Exchange Rate vs Money Supply
Notice the money supply, inflation/CPI and economic GDP forecasts are determined by an interest rate rather than an exchange rate. Inflation and /or interest rate targeting in relation to the money supply and the pricing of interbank money and capital market instruments became a phenomenon in the 1990’s for most central banks. The effect balanced an interest rate to the money supply. Both share a sort of see saw, inverse relationship, a methodology easier to manage for central banks because what was found in paper after paper was one single entity,one economy has a high correlation to its money supply, interest rates and inflation.
A proper economic forecast can be made based on the balance of all three rather than a single focus on GDP output for example. Notice the historic CHART of AUSTRALIA’s CASH RATE, INFLATION AND GDP GROWTH as one example representative of many economies today. The Cash Rate tracks inflation within the stated parameters of the Cash Rate target while GDP grows when inflation and the Cash Rate are low.
To manage the money supply in relation to a spot price or exchange rate ties two economies together so one nation attaches its economic fortunes to another. These arrangements were called pegs, fixed or crawling, and were eliminated by the major nations as a form of economic practice and exchanged for the money supply, inflation and interest rate target method because pegs caused wild swings in spot prices and so became unmanageable. Under inflation targeting, economies became separate entities with an inward focus on their own historic economic culture and the exchange rate price became a function of economic factors for each nation primarily based on a money market interest rate.
Even if one side of a currency pair was priced based on a single nation’s supply of money, the forecast, pricing and management function would be difficult and time consuming. To follow the methodologies and trade financial instruments using inflation targeting, the indicator order works as money supply, interest rates then inflation and GDP. A further management function is found in international reserves.
The management function of exchange rates as well became a separate entity for each central bank. International reserves are found in the balance sheet of every central bank and highlighted by composition of currencies in the reserve, income, profit or loss from foreign currency transactions and swaps to name a few categories. From a market and trading perspective, composition of currencies in the reserve is most important because it determines cross border flows and currency employed to facilitate those flows through swaps, which currency to replenish at month end and if an economy employs its own currency to fund their own economy. Sweden for example relies primarily on US Dollars to fund its economy so USD/SEK deserves prominent attention from a trader perspective in terms of Sweden’s money supply, interest rate and exchange rate with the US. EUR/CHF in terms of German and Swiss economic and cultural relationships is profoundly important in terms of cross border flows.
Australia not only lacks a maintenance period but a reserve requirement as well. The method employed is the target for the Cash Rate, an unsecured lending overnight rate and pays 25 basis point interest on balances below the target for the Cash Rate. (Gray 2010).
The Cash Rate is determined by an end of day survey of only the largests banks, 25 at last count. Survey questions ask about borrowed and lent funds and is based on a weighted average by value. (RBA).
The Cash Rate is the target of the overnight rate and is not only the policy rate that determines a loan rate but its the basis for all other interest rates in the Australian system. It represents a floor of interest and moves inversely with the money supply.
From a market perspective, the Cash Rate forms the basis of the money market yield curve then the capital market yield curve. What follows the Cash Rate as trade able money market instruments are Bank Accepted Bills with durations of 30, 90 and 180 days.
Bank Accepted Bills are bills of credit, drawn by customers and extended by banks to business. The market comprises 20 percent of loans, 80 percent for Certificates of Deposit. ( Matthew Boge and Ian Wilson 2011, The Domestic Market for Short Term Debt Securities, RBA Bulletin, Sept 2011 ).
Bank Accepted Bills then determine overnight Index Swap rates with 1, 3 and 6 month durations. This means as Bank Bill Swap Rates, Aussie Dollars are borrowed by prime banks at the 10:00 a.m. Sydney, 6:00 p.m. New York Fix.
Interest rates then moves to the capital market to price 1,3 and 6 month Treasury Notes as well as longer term Commonwealth Government Bonds. Figure CHART CASH RATE, BANK BILLS AND Overnight rates and notice the overnight rate priced at 4.23 and compare that rate to the targeted interbank Cash Rate. Further view the CHART CREDIT TO MONEY GROWTH HISTORY.
The current Cash Rate is 4.25 and the inflation rate is 3.50. The RBA maintains an inflation target of 2-3 percent over a medium term. The medium term is an average rather than a rate. Stability of the currency and full employment is the foundation for Monetary Policy.
The current economic situation in Australia has been fairly steady since 2006 so money supplies and interest rates equally held consistent. For the short term, its vitally important to look at the 90 day Bank Bill because its the one rate that can’t be controlled by future money supply predictions and therefore trades with volatility. This point was always known and outlined by Bob Rankin in his 1992 paper “The Cash Market in Australia”, a highly recommend read. ( “The CASH MARKET IN AUSTRALIA”, BOB RANKIN, 1992, RBA RESEARCH DISCUSSION PAPERS).
For AUD/USD, a rise in the money supply is a sell provided interest rates move opposite. In US markets, AUD/USD comprises the overnight rate/ Effective Fed Funds rate until a trading rate is established in the capital markets.
In Europe, Eonia/Aussie overnight night rates comprises EUR/AUD. Currency pairs can rearrange for example as Effective Fed Funds/Aussie overnight for USD/AUD and Aussie overnight/ Eonia for AUD/EUR.
When European markets close, EURIBOR/Aussie overnight rates comprise EUR/AUD and Aussie overnight / EURIBOR for AUD/EUR.
In Japanese trading, AUD/JPY comprises the actual Cash Rate and/ or Bank Bills to Yen Tibor when Yen Tibor is fixed in Japanese markets, opposite arrangements for JPY/AUD.
Euroyen can factor as Euro currency to Yen Tibor for EUR/JPY.
USD/CHF factors as Effective Fed Funds/ Swiss repo and Effective Fed Funds/SARON when Swiss markets close.
The true definition of a crawling peg is the link between two nation’s money supply. For Australia before formal operation of its central bank formally named the Royal Bank of Australia in 1960, reserves of Australian Dollars were held in Sterling accounts. Aussie Dollars moved in the markets based not only on British Pound movements but United Kingdom interest rates until December 1983 when the Aussie Dollar achieved its free float status.
2011 European Banking Federation Newsletter