Does the size of a central bank’s balance sheet have a material impact on the exchange rate of that country’s currency?
To gauge this, we look at the central banks’ balance sheet as percentage of GDP and plot that against the BIS’ nominal broad effective exchange rate. Here, the relationship with the exchange rate has, excepting the euro, been minimal.
However, looking at the same central banks but using the Federal Reserve as the standard and measuring the relative size of other central banks’ balance sheets vis-à-vis that of the Fed, the relationship between a relative expansion in balance sheets and a weaker currency, in very general terms, is stronger.
So, the size of central banks’ balance sheets relative to each other seems to have at least some relationship with the bilateral exchange rates of their respective currencies.
But, exchange rates are among the most difficult to forecast. They can be influenced by interest rate differentials, profit opportunities, relative growth rates, current account movements, risk premium, herd behavior or any or all of the above in any potential combination whatsoever. One of these factors seems to be the relative and possibly also absolute size of central bank balance sheets. This factor is likely to work more strongly when it coincides with other factors moving in the same direction.
Central bank monetary policies are likely to begin to diverge over the rest of 2014 and 2015. The Bank of England and the Federal Reserve are moving toward normalization of interest rates. As the Fed moves to end its asset purchases, its balance sheet should begin to stagnate.
By contrast, the ECB and the BoJ are maintaining or expanding their monetary easing. The BoJ continues its quantitative easing and the ECB’s balance sheet will expand once the targeted LTROs begin to be implemented.
The reason for this policy divergence is the different growth outlook. Higher interest rates and stronger growth should make US and UK risk assets more attractive relative to Japanese and Eurozone ones.
All three factors – the prospect of widening interest rate differentials, stronger growth and higher asset prices – should be conducive to dollar and sterling strength and to euro and yen weakness. In this process, the relative expansion of the BoJ and ECB balance sheets will play a role in reinforcing trends – but not in determining them.
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