If it wasn’t clear from the communique from the Group of 20 (G-20) finance ministers and central bankers issued after their 26–27 February meeting in Shanghai, the world’s major central banks hammered home the message through their actions and words over the past two weeks: There is a common understanding that too strong a U.S. dollar is undesirable and that monetary policy actions should be conducive to furthering broad stability among the major currencies.
As I see it, there are three parts to the Shanghai co-op agreement:
First, the European Central Bank (ECB) and the Bank of Japan (BOJ) will refrain from aggressively pushing interest rates more negative and rather focus on more domestically oriented easing steps. The intention is to put an end to the popular “currency war” interpretation of their actions and also to be mindful of the dark side of negative interest rates – the potentially damaging impact on banks and other financial institutions. Both the ECB and the BOJ have been true to their part of the agreement: The ECB on 10 March increased its quantitative easing program, introduced purchases of corporate bonds and additional funding for the banks and signaled that the 10 bps cut in the deposit rate to -40 basis points was probably the last. The BOJ didn’t ease policy further on 15 March but in its statement refrained from repeating a sentence from the previous one about cutting rates further negative if needed.
Second, the U.S. Federal Reserve delivered its part of the co-op agreement on 16 March when the Federal Open Market Committee reduced its “appropriate policy” interest rate path by more than expected and emphasized it was concerned about global risks. In addition, Fed Chair Janet Yellen at a press conference downplayed the recent upside in core inflation and also seemed relaxed about a potential pickup in wage growth. Her comments suggest that, after undershooting the inflation target for four years in a row, the Fed seems willing to “run it hot,” though without publicly committing to it.
Third but not least, China’s quid pro quo in the co-op agreement is to refrain from aggressive and disruptive currency (CNY) depreciation versus the dollar that could lead to another bout of tighter financial conditions similar to August 2015 and January 2016. In fact, the People’s Bank of China has fixed the CNY relatively stable in recent weeks. This was helped by the dollar’s weakening against the euro and the yen, which implied that the CNY has actually depreciated slightly against a basket of currencies and thus has reduced the incentive to devalue against the dollar for competitive reasons.
What are the implications of the Shanghai co-op? First, the dollar’s long ascent against virtually all currencies is behind us – it is more likely to trade in a broad range against the euro and the yen. Second, currency stability and reduced fears about disruptions from China should support risk assets. And third, with the Fed acknowledging its global role and responsibilities by adopting a more dovish stance, inflation expectations in the U.S. look likely to rise further.