do. 

In comparison, central bankers have it easy. They have legally imposed inflation-fighting mandates, which are not for them to question. And they have an argument: that losing their “credibility” — by which they mean people no longer believe they can keep inflation low — will cost even more jobs and lost income. 

But the credibility of central banks itself is only as good as the credibility of the macroeconomic regime as a whole. That is not to say central bank independence should be jettisoned, but to ask openly whether it actually works for the economy. 

In pursuit of individual mandates central banks may be collectively overtightening, as Maurice Obstfeld has suggested. Or monetary policy uncoordinated with fiscal policy may be making matters worse, as Marin hinted in follow-up comments. 

The IMF has warned governments against budgeting “at cross-purposes” with monetary tightening. But raising interest rates puts monetary policy at cross-purposes with fiscal policy priorities such as investing in the green transition or, indeed, in energy infrastructure that would itself remedy energy-induced inflation. Even if monetary considerations should take priority, such monetary dominance is undoubtedly something to be democratically debated, not technocratically imposed. 

It may even be that central bankers are not independent enough but cave in to the political pressure arising from each new monthly record in current inflation, rather than coolly focusing on their benign medium-term forecasts. 

Like in the 1980s, in time bright economists will suggest better ways of designing monetary policy against energy price shocks. And unless we have a lucky escape from a sharp downturn this winter, a political backlash is surely coming too. The alternative to openly debating these issues in a democratic space is to let that backlash fester until it breaks out in the more radical and dangerous form of a populist assault on institutions. Central banks’ credibility would not be worth much then.

Pakistan’s economic crisis & desperate hunt for costly loans laced with humiliation

 

2 Why central bankers no longer agree how to handle inflation

Chris Giles, James Politi, Martin Arnold and Robin Harding in The FT 

Once, central bankers knew what they needed to do to handle inflation. As they grapple with the economic consequences of the coronavirus pandemic, the consensus on how best to foster low and stable price growth has broken down. 

After years of setting interest rates on the basis of inflation forecasts and seeking to hit a target of about 2 per cent, the leading monetary authorities around the world are pursuing different strategies. 

The OECD warned this week that “vigilance is needed”, but any attempt to raise interest rates should be “state-dependent and guided by sustained improvements in labour markets, signs of durable inflation pressures and changes in the fiscal policy stance” — so vague that every major central bank can say its policy meets the criteria. 

The US Federal Reserve has shifted its stance to give more leeway to inflation and greater priority to employment, the European Central Bank is embroiled in a row over whether to be more tolerant of any inflation overshoot, and the Bank of Japan is vainly battling to revive consumers’ price growth expectations. 

The US shift in strategy has been the most radical; last year Fed chair Jay Powell announced a new monetary framework. 

The Fed’s creed seeks to move away from decades of pre-emptive interest rate increases to stave off potential inflationary pressures while more doggedly pursuing full employment, a strategy that it argues will benefit more Americans, including low-wage workers and minority groups. 

It will allow inflation to overshoot its 2 per cent target for some time after a prolonged undershoot, in an attempt to ensure companies and businesses expect interest rates to remain low for a long time and will therefore spend rather than save. One of the Fed’s motivations is to avoid repeating its stance after the financial crisis, when policy tightening slowed the recovery. 

“I am attentive to the risks on both sides of this expected path,” said Lael Brainard, a Fed governor, on Tuesday. She would “carefully monitor” inflation data to make sure it did not develop in “unwelcome ways” but also “be attentive to the risks of pulling back too soon”, she said, warning that pre-pandemic trends of “low equilibrium interest rates [and] low underlying trend inflation” were “likely to reassert” themselves. 

But critics worry the Fed’s strategy was designed for a world of cautious fiscal policy, not the pandemic era of massive borrowing and spending, and that this could leave it behind the curve if price pressures build. 

Friday’s 3.1 per cent annual rise in the core personal consumption expenditure index reinforced some of those fears. 

The BoJ has been pursuing an inflation-overshoot commitment for the past five years, but has not even got close to its 2 per cent target. Strikingly little has changed after the pandemic: inflation is nowhere on the horizon and spending growth is sluggish. 

Japan’s households and companies are convinced inflation will remain near zero, making it all but impossible for the BoJ to achieve its goal. 

