Fools never die - they live happily in the German Ministry of Economics

The German minister of economics criticized the US monetary policy unusually harsh after the G20 summit, where he substituted the finance minister, who was in hospital. The creation of more liquidity would be the wrong way, stated Mr. Bruederle. An excessive, permanent creation of money would be an indirect manipulation of a market price, which would not be acceptable. What else is a fixed exchange rate and a hike or cut of interest rates by the ECB, stupid?

All monetary policy intends to have an impact on asset prices and returns, which a central bank can not set directly. But those asset prices and returns on assets have an influence on macroeconomic aggregates, which are relevant for the final target of monetary policy. The transmission mechanism of monetary policy to the real sector of the economy is via changing relative asset prices and returns on assets. This is widely accepted in monetary theory.

There appears to be a widespread perception that a possible new round of quantitative easing would only target at manipulating the US dollar exchange rate. This is wrong and could be even counterproductive. The target of the Fed for QE2 would be to strengthen final demand in the US economy. The export sector is rather small compared to other major economies. On the import side, the demand for some goods is rather price inelastic in the short run, especially for crude oil imports. However, weakening the US dollar would have an impact on the price of crude oil. The correlation between the US dollar and crude oil prices is quite high and often the oil price rises more than the US dollar depreciates in percentage terms. Thus, if QE2 would target to weaken the US dollar only, it would be the wrong monetary policy measure. In additions, the CNY/USD exchange rate is immune against any QE by the Fed. The target of QE2 is clearly to strengthen domestic demand.

There seems to be another misunderstanding of QE2. Politicians like Germany’s minister of economics or Brazil’s finance minister Mantega appear to think that dollar weakness would only be created by newly printed dollars. This is a big fallacy. The Fed has not yet decided to implement QE2 and the US dollar already lost 14.2% since the US dollar index (USDX) reached its peak at 88.706 in early June 2010. And when Fed Chairman Bernanke provided the first hint about not exiting easy monetary policy, the USDX even gained slightly in early August. US dollars could be sold out of the stock of money and not only when the stock of money is increasing.

We pointed to the relative returns of assets playing a role for monetary policy above. These relative returns also play a role for investors diversifying portfolios. If financial assets in other countries offer better risk/return perspective, there is an incentive to change the asset allocation of a portfolio. In the case of the US dollar, investors have reduced the holding of dollar denominated assets and bought more assets denominated in foreign currencies. This alone is sufficient to lead to a weaker US dollar. However, this has the impact that some investors then increase the holdings of a particular asset class, which is denominated in US dollars, the commodities and especially industrial and precious metals.

 Without any political stimulus measures, US GDP growth appears to be too modest to prevent the risk of a deflation. But it would also be insufficient to attract investors. The current political landscape makes fiscal stimulus measures almost impossible. Only monetary policy has a chance to improve the US economy. Whether the Fed embarks on QE2 or not, a weaker US dollar appears to be unavoidable. Only in the case the Fed would manage to stimulate US GDP growth, the US dollar might rebound over the medium- to longer-term horizon. Therefore, the US dollar is likely to remain a supportive factor for precious and industrial metals also in 2011.