UBS: Economist Insights: Just passing through

The effects arising from the close interplay of monetary policy and exchange rate policy are not uniformly felt across the world’s economies. For the Fed, which enjoys the privilege of issuing the reserve currency, those effects are muted. Not so, however, for other Central Banks, such as the BOE.

11.11.2015 | 10:18 Uhr

The ‘great divergence’ in monetary policy between the US and UK on one side and the Eurozone and Japan on the other brings with it another great divergence: in exchange rates. Expectations of higher interest rates in the US have pushed up the USD against the EUR by over an eighth in the last twelve months alone. The trade-weighted exchange rate of GBP is up by a tenth.

Monetary policy has been driving exchange rates, but exchange rates can in turn affect monetary policy. Economics 101 teaches us that a stronger currency should make your exports more expensive and imports from others cheaper, so you export less and import more. Lower net exports reduce GDP, slowing the economy. Even more importantly, those cheaper imports act to drive down inflation, which should mean less need to tighten monetary policy. Some commentators have been sceptical that the Fed can actually hike rates in the face of such a large appreciation.

The Fed, however, has traditionally pretty much ignored the exchange rate. Aside from a few comments from Fed speakers last year, and the short-lived mention of global demand in the September FOMC statement, policy seems to be driven by domestic considerations alone. Why does the Fed remain so blasé about the exchange rate?
It is all down to the exorbitant privilege of being the issuer of the world’s dominant currency. A huge proportion of global trade is already priced in USD. Not only are virtually all commodities, and the vast majority of US trade, USD denominated, so is a large amount of non-commodity trade between other countries. Even countries that do little direct trade with the USA, such as India and Indonesia, have about three-quarters of their exports denominated in USD (chart 1). Only potential rivals for reserve currency status, like China, appear able to avoid USD dominance.

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