“The formation of inflation expectations in Japan is deeply affected by not only the observed inflation rate at the time but also past experiences and the norms developed in the process,” BoJ governor Haruhiko Kuroda said in a recent speech. 

Meanwhile eurozone policymakers are embroiled in a furious argument as the ECB conducts its own policy review; the results will be announced in September. 

Olli Rehn, who sits on the council as governor of Finland’s central bank, recently said: “From the point of view of economic and social welfare it makes sense to accept a certain period of [inflation] overshooting, while taking into account the history of undershooting.” 

But Isabel Schnabel, an ECB executive director, warned that would be risky. Schnabel said last month that although the central bank should not overreact if inflation overshoots after sluggishness, she is “sceptical” of formally targeting average inflation over a set period. 

“How long should the period be over which the average is calculated? How much of that should be communicated?” she asked. “I personally don’t think we should follow such a strategy.” 

For some economists, these disagreements are beside the point: monetary policy has become so extended that central bankers lack effective tools to do more. 

Richard Barwell, head of macro research at BNP Paribas Asset Management, said the ECB was almost “out of ammunition” and while eurozone inflation in May rose just above its target of near but below 2 per cent, it would take ambitious fiscal policy or simply luck to do so for a sustained period. 

“Unless there is some massive Biden-style fiscal stimulus coming down the road in Europe or the disinflationary headwinds suddenly dissipate, the amount of monetary stimulus needed to get inflation above 2 per cent is . . . well beyond what they can do,” he said. 

That leaves the Fed alone with a difficult choice in the months ahead. US inflation is overshooting its target, demand is rampant and it needs to decide whether to apply the brakes gently. 

Policymakers are poised to open a debate winding down some support, but they have shown no sign of wavering from their new policy framework, insisting the recent inflation rise is likely to be transitory, not sustained. 

Last week Fed vice-chair Randal Quarles said the framework was designed for the current world with “slow workforce growth, lower potential growth, lower underlying inflation and, therefore, lower interest rates”. 

“I am not worried about a return to the 1970s,” he said.

Understanding Populism

Nadeem F Paracha in The Dawn


In a March 7, 2010 essay for the New York Times, the American linguist and author Ben Zimmer writes, “When politicians fret about the public perception of a decision more than the substance of the decision itself, we’re living in a world of optics.”

On the other hand, according to Deborah Johnson in the June 2017 issue of Attorney at Law, a politician may have the best interests of his constituents in mind, but he or she doesn’t come across smoothly because optics are bad, even though the substance is good. Johnson writes that things have increasingly slid from substance to optics.

Optics in this context have always played a prominent role in politics. Yet, it is also true that their usage has grown manifold with the proliferation of electronic and social media, and, especially, of ‘populism.’ Populists often travel with personal photographers so that they can be snapped and proliferate images that are positively relevant to their core audience.

Pakistan’s PM Imran Khan relies heavily on such optics. He is also considered to be a populist. But then why did he so stubbornly refuse to meet the mourning families of the 11 Hazara Shia miners who were brutally murdered in Quetta? Instead, the optics space in this case was filled by opposition leaders, Maryam Nawaz and Bilawal Bhutto.

Nevertheless, this piece is not about why an optics-obsessed PM such as Khan didn’t immediately occupy the space that was eventually filled by his opponents. It is more about exploring whether Khan really is a populist? For this we will have to first figure out what populism is.

According to the American sociologist, Bart Bonikowski, in the 2019 anthology When Democracy Trumps Populism, populism poses to be ‘anti-establishment’ and ‘anti-elite.’ It can emerge from the right as well as the left, but during its most recent rise in the last decade, it has mostly come up from the right.  

According to Bonikowski, populism of the right has stark ethnic or religious nationalist tendencies. It draws and popularises a certain paradigm of ‘authentic’ racial or religious nationalism and claims that those who do not have the required features to fit in this paradigm are outsiders and, therefore, a threat to the ‘national body.’ It also lashes out against established political forces and state institutions for being ‘elitist,’ ‘corrupt’ and facilitators of pluralism that is usurping the interests of the authentic members of the national body in a bid to undermine the ‘silent majority.’ Populism aspires to represent this silent majority, claiming to empower it.

