The ECB Just Changed the Ball Game for Other Central Banks

As big as the European Central Bank’s new bond-buying program is, economists say it's an open question whether it can fix the eurozone's deep economic problems and push inflation up closer to its target.

Where the program will be felt, however, is in the central bank boardrooms of various mid-sized economies. Whether or not you call it a currency war, central banks are going to be fishing around for responses to the ECB’s giant liquidity injection, lest their economies start to import the eurozone’s deflation when their exchanges rates rise versus the euro.

The ECB’s plan to buy €60 billion in sovereign bonds each month until “at least” September 2016 is far bigger and more open-ended than the single year's worth of €50 billion per month that most had expected. That means currency traders, who were planning on dumping euros for, say, Swiss francs or Swedish kronar, will be thinking about doubling their orders.

Even before the big announcement Thursday from ECB President Mario Draghi, such concerns had prompted preemptive strikes from other central banks.

Last week, the Swiss National Bank, fearful it would be compelled to keep dumping ever-depreciating euros onto its balance sheet, abandoned the Swiss franc’s cap to the euro and instead signaled its intent to use negative interest rates to scare away buyers of its currency. And on Monday, the Danmarks Nationalbank cut its benchmark rates deeper into negative territory to protect the Danish krone’s peg to the euro.

Even the Bank of Canada’s surprise move to make a quarter-point cut in its overnight rate, after four-and-half years of inaction, can’t be separated from the international fallout of an anticipated eurozone policy shift. While Canada’s economic challenges mostly lie in falling oil prices, the last thing it needs is for the Canadian dollar to move higher – or even just to forestall an expected fall – because of a global spillover effect of investors fleeing low-yielding eurozone assets.

Even China, whose economy is somewhat protected by capital controls and whose central bank tends to march to its own drummer, isn’t immune from fallout. Earlier today, it injected liquidity into its banking system. This was mostly in response to its own slowing economy and the concern that banks could be left short of cash during the upcoming Lunar New Year holiday, the country’s biggest shopping season. But the People’s Bank of China is also acutely aware that its currency, the yuan, is buffeted by these international forces. Specifically, it is tied to the dollar – if more loosely than previously – which means it has mostly appreciated against everyone else’s currency, and will only do so more now. That's not helpful for Southern China's manufacturing hubs.

Now that the ECB program is far bigger than had been anticipated, it’s not hard to imagine central bankers taking further actions. Look to those of countries such as the Czech Republic and Poland, for example. Their economies are growing, but they’re both seeing deflationary forces and a stronger currency could derail that growth.

With looser policy the Czech and Polish central banks had succeeded in weakening their exchange rates over the past six months, reversing an unwanted trend in which these once volatile emerging-market currencies had matured to become de facto safe havens from the eurozone’s problems. They won’t want to forego the turnaround now, so it’s not hard to imagine them being tempted into a response to the ECB, even if their current rhetoric suggest a wait-and-see posture.

The worry is that ECB move has put other central banks toward a tipping point, where a tit-for-tat series of currency-weakening policy changes turns into something of a cycle. If so, it would be the latest in a line of such moves, with the U.S. Federal Reserve, the Bank of Japan and the Bank of England all playing their part to create what must by now be designated as a de facto currency war.

– Follow Michael J. Casey on Twitter: @mikejcasey.