Currencies, economic growth and monetary policy

Financial markets

Buttonwood's notebook

Currencies, economic growth and monetary policy

A weakling no more

by Buttonwood

WHILE most of our attention has been on the equity and government bond markets, the foreign exchange market has undergone one of its occasional changes in trend. The euro is no longer the whipping boy. Having dipped below $1.19 in early June, the European single currency is in sight of $1.30.

In part, this is down to the recent economic data. Whereas most European data (such as last week's Ifo survey) have been stronger than expected, the US numbers have been generally weaker. To the extent that investors were buying the American growth story in the first half of the year, they are now less convinced. It helps of course that the talk of imminent euro break-up has subsided a bit.

However, is growth likely to be the driver of currency movements over the long term? From time to time, other factors have driven the markets, such as yield differentials and current account deficits. Two of the strongest currencies over the long term have been the Swiss franc and the Japanese yen, neither of which has been renowned for their growth performance over the last 20 years. Instead, they are known as low-inflation countries.

If one looks at the rhetoric from the European Central Bank, as expressed in Jean-Claude Trichet's article in the FT last week, the euro-zone is aiming to be the pillar of fiscal and monetary rectitude in (implied) contrast with those spendthrift Americans. Rationally investors might prefer to hold such a currency. A strong currency might not be in the interest of Europe's exporters or its citizens but that's quite another matter.

One wonders how much of the relative improvement in Europe's economic numbers is down to the euro's weakness in 2009. If so, prolonged euro strength may lead to a period of economic weakness in 2011. It is at that point when we will see whether M. Trichet's rectitude remains in place, or whether he comes under pressure from governments to be a little less strict.