Keep up with the Federal Reserve

NEW HAVEN, Connecticut – As the pandemic of COVID-19 pushes the global economy into recession, the temptation to seek strong monetary easing increases. Indeed, the US Federal Reserve has pushed interest rates close to zero and committed to pumping trillions of dollars into the economy. The European Central Bank also boosted bond purchases, although the German Constitutional Court is stepping up some resistance. Like the easing that followed the 2008 financial crisis, it will resonate around the world through exchange rate fluctuations.

On their own, major economic shocks, such as natural disasters or disease outbreaks, tend to revalue the currencies of the affected countries. When a Cuban earthquake struck in 1995, the yen rose against the dollar, though not immediately. The 2011 Great East Japan earthquake had a stronger impact, as it pushed the yen to a historical high of ¥ 76 against the dollar.

What explains this strengthening after the disaster of the value of the currency? The exchange rates reflect the relative demand for currencies on the world market. Demand is partly dependent on supply: if there are assets in dollars far more than assets of the yen in the global market, then the rare yen will gain value. The increased demand for the yen will add to this effect.

Disasters often undermine business activities – a development that can lead to a devaluation of the currency. But this effect tends to be offset by an increase in precautionary demand for money, which hinders, along with lower consumption, supply. After all, in times of uncertainty, people want to keep more cash. In a country like Japan or the United States, where there is little risk of runaway inflation, they usually store the local currency.

This pattern was demonstrated during the COVID-19 crisis. Fascism struck Japan before it began to destroy the United States in early March, when the United States still had a few confirmed cases, the yen exchange rate rose against the dollar, reaching ¥ 103.

By March 20, an American infection was spreading, causing many, including my wife and I, to withdraw emergency funds from the bank. The desire to create a safety net started amid increasing uncertainty, along with restrictions on movement, and consumption was weakening. At the same time, Japan had a relatively outbreak of the disease. Therefore, it is not surprising that the dollar began to appreciate, reaching 112 yen.

As we saw in the aftermath of the 2008 financial crisis, monetary policy can reshape the dynamics of exchange rates. When the US mortgage market overturned, the Federal Reserve bought massive amounts of mortgage-backed securities and US Treasury bonds to increase liquidity and keep the debt market working. As the dollar flocked to global markets, the relative value of other currencies increased.

Now, the Fed is pumping dollars back into global markets – an approach that has already caused the dollar to drop to pre-epidemic levels around 107-108 yen. The dollar fell more against the euro, at least because, as is the case, the market expects more monetary expansion from the Federal Reserve than the European Central Bank.

With the Fed indicating its desire to increase the supply of the dollar further, this trend is likely to continue – with serious implications for Japanese and European economies. After all, exchange rates play a major role in the export competitiveness. After the 2008 crisis, the export cost defect caused by a stronger yen left Japan worse off than some of the countries directly affected by the financial turmoil, starting with the United States itself.

This leaves countries with only one real option: increasing the supply of their own currency as well. As Bank of Japan Governor Haruhiko Kuroda explained when he implemented expansionary policies – part of the broader Abenomics economic recovery program introduced in 2012 – increased money supply could make a difference, even against the backdrop of negative interest rates.

Today, governments generally focus on either “flattening the curve” of the first wave of COVID-19 infection, or, increasingly, on avoiding the second wave of injuries as they facilitate social divergence protocols and allow the resumption of economic activity. Meanwhile, many programs and policies are being implemented to support families and companies, in the hope of alleviating the economic consequences of closures and social exclusion.

However, although the United States appears bent on dumping global markets in dollars, even the economies that have effectively managed the crisis so far may have no choice but to pursue their own monetary easing. Japan tops that list.

Koishi Hamadeh is Professor Emeritus at Yale University and Special Adviser to Prime Minister Shinzo Abe. Project Syndicate, 2020. www.project-syndicate.org

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