QE3 and the looming currency war

An unstable situation could worsen

By Michael Casey

First, let’s get this straight: The U.S. Federal Reserve’s Open Market Committee is composed of some very smart, sensible people.

But...for all the unreasonable accusations that are sometimes leveled at Chairman Ben Bernanke and his colleagues, there is one good reason to complain about the FOMC’s detachment from the world. It stems from the fact that the Fed’s mandate extends no further than U.S. borders. The committee members are under no legal obligation to consider the impact of their actions on foreign countries. And yet their decisions inevitably have a sweeping, disruptive influence on global money markets and, by extension, on the world economy.

Our international system of independent sovereign nation states requires this detachment, of course. But because the dollar is the world’s reserve currency, the Fed has a responsibility that far exceeds that of other central banks. And these days, in an increasingly interconnected global economy, it is in America’s interest for the Fed to take this responsibility seriously.

This is relevant because the consensus view on Wall Street puts better-than-even odds on the FOMC soon launching a third round of bond-buying, also known as “quantitative easing,” a process that involves printing dollars. The debate may well be resolved on Friday, when Bernanke delivers a much-anticipated speech to the Kansas City Fed’s annual confab in Jackson Hole, Wyo.

In 2010, the last time the Fed launched a bond-buying spree in an attempt to boost the flagging U.S. economy, many of the hundreds of billions in excess dollars went in search of better-paying returns in other currencies. This prompted an international backlash against the U.S. while foreign governments tried various tricks to anchor their ascending currencies and restore their exporters’ lost competitiveness. Brazilian Finance Minister Guido Mantega characterized it as a “currency war.”

Bernanke responded to his foreign critics by declaring that the dollar’s weakness was a byproduct, not the intent, of Fed policy. Interventionist central banks should stop meddling with their currencies and instead worry about domestic inflation, he would say. That was all very well in theory, but developing countries weren’t buying it. Here they were, earnestly pursuing U.S.-recommended free-market policies, and now it seemed the Fed itself was deliberately flooding the world with dollars to lower the greenback’s value. They felt they had no choice but to fight back.

So, what direction will this global battle take if Bernanke sends a clear signal that “QE3” is on its way?

The experience during QE2 is a useful, if imperfect guide. In that case, from the moment that Bernanke first flagged the Fed’s intention to launch a second bond-buying program in August 2010 (also at Jackson Hole) until the program ended in June 2011, the Wall Street Journal dollar index, a proxy for the dollar that’s based on a volumes-weighted basket of seven currencies, registered a 10% decline. Over the same period, the Brazilian real gained more than 12% versus the dollar, a gain matched by many other such currencies.

This time, the effect will be different, but no less significant.

For one, there are fewer options for currency traders. They will shun the real, which the Brazilian authorities have taken out of contention through taxes on financial inflows, heavy dollar-buying and interest-rate cuts. Other central banks, such as South Africa’s and Indonesia’s, have also demonstrated a willingness to intervene, which will give speculators pause. Meanwhile, the Swiss National Bank has put a cap on the Swiss franc’s value versus the euro and Japanese authorities have repeatedly tried to drive down the value of the yen.

But the wave of QE money must go somewhere, which means an even bigger burden of currency appreciation will be borne by the better behaved countries: Chile, South Korea, Australia, New Zealand.

And at a time of slowing global growth and sliding commodity prices, they are hardly prepared to deal with a sudden loss of competitiveness. What’s to say they aren’t also tempted to intervene?

All of this poses a risk to the proper functioning of financial markets and, more ominously, to trade relations. If Bernanke opens the door to more QE, this unstable situation will become even more unstable.