Foreign Exchange

The Limits of Monetary Policy

Unconventional monetary policies continue to have a diminishing impact on currency markets—find out how the European Central Bank, Bank of Japan and other key central banks are navigating the current global currency landscape.
J.P. Morgan Global FX Strategy & Global EM Research
April 6, 2016

At February’s G20 summit in Shanghai, representatives of the International Monetary Fund urged the world’s largest economies to take coordinated fiscal and monetary action to reverse the slowing trajectory of global economic growth, but negotiations failed to build a consensus for any specific policy. This leaves the world’s central bankers and finance ministers free to pursue their own paths. At this point, it's unlikely that their efforts will significantly alter the status quo of slow growth in the developing world, stagnation in Europe and Japan, and soft demand for commodities.

Domestically, the US economy has emerged from a trying winter. February saw the US Dollar Index slump against rising oil and commodities prices, but declining recession risks for the US economy and the strengthening employment picture may have set the stage for an additional interest rate hike later this year.

The Limits of Unconventional Policies

Looking across the pond, the European Central Bank (ECB) has shown hesitance to lower negative interest rates further. The eurozone’s experiment with negative interest rates has, thus far, failed to spur inflation; additionally, pushing rates much lower than the current -0.4 percent will likely raise the prospect of banks passing on additional deposit losses to their account holders—a situation that has proven politically untenable.

The ECB’s next move will be to focus its monetary stimulus efforts on easing credit markets, and this return to easing will likely mean further depreciation of the euro, because currency markets typically react more strongly to interest rate adjustments than balance sheet expansions. The ECB’s balance sheet is on track to reach €3.8 trillion by March 2017, but the downward pressure that the asset purchases exert on the euro seems to be negated, at least for the time being, by the modest recessionary risks facing the US economy.

The Brexit Looms

Great Britain has formally scheduled a referendum on leaving the European Union (EU) on June 23. The vote is shaping up to be a close contest, despite the concessions on immigration and welfare policy granted to Britain at the February 19 EU leadership summit. Futures markets currently place the odds of a British exit (“Brexit”) from the EU at 30 percent, although extrapolation from FX markets seems to indicate a higher probability, perhaps closer to 40 percent. (Alternatively, currency markets may simply believe the exit would cause a greater degree of depreciation for the pound.)

The pound has already shed 9 percent of its value since November. Although the success of negotiations at the EU leadership summit generated a 2 percent bounce, the pound is likely in for greater losses as the referendum’s growing risks drive further capital outflows. Barring a shift in public opinion as the vote approaches, the pound is likely in for a turbulent spring. However, if the referendum fails, the pound could quickly bounce back.

The Bank of Japan Holds Off

The Bank of Japan (BoJ) has declined to cut interest rates further; instead, it will wait to evaluate the full impact of the current -0.1 percent negative rate, which was adopted in January. Thus far, negative interest has produced underwhelming results for the Japanese economy—inflation remains well below the official 2 percent target, and the yen actually rallied in the month following January’s rate cut. Capital outflows have increased, with investors sending ¥4.8 trillion out of the country in February, but the effects of portfolio rebalancing are likely to be offset by the nation’s considerable account surplus.

The BoJ will look to this spring’s salary negotiations for signs of incipient wage inflation, but any further policy moves will likely await the results of July’s National Diet elections. Negative interest rates are unpopular with the current government, but that could change if the policy succeeds in generating inflation in the coming months.

Will the Commodities Boom Last?

February saw an unexpected surge in commodities prices. The agreement between Saudi Arabia and Russia to freeze oil production at January’s levels spurred a 26 percent rise in oil prices over the past month. This rally helped the currencies of exporting nations, including Canada, Mexico and Russia. Iron ore prices also rose 26 percent in February, benefiting the Australian dollar and Brazilian real.

But the staying power of this rally is already in doubt. The agreement to freeze production is not sufficient to end the global oil glut, and Iran’s continuing resistance to production caps will likely further hinder the agreement's power to restore oil prices. The market’s fundamental oversupply makes a prolonged climb unlikely for oil prices in the near future, with oil projected to stay below $40 until US production begins to taper off significantly.

Emerging markets saw their currencies appreciate in anticipation of a Chinese stimulus program, but intervention to restore China’s growth no longer seems likely. A few weeks ago, the Governor of the People's Bank of China (PBoC), Zhou Xiaochuan, announced that the nation would meet its 6.5 percent growth target without significant government intervention. The PBoC’s new target is a significant downward revision from the historic 7 percent goal, and the official acceptance of China’s slowdown makes a surge in demand for commodities unlikely.

Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published March 11, 2016.

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