Why Country Monetary Policies Move Together

Why Country Monetary Policies Move Together

There are a few key reasons why countries’ monetary policies are moving together.

i) the conditions of industry are geographically linked

ii) inflation and commodity prices appear to be correlated.

iii) Countries do not want their currencies to be too strong or too weak compared to others, so the actions of certain countries’ central banks affect those of others in tandem.

As a consequence of foreign trade and cross-border facilities, the market conditions are highly linked. China has a massive impact on the rest of the world, from less than one percent of global trade in the 1980s to about 15 percent, comparable to industrialized Europe.

Some product markets are regional due to the difficulties of shipping them over long distances (e.g., natural gas). But many other commodities are global markets and seldom get too far away depending on location (e.g., crude oil, soybeans). This means that each nation pays identical prices.

Countries with similar growth levels in terms of technology adoption and equivalent feed-in product prices would appear to have similar inflation rates.

Likewise, a tradable good should see equal rates, no matter where you go. Since it depends on transportation costs, trade barriers, taxes, and other such factors, all countries would be driven to buy from the lowest-cost supplier.

There’s a currency point, too.

A weaker currency than a trading partner makes it easier to export its goods (and services) but more costly to import.

Whether policymakers want a weaker or stronger currency depends on the essence of the relationship between the two countries and their own domestic conditions.

If a country exports a lot to a certain market but imports a little, it would usually want a lower relative exchange rate to maximize that relationship’s economics.

When a country has a lot of debt, particularly a lot of foreign debt denominated in its own currency, and can print its own money, it will eventually want to depreciate its currency. (A government that is reluctant or unwilling to print its own money will inevitably have to restructure its debts.)

A weaker currency in the form of printing money is everyone’s favorite type of stimulus. It’s much more palatable than reducing spending (because people rely on that revenue spending) or raising taxes that can cause capital flight, arbitrage, and ultimately lower revenue.

Wealth transfers (e.g., expenditure changes and tax revenue) are seldom made in adequate amounts during economic or financial crises due to each’s limitations.

So countries either have to print money to cover the gap or sacrifice it through lower wages or poor inflation problems. Countries with reserve currencies (all developed countries to different degrees) will continue to print. Those who do not (emerging markets) will either have inflation issues or tolerate lower living standards.

From the point of view of the US and nearly all developing countries that have a lot of debt and deflationary impact, they want a currency devaluation.

On top of that, currency devaluations can cause stock-market rallying, which is one of the easiest ways to do it.

Part of the debt relief effects is the introduction of extra funds into financial assets. Part of the lower real interest rates put more capital into the stock market and away from lower-yielding assets.

It’s also good for commodities and gold and bad for bonds (i.e., being paid back in depreciated money).

Co-movements of policy concentrations

Nominal interest is a feature of nominal growth rates. The nominal growth rate must be below the nominal growth rate by a sufficient spread to ensure sustainable credit growth. Short-term interest rates are set by central banks (and often long-term interest rates and short-term interest rates that can no longer be lowered).

If nominal interest rates are above nominal growth rates, the debt will rise faster than the economy will develop, and debt servicing issues will eventually arise.

Although there is some variation in growth rates between the different developed countries and monetary policy is generally regarded within the domestic context, the various types of linkages and commonalities between countries generate similar patterns and nominal growth levels and thus interest rates.

Inflation: US, Japan, UK, Euro area

The graph above shows the heavy co-movement of CPI inflation rates in the US, Japan, the UK, and the euro area from 1970 to the present.

Inflation grew in the 1970s, and the “simple” policy of the central bank did not do enough to tackle the impact of commodity price rises on the overall price level. Higher inflation expectations have taken place.

Before the 2008 financial crisis, short-term interest rates were in positive territory, so interest rates were largely calculated by buying and selling shorter-term bonds.

The graph below shows the significant changes in monetary policy rates in the major economies from 1970 to the present for the Federal Reserve (US), the Bank of Japan, and the Bank of England. Both of them lifted interest rates from the intolerably high inflation of the 1979-81 period and them until inflation was regulated.

Interest Rates: US, Japan, UK

When interest rates hit zero or a bit below, they cease being effective as a means of stimulating private-sector credit creation.

Because the Fed, BoE, and BoJ hit zero on short-term interest rates, they had to move into a secondary monetary policy form. This came to be known as “quantitative easing,” or QE, where central banks increase the money supply by buying longer-term bonds to reduce long-term interest rates.

As the 2008 financial crisis impacted all developed market economies, central bank balance sheets increased at the same time. The exception was Japan, as their economy isn’t as financialized as that of the US or England.

Central Bank Balance Sheets: US, Japan, UK, Euro area

From the graph, you can also see that the US Fed’s balance sheet began to expand at the end of 2012 while the ECB began to decline. In other words, the US continued to print money while the EU agreed to let bonds roll off its balance sheet, claiming that it no longer needed stimulus.

