Global Monetary Policy

While our focus is often just on what the Bank of England is up to (speaking of which, today is December’s interest rate announcement from the Bank of England), there are other more important central banks out there, most notably the European Central Bank (ECB), and the Federal Reserve, representing the eurozone and the US respectively.

This article in the Guardian worries about what seems likely to happen this month: the US will tighten monetary policy while the ECB will loosen policy further.

Why does this matter? The worry is of considerable exchange rate movements. As we’ll learn towards the end of next term, one of the ways in which we believe exchange rates move in the shorter term as economists is via relative interest rate movements. This is because rates of interest reflect how much an investor could earn by moving their wealth into that country.

Hence, everything else being equal, if interest rates are higher in the US than in the eurozone, it is feared people will move their wealth out of European assets into US-based assets, increasing the demand for US dollars, and reducing the demand for euros. This would then lead to an appreciation in the value of the dollar (more demand), and a depreciation in the value of the euro (less demand). This need not be a bad thing, since a recovering economy ought to be aided by a weaker currency.

Of course things aren’t necessarily that simple; if eurozone producers use goods imported from the US to make their goods, and if eurozone consumption is often of US-produced goods, then eurozone economic activity would likely be negatively affected by the movements.

The bottom line is that larger than normal exchange rate movements ought to be expected in the coming months…