Is the “Bernanke-Evans rule” working? Hell yes! At least in Mexico!
The Mexican economy recovered fast from the shock in 2008-9 and real GDP has been growing around 5% in the last three years and now growth is getting a further boost from the Fed’s monetary easing. Just take a look at the graphs below – especially keep an eye on what have happened since September 13 when the so-called Bernanke-Evans rule effectively was announced.
The Bernanke-Evans rule boosts the Mexican stock market
Mexican consumers get a boost from Bernanke
Mexican industrialists are falling in love with Bernanke
The US-Mex monetary transmission mechanism
A traditional Keynesian interpretation of what is going on would be that Bernanke’s monetary easing is boosting US industrial production, which is leading to an increase in Mexican exports to the US. The story is obviously right, but I would suggest that it is not the most important story. Rather what is important is the monetary transmission mechanism from the US to Mexico.
Here is that story. When the Fed steps up monetary easing it leads to a weakening of the dollar against all other currencies – including the Mexican peso as funds flow out of the US and into the Mexican markets. The Mexican central bank Banxico now has two options. Either the central bank de facto allows the peso to strengthen or it decides to “import” the Fed’s monetary easing by directly intervening in the currency market – buying dollars and selling pesos – or by cutting interest rates. No matter how this is done the result will be an increase in the Mexican money supply (relative to what otherwise would have happened). This in my view is what is driving the rally in the Mexican stock market and the spike in consumer and business confidence. It’s all monetary my friend.
Obviously Banxico don’t have to import the monetary easing from the US, but so far have chosen to do so. This has probably been well-advised, but the Mexican economy is certainly not in need of a US scale monetary easing. What is right for the US is not necessarily right for Mexico when it comes to monetary easing. Therefore, Banxico sooner or later have stop “importing” monetary easing from the US.
Luckily the Banxico can choose to “decouple” from the US monetary easing by allowing the peso to strengthen and thereby curb the increase in the money supply and reduce potential inflationary pressures. This in fact seems to be what has been happening in recent weeks where the peso has rallied against the dollar.
This is not the place to discuss what Banxico will do, but think the discussion of the US-Mex monetary transmission mechanism pretty well describe what many Emerging Markets central banks are now facing – monetary easing from the US is forcing them to choose between a stronger currency or a monetary expansion. However, unlike what Brazilian Finance Minister Mantega seems to think this is not such a terrible thing. Banxico and the Brazilian central bank and other EM central banks remain fully in charge of monetary policy themselves and if the central banks are clear about their monetary targets then the markets will do most of the lifting through the exchange rate channel.
Imagine for example that the Mexican peso starts to strengthen dramatically. Then that likely will push down Mexican inflation below Banxico’s inflation target pretty fast. With inflation dropping below the inflation target the markets will start to price a counter-reaction and a stepping up of monetary easing from Banxico and that in itself will curb the strengthening of the peso. Hence, the credibility of the central bank’s target is key.
And it is here that the Brazilians are facing a problem. As long as the central bank has one target things are fine. However, the Brazilian authorities often try to do more than one thing with monetary policy. Imagine the Brazilian economy is growing nicely and inflation is around the central bank’s inflation target. Then a positive monetary shock from the US will lead the Brazilian real to strengthen. That is no problem in terms of the inflation target. However, it will likely also lead the Brazilian export sector facing a competitiveness problem. Trying to “fix” this problem by easing monetary policy will on the other hand lead to excessively easy monetary policy. The Brazilian authorities have often tried to solve this “problem” by trying to curb currency inflows with different forms of currency restrictions and taxes. That has hardly been a success and luckily the Mexican authorities are much less interventionist in their attitudes.
The lesson here is that the Federal Reserve is a monetary superpower and the Fed can export monetary easing to other countries, but that do not mean that the Fed is in charge of monetary policy in Brazil or Mexico. The Brazilian and Mexican central banks can also choose not to import the monetary easing by simply letting their currencies strengthen and instead focus on it’s own monetary policy targets instead of trying to solve other “problems” such as competitiveness concerns. Excessive focus on competitiveness will lead central banks to ease monetary policy too much and the result is often rising inflationary pressures and bubbles.
PS don’t think that is this a zero sum – just because the Fed’s easing is working in Mexico does not mean that it is not working in the US.
PPS Nick Rowe once told a similar story about Hong Kong…with another FX regime.