Simply put, all this, in varying degrees, is at the core of populist regimes that, in the last decade or so, began to take shape in various countries — especially in the US, UK, India, Brazil, Turkey, Philippines, Hungary, Poland, Russia, Czech Republic and Pakistan. Yet, if anti-establishmentarian action and rhetoric is a prominent feature of populism, then what about populist regimes that are not only close to certain powerful state institutions, but were or are actually propped up by them? Opposition parties in Pakistan insist that Imran Khan’s party is propped up by the country’s military establishment, which is aiding it to remain afloat despite it failing on many fronts. The same is the case with the populist regime in Brazil.

Does this mean such regimes are not really populist? No. According to the economist Pranab Bardhan (University of California, Berkeley), even though populists share many similarities, populism’s shape can shift from region to region. Bardhan writes that characteristics of populism are qualitatively different in developed countries from those in developing countries. For example, whereas globalisation is seen in a negative light by populists in Europe and the US, a November 2016 survey published in The Economist shows that the people of 18 developing countries saw it positively, believing it gave their countries’ economies the opportunity to assert themselves.

Secondly, according to Bardhan, survey evidence suggests that much of the support for populist politics in developed countries is coming from less-educated, blue-collar workers, and from the rural backwaters. Populists in developing countries, by contrast, are deriving support mainly from the rising middle classes and the aspirational youth in urban areas. To Bardhan, in India, Pakistan, Turkey, Poland and Russia, symbols of ‘illiberal religious resurgence’ have been used by populist leaders to energise the upwardly-mobile or arriviste social groups.

He also writes that, in developed countries, populism is at loggerheads with the centralising state and political institutions, because it sees them as elitist, detached and a threat to local communities. But in developing countries, the populists have tried to centralise power and weaken local communities. To populists in developing countries, the main villains are not the so-called cold and detached state institutions, but ‘corrupt’ civilian parties. Ironically, while populism in the US is against welfare programmes, such programmes remain important to populists in developing countries.

Keeping this in mind, one can conclude that PM Khan is a populist, quite like his populist contemporaries in other developing countries. Despite nationalist rhetoric and his condemnatory understanding of colonialism, globalisation that promises foreign investment in the country is welcomed. His main base of support remains aspirational and upwardly-mobile urban middle-class segments. He often uses religious symbology and exhibitions of piety to energise this segment, providing religious context to what are actually Western ideas of state, governance, economics and nationalism. For example, the Scandinavian idea of the welfare state that he admires is defined as Riyasat-i-Madina (State of Madina).

Unlike populism in Europe and the US, populism in developing countries embraces the ‘establishment’ and, instead, turns its guns towards established political parties which it describes as being ‘corrupt.’ Khan is no different. He admires the Chinese system of central planning and economy and dreams of a centralised system that would seamlessly merge the military, the bureaucracy and his government into a single ruling whole. His urban middle-class supporters often applaud this ‘vision.’

Central banks were always political – so their ‘independence’ doesn’t mean much

The separation of monetary and fiscal policy serves the neoliberal status quo. It won’t survive the next crash writes Larry Elliott in The Guardian 

 

‘The Federal Reserve is coming under enormous pressure from Donald Trump to cut interest rates.’ Donald Trump with Jerome Powell, then his nominee for chairman of the Federal Reserve, Washington DC, November 2017. Photograph: Carlos Barría/Reuters


Independent central banks were once all the rage. Taking decisions over interest rates and handing them to technocrats was seen as a sensible way of preventing politicians from trying to buy votes with cheap money. They couldn’t be trusted to keep inflation under control, but central banks could.

And when the global economy came crashing down in the autumn of 2008, it was central banks that prevented another Great Depression. Interest rates were slashed and the electronic money taps were turned on with quantitative easing (QE). That, at least, is the way central banks tell the story.

An alternative narrative goes like this. Collectively, central banks failed to stop the biggest asset-price bubble in history from developing during the early 2000s. Instead of taking action to prevent a ruinous buildup of debt, they congratulated themselves on keeping inflation low.

Even when the storm broke, some institutions – most notably the European Central Bank (ECB) – were slow to act. And while the monetary stimulus provided by record-low interest rates and QE did arrest the slide into depression, the recovery was slow and patchy. The price of houses and shares soared, but wages flatlined.

