central banks, money, and the global economy

Here are two weekly forex bar charts. The top chart shows the price of the euro in US dollars, while the bottom chart shows the price of the US dollar in yen.

The past four years have seen three distinct episodes of world wide fears of possible bank panics in the US and in Europe in 2008, 2010 and 2011. In each case there were fundamental economic problems that lay underneath the banking problems - in 2008 bad real estate loans and associated derivative products and in 2010 and 2011 uncompetitive economies in Greece, Portugal, Spain, Italy, Ireland, .....

Monetary policy cannot solve economic problems, but it can buy time to solve such problems by allaying fears of a banking panic and bank collapses. During the past three years the Fed, the European Central Bank, the Bank of England, and the Bank of Japan have all attempted to provide markets with necessary liquidity through programs of quantitative easing.

This quantitative easing was necessary because economic uncertainties and risks had increased the demand for short term, safe and liquid assets. Absent central bank action this increased demand for liquidity would have led to the collapse in the value of longer term assets (loans and bonds) held by commercial banks. Indeed such a collapse occurred during the second half of 2008 before central banks even realized there was a problem. A collapse in asset prices is always associated with economic weakness and this makes it harder for governments to do something about underlying economic problems.

Quantitative easing by a country's central bank generally leads to a depreciation in that country's currency. Indeed, this is the single most important indication that the central bank's action has been effective.

You can see in the charts above that the Fed (and the Bank of England) took the lead in implementing quantitative easing programs. The first effort by the Fed lasted about a year from March 2009 to April 2010. The second phase started in October 2010 and ended in May 2011. Both phases were associated with significant depreciating of the US dollar against the euro and against the yen (green arrows on both charts).

Next up was the Bank of Japan which sold yen against foreign currencies to stop yen appreciation which is an effective tightening of monetary policy unless counteracted. On four separate occasions, starting in March 2011 around the time of the big earthquake in Japan, the Bank of Japan intervened dramatically in the currency markets (four purple arrows on upper chart).

Late last year the European Central Bank began a program of buying sovereign bonds from commercial banks. This program is scheduled to end on February 28 and has had a modest effect on the euro (blue arrow).

I personally think the central banks have not provided nearly enough liquidity to the markets but at least their hearts are in the right place as these charts show. They have warded off the imminent threat of a banking panic which would have done terrible economic damage above and beyond the damage we have already seen. Looking forward I think their efforts will be reflected in higher stock prices in the US, in Europe, and in Asia over at least the next year or so.