The Forex- Effect of the ECB’s Monetary P olicy

Formula 44 New Order of (Fractional) Pass-Through Stringency (based on Figure 45) Entry: E: Stringency denoted as PT efficiency of interest rates in relation to the ECB’s monthly MRO rate, i: nominal interest rate, cons.: consumer, corp: corporation

4.3.3The Forex-Effect of the ECB’s Monetary Policy

The public money supply by the ECB and the private money multiplication by MFI, not only affects the prices in the euro area it also affects the purchasing power (PP) of the EMU’s currency in the world, found in exchange rates. According to recent macro-economical the-ory, there are two effects: (1) an increase in the money supply proportionally lowers the exchange rate (in indirect quotation) and decreases the PP per unit of currency, and causes (2) effects associated with a lowering of the interest rates, e.g. shift in portfolio investment.

This plays a key role in monetary transmission (MTC2, MTC16), while the international sys-tem generally converges towards purchasing power parity (PPP), due to the ‘law of one price’ and short to medium-term ‘arbitrage equilibria’, and since exchange rates (Fx) also have an impact on domestic prices, inflation, imports/exports, investment, and GDP.

(1) Effect of MP on the Foreign Exchange Market in the EMU

Empirically matching the real world data with the theoretical textbook ‘monetary Fx model’ (Formula 19) uncovers more noisy, less stringent, and more complex trends that is, howev-er, generally still much in line with the theory, also if diverse time delays and ‘major shifts’

are incorporated (not shown here): Figure 46 pinpoints the development of the three key

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important Fx rates/indexes for the EMU: the quarterly US$/€ spot rate, the EER-19 spot index, which reflects the euro area’s total exchange rate changes with selected major trad-ing partner in the world, and the Chinese Renminbi, also shown here as a CNY/€ index.

Figure 46 Major Euro Exchange Rate Developments from 1999 till 2015

Upon the Euro’s launch in 1999 a slight depreciation period occurred (due to the fixed intra EU rates, economical circumstances and expectations) until it became the common curren-cy in spring 2002. Since then, and until 2010, it was strongly gaining up to 40% (max. 66%, a ca. 6-year-long 2003-2009 high) against the US dollar and the Chinese Renminbi (ca. 40%).

The EER-19, a weighted average of all main trading partners of the EMU-19, had a lower amplitude, and was influenced by the CNY and US Dollar (ca. 15% increase), at that time.

This increase in PP of the Euro, from 2002 to 2010 reflects the heightened demand for Euro with respect to the other currencies, since the Euro became the second most traded cur-rency in the world (ca. 40%) in 2010 (BIS 2013). It then started to fall back to 33% ‘on one side’ of all global daily shares in 2012 (BIS 2013). At the same time the exchange rate of the Euro lost its previous gains. This also stems from global demand for Euro as monetary vehi-cle (BIS 2013)(ca. 40%, o.c.). The velocities with non euro area residents grew temporarily.

In 2010 Euro dwindling was further globally evoked by the first news releases of an upcom-ing sovereign debt crisis, which must have shifted also the demand stemmupcom-ing from usupcom-ing the Euro as payment vehicle back towards the older currencies like the US dollar (BIS 2013;

Economist 2010). Exporting firms benefited, especially in Germany (place 1, 29% of ex-ports), the Netherlands (2., 9.3%), France (3., 7.9%), as exports became more affordable.

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(2) The MP Effects on International Portfolio Investment

A second effect of MP induces shifts in exchange rates that drive interest rates and prefer-ences in portfolio investment. The exchange rate is the co-action of many effects (Giddy 1994; Sperber 2015). Among them: (1) the intermediation of different price levels, domes-tic and foreign (Fx strives for a general PPP). (2) This also includes financial products as shown in John Maynard Keynes ‘Interest Rate Parity Theory’, when arbitrage on interest rates mediates Fx market changes (whenever the interest spread > SWAP rate). In general, the higher the interest rate (and its future expectations) the stronger the Fx rate, as the demand for the currency increases, including its usage as monetary vehicle. Both effects, (1) price level (PPP) and (2) interest parity, are thus to be addressed by comparing the euro area with other countries, e.g. the US, which offers the advantage that both economies are of comparable size and interdependency making a comparison more meaningful.