A decade on from the 2008 crash, another financial crisis is brewing. The US central bank – the Federal Reserve – is coming under huge pressure from Donald Trump to cut interest rates and restart QE. The poor state of the German economy and the threat of deflation means that on Thursday the ECB will cut the already negative interest rate for bank deposits and announce the resumption of its QE programme.

But central banks are almost out of ammo. If cutting interest rates to zero or just above was insufficient to bring about the sort of sustained recovery seen after previous recessions, then it is not obvious why a couple of quarter-point cuts will make much difference now. Likewise, expecting a bit more QE to do anything other than give a fillip to shares on Wall Street and the City is the triumph of hope over experience.

There were alternatives to the response to the 2008 crisis. Governments could have changed the mix, placing more emphasis on fiscal measures – tax cuts and spending increases – than on monetary stimulus, and then seeking to make the two arms of policy work together. They could have taken advantage of low interest rates to borrow more for the public spending programmes that would have created jobs and demand in their economies. Finance ministries could have ensured that QE contributed to the long-term good of the economy – the environment, for example – if they had issued bonds and instructed central banks to buy them.

This sort of approach does, though, involve breaking one of the big taboos of the modern age: the belief that monetary and fiscal policy should be kept separate and that central banks should be allowed to operate free from political interference.

The consensus blossomed during the good times of the late 1990s and early 2000s, and survived the financial crisis of 2008 . But challenges from both the left and right, especially in the US, suggest that it won’t survive the next one. Trump says the Fed has damaged the economy by pushing up interest rates too quickly. Bernie Sanders says the US central bank has been captured by Wall Street. Both arguments are correct. It is a good thing that central bank independence is finally coming under scrutiny.

For a start, it has become clear that the notion of depoliticised central bankers is a myth. When he was governor of the Bank of England, Mervyn King lectured the government about the need for austerity while jealously guarding the right to set interest rates free from any political interference. Likewise, rarely does Mario Draghi, the outgoing president of the ECB, hold a press conference without urging eurozone countries to reduce budget deficits and embrace structural reform.

Central bankers have views and – perhaps unsurprisingly – they tend to be quite conservative ones. As the US economist Thomas Palley notes in a recent paper, central bank independence is a product of the neoliberal Chicago school of economics and aims to advance neoliberal interests. More specifically, workers like high employment because in those circumstances it is easier to bid up pay. Employers prefer higher unemployment because it keeps wages down and profits up. Central banks side with capital over labour because they accept the neoliberal idea that there is a point – the natural rate of unemployment – beyond which stimulating the economy merely leads to higher inflation. They are, Palley says, institutions “favoured by capital to guard against the danger that a democracy may choose economic policies capital dislikes”.

Until now, monetary policy has been deemed too important to be left to politicians. When the next crisis arrives it will become too political an issue to be left to unelected technocrats. If that crisis is to be tackled effectively, the age of independent central banks will have to come to an end.

Doomsday clock for global market crash strikes one minute to midnight as central banks lose control

China currency devaluation signals endgame leaving equity markets free to collapse under the weight of impossible expectations

 

It is only a matter of time before stock markets collapse under the weight of their lofty expectations and record valuations. Photo: Reuters

By John Ficenec in The Telegraph
 

When the banking crisis crippled global markets seven years ago, central bankers stepped in as lenders of last resort. Profligate private-sector loans were moved on to the public-sector balance sheet and vast money-printing gave the global economy room to heal.


Time is now rapidly running out. From China to Brazil, the central banks have lost control and at the same time the global economy is grinding to a halt. It is only a matter of time before stock markets collapse under the weight of their lofty expectations and record valuations.


The FTSE 100 has now erased its gains for the year, but there are signs things could get a whole lot worse.



1 - China slowdown


China was the great saviour of the world economy in 2008. The launching of an unprecedented stimulus package sparked an infrastructure investment boom. The voracious demand for commodities to fuel its construction boom dragged along oil- and resource-rich emerging markets.


The Chinese economy has now hit a brick wall. Economic growth has dipped below 7pc for the first time in a quarter of a century, according to official data. That probably means the real economy is far weaker.


The People’s Bank of China has pursued several measures to boost the flagging economy. The rate of borrowing has been slashed during the past 12 months from 6pc to 4.85pc. Opting to devalue the currency was a last resort and signalled the great era of Chinese growth is rapidly approaching its endgame.

