The PBoC’s monetary supremacy over Brazil (but don’t blame the Chinese)

Brazilian Finance Minister Guido Mantega likes to blame the Federal Reserve (and the US in general) for most evils in the Brazilian economy and he has claimed that the fed has waged a ‘currency war’ on Emerging Market nations.

As my loyal readers know I think that it makes very little sense to talk about a currency war and  I strongly believe that any nation with free floating exchange rates is in full control of monetary conditions in the country and hence of both the price level and nominal GDP. However, here the key is a freely floating exchange rate. Hence, a country with a fixed exchange rate – like Hong Kong or Denmark – will “import” the monetary policy from the country its currency is pegged to – the case of Hong Kong to the US and in the case of Denmark to the euro zone.

In reality few countries in the world have fully freely floating exchange rates. Hence, as I argued in my previous post on Turkey many – if not most – central banks suffers from fear-of-floating. This means that these central banks effectively will at least to some extent let other central banks determine their monetary policy.

So to some extent Mantega is right – the fed does in fact have a great impact on the monetary conditions in most countries in the world, but this is because that the national central banks refuse to let their currencies float completely freely. There is a trade off between control of the currency and monetary sovereignty. You cannot have both – at least not with free capital movement.

From Chinese M1 to Brazilian NGDP  

Guido Mantega’s focus on the Federal Reserve might, however, be wrong. He should instead focus on another central bank – the People Bank of China (PBoC). By a bit of a coincidence I discovered the following relationship – shown in the graph below.

China M3 Brazil NGDP

What is the graph telling us? Well, it looks like the growth of the Chinese money supply (M1) has caused the growth of Brazilian nominal GDP – at least since 2000.

This might of course be a completely spurious correlation, but bare with me for a while. I think I am on to something here.

Obviously we should more or less expect this relationship if the Brazilian central bank had been pegging the Brazilian real to the Chinese renminbi, but we of course all know that that has not been the case.

The Chinese-Brazilian monetary transmission mechanism

So what is the connection between Chinese and Brazilian monetary conditions?

First of all since 2008-9 China has been Brazil’s biggest trading partner. Brazil is primarily exporting commodities to China. This means that easier Chinese monetary policy likely will spur Brazilian exports.

Second, easier Chinese monetary policy will also push up global commodity prices as China is the biggest global consumer of a number of different commodities. With commodity prices going up Brazil’s export to other countries than China will also increase.

Therefore, as Chinese monetary easing will be a main determinant of Brazilian exports we should expect the Brazilian real to strengthen. However, if the Brazilian central bank (and government) has a fear-of-floating the real will not be allowed to strengthen nearly as much as would have been the case under a completely freely floating exchange rate regime.Therefore, effectively the Brazilian central bank will at least partly import changes in monetary conditions from China.

As a result the Brazilian authorities has – knowingly or unknowingly – left its monetary sovereignty to the People’s Bank of China. The guy in control of Brazil’s monetary conditions is not Ben Bernanke, but PBoC governor Zhou Xiaochuan, but don’t blame him. It is not his fault. It is the result of the Brazilian authorities’ fear-of-floating.

The latest example – a 50bp rate hike

Recently the tightening of Chinese monetary conditions has been in the headlines in the global media. Therefore, if my hypothesis about the Chinese-Brazlian monetary transmission is right then tighter Chinese monetary conditions should trigger Brazilian monetary tightening. This of course is exactly what we are now seeing. The latest example we got on Wednesday when the Brazilian central bank hiked its key policy rates – the SELIC rate – by 50bp to 8.50%.

Hence, the Brazilian central bank is doing exactly the opposite than one should have expected. Shouldn’t a central bank ease rather than tighten monetary policy when the country’s main trading partner is seeing growth slowing significantly? Why import monetary tightening in a situation where export prices are declining and market growth is slowing? Because of the fear-of-floating.

Yes, Brazilian inflation has increased significantly if you look at consumer prices, but this is primarily a result of higher import prices (and other supply side factors) due to a weaker currency rather than stronger aggregate demand. In fact it is pretty clear that aggregate demand (and NGDP) growth is slowing significantly. The central bank is hence reacting to a negative supply shock (higher import prices) and ignoring the negative demand shock.

Obviously, it is deeply problematic that the Brazilian authorities effectively have given up monetary sovereignty to the PBoC – and it is very clear that macroeconomic volatility is much higher as a result. The solution is obviously for the Brazilian authorities to get over the fear-of-floating and allowing the Brazilian real to float much more freely in the same way has for example the Reserve Bank of Australia is doing.

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Guido Mantega be careful what you hope for

A friend wrote this on Facebook (I paraphrased it slightly):

It’s a bit ironic that the large emerging markets countries, which complained about monetary easing in the US (Brazilian Finance Minister Guido Mantega called it ‘currency war’) now these countries are the hardest hit when talks about tapering are now hitting the headlines… Be careful what you hope for… Brazil just had a massive weakening of its currency and the central bank had to hike rates to defend the currency. Not good for growth. Talk about bad policies….