Increasing the supply of money is bearish for a currency while reducing the financial system’s liquidity from a smaller balance sheet is bullish for a currency. The trending changes in the balance sheets in various directions have been perfect for currency traders with a multi-year outlook.

As a consequence, you can see the value of the EUR against the USD during this time.

EUR/USD: Mid-2012 to 2014

The valuation of the assets on the central banks’ balance sheets is an incomplete way of calculating the stimulus given by quantitative easing.

The central bank balance sheet graph is based on the index value instead of the assets’ value in currency. This gives an approximate comparison of the scale of each program.

The United States and the Bank of England were the first to respond in 2008-09. The ECB did so to a lesser degree and later picked up the rate of purchases in response to the sovereign crisis in 2011-12. The BOJ started in 2013 in response to their stagnation, followed by the ECB again in 2015 after a two-year cycle of mild stagnation.

Naturally, when the Covid-19 pandemic came, and the rates were still very poor, central banks had to turn back to QE, and the Fed’s balance sheet exploded again. Other central banks followed suit (not seen in the graph above).

Concluding

Monetary policies between countries generally shift together for the simple reason that market conditions are globally linked.

Capital flows, products and services flow, people flow (largely), commodity prices, and other forces largely move together. Countries tend to shift production to where it is cheapest and buy products where they are cheapest. This results in correlations between economies and changes in their capital markets.

Developed countries have heavily embraced many of the same innovations for a large proportion of their populations, have similar education systems, and thus tend to have similar productivity rates.

Investors are global and want to transfer their capital where they can get the best return on investment.

Some emerging markets have their currencies indexed to established market currencies, normally to whomever their largest trading partner is. For example, it is the US for Saudi Arabia, so the SAR is pegged to the US dollar in its fixed exchange rate regime.

Some countries also do not want to be left at a competitive disadvantage when one country moves its monetary policy in one direction, given their effect on the currency.

If a country increases interest rates, the return on short-term debt may become more attractive. This leads to capital inflows and currency appreciation, making all else equal. A nation that deals with that nation may not want a weaker relative currency and want to lock its monetary policy.

Similarly, when a nation reduces its policy rates, it does not want a stronger relative exchange rate and goes down in turn.

When the Federal Reserve lowered interest rates three times in 2019, several other countries (especially those whose national income depends heavily on exporting goods to the US) followed suit to avoid undesired currency appreciation.

Further Details

Although managing short-and long-term interest rates (and now monetary policy and fiscal policy coordination) is the predominant way monetary policy functions today, it has not always operated that way traditionally.

We’re in a fiat monetary system, often with different currencies free-floating against each other.

Other structures are commodity-linked, where a certain volume of a currency can be traded for a certain quantity of a commodity. Typically it’s gold, but occasionally it’s silver (or both, or something else it’s got a lot, like oil).

It’s a pure commodity system sometimes.

In commodity and commodity-related structures, restriction on money production means either increasing gold reserves (or whatever currency is connected to) or raising the amount of money that can be exchanged for commodities.

For example, in the early 1930s, before President Roosevelt broke the US dollar’s gold bond, one ounce of gold could be traded for $20.67. Owing to the tight restriction on money production, this was lifted in March 1933 to help ease the period’s debt burdens.

Later, during the Bretton Woods monetary scheme, which lasted from 1944 to 1971, every ounce of gold could be traded for $35. It was split again in August 1971. This led to a dramatic rise in the price of gold produced ten years ago as a currency to help ease the pressure associated with the burgeoning number of debt claims.

This is different from pure fiat monetary systems, where the simple adjustment of interest rates is usually used to extend and contract capital and credit production without any restrictions (i.e., backed by tangible reserves).

Governments favor fiat regimes because they can print currency, generate credit, and redistribute wealth by altering the value of money.

Inevitably, fiat regimes contribute to highly indebted economies, and commodity-based schemes are implemented when the value of the currency has been heavily depreciated after the government has “printed” a lot to ease the resulting debt burden.

If a nation undergoes hyperinflation that makes its currency worthless, the next step is to set up reserves for a commodity with value and use it as a hard backer.

The government then eliminates the old currency from circulation, which has lost its value and institutes a new currency backed by the product.

Commodity-based structures are discarded when the restrictions on money and credit production become too burdensome. As a result, we continue to oscillate traditionally between the two mechanisms.

The monetary cycle is, of course, another economic and business cycle. It is less well known concerning the business cycle because significant turning points seldom occur.

The last change in the US monetary system was in 1971. As stated earlier, the gold claims had become too high compared to the gold supply, so the bond was eventually broken.

Central banks are doing a decent job of adjusting interest rates and managing credit growth to the point that currency structures have proven to operate well for decades, and these infections are seldom reached.