Data for exports showed an 8.9pc slump in July from the same period a year before. Analysts expected exports to fall only 0.3pc, so this was a huge miss.

The Chinese housing market is also in a perilous state. House prices have fallen sharply after decades of steady growth. For the millions who stored their wealth in property, it makes for unsettling times.


2 - Commodity collapse

The China slowdown has sent shock waves through commodity markets. The Bloomberg Global Commodity index, which tracks the prices of 22 commodity prices, fell to levels last seen at the beginning of this century.


The oil price is the purest barometer of world growth as it is the fuel that drives nearly all industry and production around the globe.

Brent crude, the global benchmark for oil, has begun falling once again after a brief rally earlier in the year. It is now hovering above multi-year lows at about $50 per barrel.


Iron ore is an essential raw material needed to feed China’s steel mills, and as such is a good gauge of the construction boom.

The benchmark iron ore price has fallen to $56 per tonne, less than half its $140 per tonne level in January 2014.


3 - Resource sector credit crisis

Billions of dollars in loans were raised on global capital markets to fund new mines and oil exploration that was only ever profitable at previous elevated prices.

With oil and metals prices having collapsed, many of these projects are now loss-making. The loans raised to back the projects are now under water and investors may never see any returns.



Nowhere has this been felt more acutely than shale oil and gas drilling in the US. Tumbling oil prices have squeezed the finances of US drillers. Two of the biggest issuers of junk bonds in the past five years, Chesapeake and California Resources, have seen the value of their bonds tumble as panic grips capital markets.


As more debt needs refinancing in future years, there is a risk the contagion will spread rapidly.


4 - Dominoes begin to fall

The great props to the world economy are now beginning to fall. China is going into reverse. And the emerging markets that consumed so many of our products are crippled by currency devaluation. The famed Brics of Brazil, Russia, India, China and South Africa, to whom the West was supposed to pass on the torch of economic growth, are in varying states of disarray.

The central banks are rapidly losing control. The Chinese stock market has already crashed and disaster was only averted by the government buying billions of shares. Stock markets in Greece are in turmoil as the economy grinds to a halt and the country flirts with ejection from the eurozone.

Earlier this year, investors flocked to the safe-haven currency of the Swiss franc but as a €1.1 trillion quantitative easing programme devalued the euro, the Swiss central bank was forced to abandon its four-year peg to the euro.


5 - Credit markets roll over

As central banks run out of silver bullets then, credit markets are desperately seeking to reprice risk. The London Interbank Offered Rate (Libor), a guide to how worried UK banks are about lending to each other, has been steadily rising during the past 12 months. Part of this process is a healthy return to normal pricing of risk after six years of extraordinary monetary stimulus. However, as the essential transmission systems of lending between banks begin to take the strain, it is quite possible that six years of reliance on central banks for funds has left the credit system unable to cope.



Credit investors are often far better at pricing risk than optimistic equity investors. In the US while the S&P 500 (orange line) continues to soar, the high yield debt market has already begun to fall sharply (white line).




6 - Interest rate shock

Interest rates have been held at emergency lows in the UK and US for around six years. The US is expected to move first, with rates starting to rise from today’s 0pc-0.25pc around the end of the year. Investors have already starting buying dollars in anticipation of a strengthening US currency. UK rate rises are expected to follow shortly after.




7 - Bull market third longest on record

The UK stock market is in its 77th month of a bull market, which began in March 2009. On only two other occasions in history has the market risen for longer. One is in the lead-up to the Great Crash in 1929 and the other before the bursting of the dotcom bubble in the early 2000s.



UK markets have been a beneficiary of the huge balance-sheet expansion in the US. US monetary base, a measure of notes and coins in circulation plus reserves held at the central bank, has more than quadrupled from around $800m to more than $4 trillion since 2008. The stock market has been a direct beneficiary of this money and will struggle now that QE3 has ended.


8 - Overvalued US market

In the US, Professor Robert Shiller’s cyclically adjusted price earnings ratio – or Shiller CAPE – for the S&P 500 stands at 27.2, some 64pc above its historic average of 16.6. On only three occasions since 1882 has it been higher – in 1929, 2000 and 2007.