As many rush to ease monetary policy even more to revive their lackluster economies, those that don't—such as the U.S. Federal Reserve and Bank of England—have found their growth penalized by rising currencies. That may contribute to a more accommodative policy path than they envisaged, reversing foreign-exchange rate gains and putting pressure on their counterparts to take further action.
This kind of vicious cycle may be one reason why investors are increasingly questioning the ability of monetary policy to spur economic growth. It marks a potential shift from what was supposed to be a year of divergence in central bank policies.
"If growth is disappointing and countries that hit the zero bound try to export their problems through currency weakness, that sucks everyone else closer to the zero bound," said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. "You have a contagion."
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The U.S. economy, the world's largest, has been expanding for more than six years, and the Fed was expected to diverge from the monetary-policy pack this year. The central bank raised interest rates for the first time in almost a decade in December, and officials projected four more quarter-point increases would be warranted in 2016.
That path appears increasingly doubtful. A slump in commodity prices and slowing global demand have kept a lid on inflation, and turmoil in financial markets has made additional tightening a difficult call. What's more, the dollar appreciated 9 percent last year against a basket of leading global currencies in anticipation of Fed hikes—a move that tightened conditions in and of itself.
Markets have become less convinced that Fed rate changes are coming soon, with futures traders pricing in zero probability of an increase in March and reduced odds of a hike anytime this year. The greenback has reversed some of its gains, and that has limited how much extra oomph the European Central Bank, for instance, can get from a weaker currency that makes the region's exports more attractive than America's.
"The unfortunate thing is that it takes two to tango, and the only one at the other end of the exchange-rate channel was the Fed," said Stefan Schneider, an economist at Deutsche Bank AG in Frankfurt. While a Bank of England rate hike was also once believed possible, Governor Mark Carney took that off the table last month.
"In a world where everybody is prepared to let his own currency soften, and no one is willing to let their currency appreciate, you have problems," Schneider said.
As rates diverge less than expected, some central banks are becoming even more aggressive with their policy tools. Sweden's Riksbank cut interest rates deeper below zero Thursday, sending the krona lower, while officials in Switzerland and Japan signaled to traders that they don't want strong appreciations of their respective currencies.
Renewed Focus on Exchange Rates
The Fed on hold "does make it more challenging for the central banks that were benefiting from the weakening of the exchange rate," said Nick Matthews, head of European economic research at Nomura International Plc in London. "It's put renewed focus back on the exchange-rate channel, and why there's a lot of focus on central banks—and mention of a sort of race to the bottom."
The situation is reaching a point where more coordination may be needed. The world's top finance ministers and central bankers should pledge to step up efforts to boost global growth at the Feb. 26-27 Group of 20 meetings in Shanghai, according to a European Union planning document obtained by Bloomberg News.
If other economies successfully use monetary tools to keep their currencies cheap, it could hurt trade and weigh down prices in the U.S., where the effects of last year's currency appreciation are already a major concern. Fed Chair Janet Yellen mentioned the dollar four times in prepared testimony to Congress this week, saying its strength slowed exports, tightened financial conditions and kept inflation too low.
Even if countries that are easing manage to push their currencies down against the dollar, the effect may not may not be enough to derail growth in a big economy like America's. Figures on Friday showed U.S. retail sales increased for a third month in January, with spending on a group of goods and services used to calculate gross domestic product rising 0.6 percent, the most since May.
The U.S. is still benefiting from the same positive consumer trends that gave policy makers the confidence to raise interest rates in December: Unemployment has fallen dramatically, wage growth may be showing early signs of a pickup, and spending on cars and other goods has managed to hold up.
Fed to Take a Gradual Path
Fed policy makers meet next month and will have to account for how deeply global turmoil and the currency environment are affecting the outlook. Yellen this week stuck to her forecast for moderate growth and "gradual adjustments" in the policy rate.
"Can they keep raising while everyone else is easing or taking actions to soften their currency? Yes," said Omair Sharif, rates sales strategist at SG Americas Securities in New York, noting that a shallow path of increases should prevent a repeat of the dollar's 2015 strengthening. "The pace of rate hikes they've laid out is still gradual."
–With assistance from Simon Kennedy.
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