The price levels (CPI, 1998=100, World Bank) in the US and euro area (19 countries), from 1999 until today (2015), have both developed in a very similar fashion: mainly, US inflation is only marginally higher (ΔπEMU,US=0.27%). In theory, the MTC-effect of this difference should slightly affect the Fx-rate equilibrium (Giddy 1976; Sperber 2015) (i.e. a very slight depreciation of the dollar) in periods of a higher inflation in the US as compared to the EMU (see 2.4.2). The spread of the CPI index has had a partial effect in 2002-2007, when inflation was higher in the US (with a minor exception in 2003). This seems to have added to depreciation of the Fx rate. When the gap was closed the Fx rate began to return, and after the FC+EC it librated in the Dollar-appreciating direction in 2015 - back to its initial course of 1.10 $/€. Reasons are a stronger economic recovery in the US as compared to Europe and the ongoing bad news about the EC. Since 2010, the US has created more jobs than Europe, Japan, and the top advanced 36 economies of the world in sum: over 13 mil-lion people (backed by IMF data, and the White House, still a 0.17m/month) many via new businesses less than five years old, while the labor participation rate has only slightly fallen (according to (WB 2015), ca. -1.4%,- due to aging, learning, and more disabilities).

It is known from several previous studies that the employment level is an indicator for real future GDP growth and can appreciate the Fx rate: announcements of the payroll employ-ment rate have impact on the Fx rate: abbreviated to ‘employment stabilizes the US dollar’

and also the Euro, and also evokes investment (Harris & Zabka 1995). Previous economic theories saw two main reasons: (1) a higher employment raises expected inflation, and (2)

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causes a tightening of the credit market and the probability of a future restrictive MP (Harris & Zabka 1995). Based on the data in this study here, both theories don’t fully ex-plain the effect, as expected inflation and expected MP did not always react this way.

Hence, a new theory needs to update the old theory: (1) the Fx rate is affected more on the basis of real GDP natural trends and the job market, (2) market data and expectation about money, inflation and financial markets, and (3) global financial yields and rates.

The overlay of US/EMU real GDP-ratio and p.a. Fx-ratio trends are shown in Figure 47: an upward trend of US real GDP (faster than in the EMU) appreciates the Fx rate [drops the

$/€]. This correlation becomes stronger over time: after 1 month R=0.38, after 1-2 years R=0.55. Other effects were in play in 2002-2005, and blurring and delaying happens.

Figure 47 The Fx Rate ($/€) depends on Real GDP but not on M² (% of GDP) [US/EMU]

Figure 47 also shows that the money supply, M2 (money and quasi money), does not seem to pull the Fx-trigger even if the ratio of M2 as % of GDP between the US and EMU is taken.

Comparing this normalized level of M2 between the US and the EMU seems to break with the monetaristic assumption ‘that (mainly) money drives inflation and the Fx market’: Even the opposite could be indicated in this figure: the reason for this is FRI (see chapter 4.1.1).

The second effect of the ECB’s MPs on the Fx market is portfolio related and return pro-voked. Figure 48 delineates the margin of 10-year G-Bonds between the US and the EU.

As is claimed by Keynes’ Interest Parity Theory (2.3.8) the country-difference in yield corre-lates with the Fx rate. A higher interest rate in the EMU (green area) coincides with a lower Fx rate [€/$, direct quotation], or with a higher indirect quotation [$/€] (see Figure 48).

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Figure 48 Long-term Interest Rates and Fx Rates in the Euro Zone and the US

Around 2000, the margin turned negative (yellow area) as US bonds became more attrac-tive, and the directly quoted Fx rate [€/$] also surged indicating appreciation of the US Dol-lar, by the interest rate settings at a regular transmission level (see MTC2). This margin still seems to be predictive and causally relevant for global Fx rates, with only infrequently oc-curring historic exceptions and shifts. Comparing the EU/US 10-Y-G-Bond interest ratio with the Fx ratio [€/$] highlights this dynamic dependency and the margin of the two is in fact mathematically explicatory for the Fx trend rate (right) (R=0.7, data stationary normalized).

Interestingly, both margins (demarcated at horizontal axis) much resemble each other (see left+right), based on which they become predictive for future Fx trends: e.g. the yellow area predicts that the US$ will appreciate to the Euro in 2015, which in also seems to happen.