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Central Banks Still Fumbling in the Dark

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Central Banks Still Fumbling in the Dark

Ever since the "Taper Tantrum" that accompanied the Federal Reserve's gradual move away from monetary stimulus measures popularly known as "quantitative easing," the global markets have remained in a perpetual state of volatility. The transition from emergency-measure, accommodative central bank policies back to a normal rate environment has been fraught with difficulty thanks to the uncertainty swirling around what the world's leading monetary authorities will do next. Not to mention that the longer the outlook for the global economy remains unclear, the farther these central banks venture into the dark unknown—potentially further and further in the wrong direction.

A great deal of attention will be placed on the next meeting of the Federal Reserve Open Market Committee (FOMC) two weeks from today, on September 16, when a considerable number of analysts still believe the Fed will announce its first increase to the federal funds rate in about a decade. Before then, the European Central Bank (ECB) governing council will meet on Thursday in Frankfurt.

"Quantitative Tightening"?

For many years, dating back to the 1990s, it seemed that the "New Normal" for central bank policy was the aggressive accumulation of foreign reserves in order to protect against swift capital outflows from a nation's domestic economy, like what happened in Asia during the financial crisis of 1997/1998. As a bulwark against such a situation recurring, China and Japan in particular amassed incredible stockpiles of forex reserves to go along with their unparalleled holdings of U.S. debt. (Both countries maintain about $12 trillion in Treasuries.)

Source: OptionsClick blog Source: OptionsClick blog

Yet, as global trends—however slowly—swing back toward central banks tightening policy, major economic powers like China and Japan are realizing that they can only stretch monetary easing so far before no more benefits can be derived. Holding enormous amounts of foreign currencies in their reserves has the effect of devaluing the yen and yuan; the IMF has warned both the People's Bank of China and the Bank of Japan that further efforts to stimulate their respective economies through undercutting the national currency could prove detrimental in the long run.

In fact, China is very interested in elevating the yuan/renminbi to a more prominent place on the international stage, meaning it is more likely to follow the IMF's guidelines in order to secure the coveted feather-in-their-cap that comes with inclusion in the Fund's Special Drawing Rights, made up of a basket of the world's major currencies. In Japan, the outlook for the yen (which now trades around 120 per dollar, compared to just over 6 per dollar for the yuan) is still less clear-cut. (The yen is already included in the IMF's SDR, as it is often seen as a safe haven despite its current weakness.)

Source: China.org.cn Source: China.org.cn

Worldwide Trend

After insulating themselves with billions upon billions of dollar worth of foreign reserves, central banks the world over are beginning to cut those giant piles of U.S. dollars, Swiss francs, and euros. (These are the most typical currencies for foreign central banks to diversify into.) As the shake-up of the global economy has forced several countries to remove pegs or fixes from their currencies, the easiest way to support a currency's value is to exchange those foreign reserves in order to purchase more of the national currency (i.e. China selling euros to "buy back" yuan, thus bolstering the exchange rate).

bank_reservesThe underlying problem with this isn't the practice itself, but the discord between central banks that are engaging in this form of monetary tightening and others that insist on still more monetary easing (the opposite). Even before the Fed or the Bank of England pulls the trigger on gradually normalizing their benchmark interest rates, the world economy could feel the effects of divergent central bank policy wherein some countries move toward normalcy while others resist turning off the metaphoric faucet of liquidity.

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