Last week, I spoke to a group of central bankers from around the world at CME Group’s Chicago headquarters regarding the special challenges they face in the current economic environment. Among other markets traded on CME-owned exchanges, the futures and options markets for rates and currencies are front and center to the uncertainties in Europe. One of the key concepts to emerge from the presentation was the difficulty of managing domestic monetary policy given the inability of Europe to calm market fears over its sovereign debt crisis and banking system challenges.
What has happened in Europe has illustrated the powerful linkages among markets, and the European disruptions have contributed to slower growth in many parts of the world that have managed their own affairs quite well. Many central bankers in emerging market countries that had been focusing on their own inflation pressures now find themselves having to lower interest rates to respond to slower global growth.
Moreover, the extended period of near-zero federal funds rates provided by the U.S. Federal Reserve – along with expansion of the “Operation Twist” program of selling short-term US Treasury bills and notes and buying long-term bonds following this week’s Fed announcement – causes more challenges for central bankers. Even though the US economy has logged a few years of real GDP growth since the financial crisis of 2008, unemployment has declined from its peak of 10 percent to the 8 percent zone, and U.S. banks are very well-capitalized and profitable, the Fed is still acting like the U.S. economy is in a recession and using tools like “Operation Twist” can distort the market and have indirect and long-term costs.
Thus, even as emerging economy central banks reduce their own rates, there is still a large short-term interest rate differential with the United States. The extreme nature of the rate differential will exist so long as the Federal Reserve remains in emergency mode. The rate differential makes it harder for central bankers in emerging economies to manage their domestic economy and it also contributes to currency volatility.
The currency volatility impact occurs in many ways, one of which is through market participants activity in the FX carry trade (i.e., buying the high-rate currency and borrowing the low-rate currency) when fears abate (risk-on) and taking the trade off when fears are rising (risk-off). The currency volatility makes encouraging trade flows just that much more difficult for these dynamic economies.
From getting a perspective on Europe (no drachma for now) to understanding the policy decision process at the U.S. Federal Reserve (worried about US fiscal policy as well as the European sovereign debt crisis), central bankers from around the world engaged CME professionals in a wide variety of discussions. Further meetings are planned to expand the sharing of research and ideas between central banks and CME Group.