My friend is of course is completely right. Monetary easing in the US and Japan was never a problem for Emerging Markets and in the case of Brazil it is clear that the country has much bigger problems than monetary easing in the US and Japan to worry about.

HT Transmussen

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

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PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

Bring on the “Currency war”

I have been giving the issue of devaluation a bit of attention recently. In my view most people fail to understand the monetary aspects of currency moves – both within a floating exchange rate regime and with managed or pegged exchange regimes.

I have already in my post “Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons” argued that what we should focus on when we are talking about the effects of devaluation is the impact on the money supply and on money-velocity rather than on “competitiveness”. In my post “Mises was clueless about the effects of devaluation” I argued that Ludwig von Mises basically did not fully comprehend the monetary nature of devaluations.

The failure to understand the monetary nature of devaluation often lead to a wrongful analysis of the impact of giving up pegged exchange rates or leaving a currency union – or for that matter giving up the gold standard. It also leads to a very wrong analysis of what has been called “competitive devaluations” – a situation where different countries basically are moving to weaken their own currencies at the same time. This discussion flared up in the second half of 2010 when (the expectations of) QE2 from the Federal Reserve triggered a strengthening of especially a number of Emerging Market currencies. Many EM central banks moved to counteract the strengthening of their currencies by cutting interest rates and intervening in the FX markets – basically undertaking QE on their own. Brazilian Finance Minister Guido Mantega even talked about currency war (and he has apparently just redeclared currency war…)

However, the term “currency war” is highly misleading. In a world of depressed global NGDP and deflationary tendencies there is no problem in competitive devaluations. The critiques would argue that not all countries can devalue and that the net impact on global economic activity therefore would be zero. This, however, is far from right. As I have earlier argued devaluation is not primarily about competitiveness, but rather about the impact on monetary conditions. Hence, if countries compete to devalue they basically compete to increase the money supply and velocity. This obviously is very positive if there is a general global problem of depressed nominal spending. Hence by all means bring on the currency war! Furthermore, it should be noted that in a situation where there is financial sector problems it is likely that the transmission mechanism would work much stronger through the FX channel than through the credit channel. See my related post on this here.

Imagine this highly unrealistic scenario. The ECB tomorrow announces a target for EUR/USD of 1.00 and announce it will buy US assets to achieve this target. The purpose would be to increase the euro zone’s nominal GDP by 15% and the ECB would only end its policy once this target is achieved. As counter-policy the Federal Reserve announces that it will do the opposite and buy European assets until EUR/USD hits 1.80 and that it will not stop this policy before US NGDP has been increased by 15%. Leave aside the political implications of this (the US congress would freak out…) what would happen? Well basically the Fed would be doing QE in Europe and ECB would be doing QE in the US. EUR/USD would probably not move much, but I am pretty sure inflation expectations would spike and global stock markets would increase strongly. But most important NGDP would increase sharply and fast hit the 15% target in both the euro zone and the US. Obviously this policy could lead to all kind of unwarranted side-effects and I would certainly not recommend it, but it is a illustration that we should not be too unhappy if we have “friendly” currency war. By “friendly” I mean that the currency war does not trigger capital restrictions and other kind of interventionist policy and that is clearly a risk. However, it is preferable to the present situation of depressed global NGDP.

Matthew O’Brien the associate editor at The Atlantic reaches the same conclusion in a recent comment. In “Currency Wars Are Good!” Matthew aruges along the same lines as I do:

A currency war begins, simply enough, when a country decides to push down the value of its currency. This means either printing money or just threatening to print money. A cheaper currency makes exports cheaper, and more competitive exports means more growth and happier people. Well, everybody except people in other countries who were just undersold and lost exports. That’s why economists call this kind of devaluation a “beggar-thy-neighbor” policy: Countries boost exports at the expense of others.

This sounds bad. Rather than cooperating, countries are fighting over trade. But in this case, some fighting is good, and more fighting is better. Countries that lose exports want to get them back. And the best way to do that is to devalue their own currencies too. This, of course, causes more countries to lose exports. They also want to get their exports back, so they also push down their currencies. It’s devaluation all the way down. All thanks to economic peer pressure.

The downside of devaluation is that no country gains a real trade advantage, and weaker currencies means the prices of commodities like oil shoot. But — and here’s the really important part — devaluing means printing money. There isn’t enough money in the world. That’s the simple and true reason why the global economy fell into crisis and has been so slow to recover. It’s also the simple and true reason why the Great Depression was so devastating. We know from the 1930s that such competitive devaluation can turn things around.

War is good if it creates more of something you want. A “charity war” between friends is good because it leads to more donations. A currency war is good because it leads to more money. If war is politics by other means, a currency war is stimulus by other means.

So true, so true. So next time somebody starts to worry about “currency war” please tell them that is exactly what we want and for those countries where monetary policy is not too tight tell them to let their currencies appreciate. It will not do them harm. Is monetary policy is already too loose currency appreciation will be a welcomed tightening of monetary conditions.

PS you obviously don’t want to see competitive devaluations in a world of high inflation. That is what happened during the 1970s, but we can hardly talk of high inflation today – at least not in the US and the euro zone.

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