Quantitative easing (QE) can have disinflationary consequences in at least one of two ways, and sometimes both at once. The first is that the central bank engaging in it essentially exports disinflation through the nominal exchange rate, by driving the value of its currency down and the value of other currencies up. Beyond the extent to which these bilateral exchange rate movements drive the CPI-adjusted real exchange rates lower for countries on the ‘receiving end’ of these QE forces, that exported deflation can become something of a headache for policy makers. These flows are sometimes known as something else: they’re also called ‘currency wars’.
The second is that the withdrawal of QE can have a negative impact on asset prices, if the ‘wedge’ between underlying fundamentals and the value of assets has become big enough. Declining asset prices have disinflationary implications. Although the rate has since recovered to about 1.80%, during Q2 – when expectations that the Fed might taper its QE programme were probably the most pronounced – the US 5-year breakeven rate fell from about 2.40% to a low of about 1.50%. So QE3 ultimately caused some disinflation. How is that for irony?
We think this is crucial because RBNZ, BoC and potentially ECB policies all contain an element of ‘deflection’, as the latter pertains to the flows triggered by QE. The SEK isn’t so strong recently versus the NZD and the CAD because the fundamentals for the SEK have suddenly become so incredibly compelling. It’s strong because neither the NZD nor the CAD can be. Those currencies’ central banks are busy ‘deflecting’.
This theme in FX will continue reasserting itself, hopping from one currency to the next until the Fed ‘taper’. Afterwards, fundamentals will do the driving again.
BMO