Central Banks: Dangerous FX implications of the taper discussion – Goldman Sachs

Research Team at Goldman Sachs, suggests that last month’s BoJ switch to yield targeting was interpreted by some as a way to disguise a tapering of JGB purchases, and the tapering discussion has stayed with markets and has now engulfed the ECB.

Key Quotes

“With speculation that an extension of sovereign bond buying – our economics team forecast an extension to the end of next year – could come at the cost of tapered monthly purchases.

EUR/$ jumped on this news, underscoring our belief that both the Euro and the Yen could appreciate sharply should there be an explicit tapering signal. This is because the weakening in both currencies in recent years reflects a dovish shift in the perceived reaction function of both central banks. With both undershooting their inflation targets by large margins, any tapering would cause the market to seriously revise this perception, pushing the Euro and the Yen stronger, potentially substantially so.

Put differently, foreign exchange markets would take a dim view of reducing monetary stimulus at this stage and see this as going back on previous promises. Our biggest worry at the moment is that policy makers don’t fully appreciate how much the Euro and Yen could appreciate. In the case of the BoJ, we are sufficiently worried to call this the (Y)ENd game.

The tapering discussion reflects two things. First, there is a sense that central banks are running out of bullets, which is what the JGB and Bund scarcity debates have been about. Second, there is a sense that monetary policy can pass the baton to fiscal policy, given that a positive fiscal impulse in many places – coupled with shrinking output gaps – should help drive inflation higher. We think this latter reasoning is misguided. As we have documented in the past, the Euro zone Phillips curve may have shifted down in recent years, as a result of ongoing internal devaluation in periphery countries which means that, all things equal, HICP inflation is lower for a given output gap.

In Japan, the Phillips curve gives the impression of being quite steep, but this is largely because the Yen devaluation since 2012 buoyed inflation and employment simultaneously. Without this foreign exchange effect, the Phillips curve is quite flat. The fact that the Phillips curve is so flat in both places means that fiscal stimulus is unlikely to deliver material gains in inflation, so that currency devaluation from monetary easing remains the only game in town. In our assessment, foreign exchange markets know this and will be quick to punish any signals to the contrary from the ECB or BoJ.

 An interesting question is why a reduction in stimulus is being considered at all, given that both central banks are falling short – by a large margin – of meeting their inflation targets. Compared with the US, banks in Europe and Japan play a greater role in the economy and have, presumably, more lobbying power. This is making it more difficult to pursue aggressive unconventional easing policies. But at a more fundamental level, the societies in Japan and Germany (the country with effective veto power over the ECB) are more conservative than the US and place a greater weight on stable central bank balance sheets. Political opposition to unconventional easing is therefore greater, which is really the root cause of the tapering discussion. It is the job of the ECB and BoJ to push through this opposition. Failure to do so will likely cause the Euro and the Yen to appreciate sharply, which would leave Europe and Japan even worse off.”