No one wants to acknowledge it, but global central banks have stepped up their efforts to devalue their currency in order to look after their domestic interests – at the expense of their neighbors.
A list of central banks that either cut their interest rates or expanded on bond buying efforts in the past three months has gotten longer as economies struggle to fend off falling prices, pay down on debts, and expand growth. Analysts are anticipating that other central banks, including the Reserve Bank of Australia and the Bank of Canada, will soon be added to the list (see below) as their currency becomes less competitive in the global market and deters their exports and growth.
October 31 – Bank of Japan buys more bonds to raise prices
November 23 – China cuts rates amid falling exports and contracting credit
January 15 – India cuts rates to stimulate growth and Swiss National Bank gives up and abandons currency floor against the euro
January 21 – Bank of Canada cuts rates to combat falling oil prices
January 22 – European Central Bank announces an aggressive bond buying program
January 28 – Monetary Authority of Singapore cuts rates to devalue the dollar
January 29 – Danmarks Nationalbank cut rates to deter capital inflow from the Eurozone
Of course, in today’s interconnected financial markets, any actions taken by the central banks invite tit-for-tat responses and may result in a competitive-devaluation spiral. In the long run, this risks high inflation and erodes the standard of living at home.
The risk of the competitive-devaluation spiral, commonly referred to as a currency war, is high right now. About a third of global central banks have already cut interest rates over the past six months and they are closely monitoring their economy to see if more cuts are warranted. Meanwhile, the International Monetary Funds (IMF) revised their 2015 global forecast down to 3.5 percent from 3.8 percent last week. The original forecast was only made in October. A further slowdown in the global economy will put renewed pressure on the central banks to further cut their rates before their neighbors do.
So, is it a deflationary gloom that awaits the global economy this year? Not necessarily. The US economy has performed “solidly” according to a Fed meeting statement released yesterday. The Fed noted that the employment condition has sufficiently recovered. Therefore, the Fed is preparing to raise short term interest rates sometime this year, despite gloomy global prospects of deflation, low growth and geopolitical risks.
The dollar has rallied by 18 percent against a basket of major trading currencies since July, based on a market expectation that the US economy will outperform its peers. And if the economy, which accounts for 22 percent of the global economy, continues to expand solidly this year, a rising income and a stronger dollar will provide an attractive market for exports from struggling global economies. However, if the economy falters, then the Fed may be persuaded to join the currency war. This would mean devaluing the dollar to protect domestic producers from lower-price import competition and also help boosts overseas earnings for exporters.
This Friday, the 4th quarter US Gross Domestic Product (GDP) report will be released. In the past two quarters, the economy surpassed everyone’s expectations by expanding by more than 4.5 percent annually. In contrast, the Eurozone and Japan managed to eke out less than 1 percent annual growth during the same period.
Therefore, if tomorrow’s GDP data shows that the economy has not faltered in the final quarter of the year then a chance of avoiding the currency war may gain some confidence. That said, the market remains cautious. The recent economic data including retail sales and durable goods orders have been somewhat disappointing despite falling gas price at the pump and low interest rates suggesting that a prospect for an all-out currency war is real possibility.