We Are Entering a New World, and We Will Have a New Currency War.

Central banks are faced with an impossible dilemma between recession and inflation.

We have entered a new world whether you realize it or not. Since the beginning of 2022, the foreign exchange market has entered new territory. The variations are impressive. The Japanese currency has lost almost 25% of its value against the US dollar since the beginning of 2022. The euro has fallen by 15% against the greenback over the same period. This is a massive drop.

But others are doing even worse: the Norwegian krone is down 21% and the British pound 27%. The latter is dangerously close to parity with the dollar, in what looks very much like an investor panic. After Brexit, the energy crisis, and the threat of recession, the last expensive budget presented by the British Government of Liz Truss at the end of September 2022, seems to have had the right of the investors' confidence.

This is certainly only the beginning. The consequences are heavy for companies that did not anticipate the extreme volatility of the markets, which added to already heavy inflation. In this highly inflammable context, governments and central banks are playing with each other. And for the moment, only the US dollar seems to be doing well.

Because of the risk of recession and the tightening of financial conditions resulting from the increase in key rates by central banks to fight inflation, capital flows will recycle to the United States, which automatically strengthens the US dollar. In times of crisis, the US dollar plays its full role as a safe haven. And the other monetary centers of gravity are struggling to counteract the firepower of Uncle Sam.

Intervention in the currency market: a false good idea

To combat the decline of their currencies, central banks can opt for direct intervention in the foreign exchange market. This is what the central banks of Japan and India have done in recent days. The Bank of England could follow suit as the pound sterling is at a 37-year low against the US dollar.

But success is far from guaranteed. The prerequisite is that one must have sufficient foreign exchange reserves. In the case of the UK, they are insufficient. Since 2010, successive British governments have increased the level of reserves to $200 billion if we add up the joint reserves of the Bank of England and the British Treasury. This is small compared to Japan's estimated 1.7 trillion dollars. Exchange rate interventions are wars of attrition that require sufficient ammunition overtime to win. Even when reserves are theoretically sufficient, this does not guarantee the outcome of the battle.

Let's remember: in 1998, Japan and the United States intervened in a coordinated way to support the Japanese yen. It was a bitter failure. It was not until the collapse of the highly leveraged hedge fund LTCM in the second half of 1998 that the safe haven status of the yen took effect and the yen strengthened against the US dollar. A story that teaches us how essential coordination between the major central banks is to ensure effective intervention in the foreign exchange market.

Exit from negative real interest rates

To stop the depreciation of their currencies, central banks have another well-known weapon in their arsenal: policy rates. While the FED and the ECB are taking determined action to fight inflation, one central player in the foreign exchange ecosystem now has its back to the wall: Japan.

During the summer, the Japanese central bank intervened massively in the Japanese bond market to defend its policy of controlling the yield curve. This consists of ensuring that long-term borrowing rates are close to zero, which makes it possible to maintain accommodative financing conditions. This is a challenge in a context where global interest rates are constantly rising.

Now, everyone agrees on this point: it is only by drastically raising policy rates that Japan (and central banks in general) can have a small chance of fighting the ongoing monetary meltdown. In plain language, this means returning to positive real rates, which are still very negative compared to the current galloping inflation. All this without being accused of promoting recession.

Recession or inflation: the impossible dilemma

This is because raising policy rates generally leads to a rise in the value of money, which has the beneficial effect of reducing imported inflation. The downside is that this strategy also leads to tighter financial conditions for households and businesses, exacerbating the contraction of the economy. Given the latest PMI indicators, the Eurozone and the UK are likely to have already entered a recession in the third quarter of 2022 ... generating a particularly risky protective reflex.

Faced with this dilemma between inflation and recession, a final temptation is indeed emerging: withdrawal into the post-1929 world.

After a decade of high inflation and monetary instability, Western governments imposed heavy tariffs on each other that hampered trade. The consequences are well known: wealth creation collapsed and unemployment soared in the wake, fuelling the warlike tendencies of nations. A vicious circle that we must avoid at all costs.

Today, the new currency war is well and truly back with its attendant challenges for states, companies, and individuals. A currency war, rough and with often painful consequences, but which will always be better than the drift of protectionism and its inevitable bellicose consequences.