Forecasting the Real Exchange Rate

This brief examines the historical relationship between exchange rates and relative inflation rates for a group of major industrial countries. It establishes the concept of the ‘real exchange rate’ and the ‘productivity-adjusted real exchange rate’ (PARE) as essential in understanding these relationships and projecting them into the future. It puts the discussion into the context of company decision making, as one important factor in the rate of return likely to accrue from different methods of supplying an overseas market. Differences in productivity between countries explain the divergences in prices of ‘non-traded goods’. To give a simple example, a haircut costs much more in New York than in Madrid since high US wages reflect high productivity which does not apply in many parts of the service sector. These differences rule out the acceptance of the over simple ‘purchasing power parity’ approach which assumes that exchange rates will settle at a point where all prices (in terms of a common currency) are the same everywhere, or move together. Even after account has been taken of differences in productivity growth, productivity-adjusted real exchange rates (PARE) - though reasonably stable - can still show some deviations, or ‘blips’. The ‘blip’ may occur because of rapid changes in the actual exchange rate or in domestic prices, in which case it is likely to prove temporary and the PARE rate will tend to adjust back to its normal level. But it may come from major structural changes, in which case PARE will be altered permanently within definable limits. A way of recognising the different categories of ‘blip’ is suggested in the brief. The PARE framework is then used to provide a guide to UK businesses who are concerned to calculate the future sterling value of foreign currency sales or, more generally, to estimate their competitiveness in supplying specific export markets. (The method used would apply equally well to other countries.) This is done by showing step-by-step the forecasting procedure to compute sterling's effective exchange rate to 1981 on assumptions concerning respective rates of inflation, monetary policy and the impact of North Sea oil. The computation shows that a sustained period of exchange rate stability is possible for the UK, even if UK inflation rates remain significantly above the world level for the next two years.     

THE REAL WAGE GAP

Over the past year a gap has opened up between the growth of manufacturing productivity and that of real wages. This gap cannot persist indefinitely, but it can be closed in many different ways. The best that can happen is that wage settlements fall while output and productivity accelerate. The worst outcome would be continued stagnation of real output and no deceleration of wages, in which case the required productivity improvement would have to come about through renewed labour shedding. There are worrying signs that this has started to happen. An intermediate solution might involve a fall in the exchange rate, with some improvement in competitiveness boosting real output (so that UK producers get a larger share of buoyant consumer spending) and some rise in prices holding back real wages.
We continue to believe that the most likely outcome is a rise in output and a fall in the rate of wage settlements. In our June forecast this occurs despite a fall in the real exchange rate. In these circumstances we expect the growth of unit labour costs to fall back from its current high level so that the current 3 per cent inflation rate becomes a true "core" rate. But a moderate fall in the real exchange rate may prove hard to achieve, especially if the oil price continues to weaken. We therefore explore what would happen if the required depreciation happens more rapidly, so that interest rates have to remain high to prevent it getting out of control. In this case we would expect lower growth and higher inflation than we forecast in June.     

The Pound and the Punt: A Study in Exchange Rate Policy

The rise in sterling during 1979 and 1980 was a remarkable and largely unexpected development While it has been accepted that the rise in the exchange rate played an important part in the reduction in the UK inflation rate during 1980 it has also been suggested that the appreciation of sterling was a major cause of the fall in output, particularly in the manufacturing sector.
In this Viewpoint we attempt to assess the effect of the rise in sterling on output and inflation by comparing the performance of the UK economy with that of the Irish Republic. As a member of the European Monetary System (EMS), Ireland shared the general depreciation of the European currencies against sterling. We suggest that the result has been a higher rate of inflation in Ireland than in the UK Also, although the Irish manufacturing sector avoided the UK's loss of competitiveness, the fall in manufacturing output in Ireland during 1980 was - when allowance is made for a higher underlying rate of growth in Ireland - comparable to that in the UK     

Monetary Targets and the World Economy

The dominant obsessions to watchers of the world economy at the moment are the weakness of the US dollar and the fear that the world economy is stagnating. In this ‘Briefing Paper’ we seek to put both events into the same intellectual framework, and to show that they are the consequence of monetary policies which are not logically related to each other, nor to a common objective of bringing world inflation steadily down to an acceptable level. Specifically, the US - which for reasons outlined below can warrant monetary growth rather below the world average if it is to preserve some dollar stability - is showing an above average outturn in its monetary aggregates. Germany and Japan, which can accommodate increases well above the average, are in fact adopting monetary targets which are leading to exchange rate appreciation, arid a reduction in both countries' expectations for real growth. The dangers for the world economy in this situation are very serious, particularly at a time when further dollar devaluation could be risky both from the viewpoint of US inflation wide the dollar's role as the key reserve asset. It could lead at worst to US protectionism and a monetaryled recession, rein forcing the slow growth rates already being widely predicted in 1978 for many other industrial countries. However, we show in this ‘Briefing Paper’ that this is not a necessity outcome of the present situation, given three vital perceptions. The first, required by statesmen as much as by technicians. is that the recent stagnation in European & Japanese output and exchange rate instability are essentially a monetary phenomenon, requiring essentially monetary (rather than fiscal) remedies. The second is acceptance of the need and practicability of some monetary consignation, based on reasonably common objectives among the major countries regarding inflation, bands for exchange rate movement and red rates of growth. the third, at the most practical level, is agreement on the actual monetary numbers which broadly reconcile these objectives and also take account of the very different ‘unwanted’ rates of monetary growth between countries which reflect their different underlying conditions of output, productivity and demand for money. It is the (ambitious) aim of this ‘Briefing Paper’ to substantiate these perceptions and to provide the numbers mound which a consideration of monetary policies can be framed. The numbers are necessarily based on trends established over a number of years and need to be supplemented by detailed understanding of each country's financial status But the monetary targets provided do, in our judgement, embody trade-offs between inflation, growth and exchange rate movements which should broadly satisfy national ambitions, and reset the world economy on a worthwhile growth path during 1978 or 1979.     

WORLD OUTLOOK

In the course of 1984 growth rates in the major economies came together. This reflects a slowdown in the United States, and to a lesser extent Japan, from the middle of the year and continuing recovery in Europe. This convergence is expected to continue in 1985 when total output in the OECD area is forecast to increase by 3 per cent. Within this total it is likely that the US, West Germany and the UK all achieve about 3 per cent; Japan should grow more quickly, France more slowly. In spite of a rapid recovery in output from the late-1982 trough, inflationary pressures remain weak. Measured in dollar terms, non-oil commodity prices have fallen and the oil price is under considerable down wards pressure. We expect inflation to stay at about its preset level in the US, West Germany, Japan and the UK and decline further in France, Italy and other countries where policy reaction to the 1979-80 oil price shock was delayed. In the medium term we expect the world economy to experience steady growth combined with a constant or slightly increasing inflation rate. This reflects a stable policy environment and falling real oil prices. After the excesses of the 1970s and early 1980s it is possible that the rest of the decade will experience u greater stability than at any time since the 1960s.     

Has the ECB increased interest rates too soon?

Even though the Eurozone recovery is far from entrenched, the ECB decided to raise interest rates towards the end of 2005 and another hike is expected soon. Those in the ECB who have been looking for a reason to start tightening for some time can point to an inflation rate that remains stubbornly above target as a justification. In this article we find that the price rises of non‐energy industrial goods ‐ particularly those for clothing and footwear ‐ have remained very sticky when compared to the deflation seen in countries like the UK. A lack of competitive forces may be an issue ‐ the impact of China and India on goods prices does not seem to be fully feeding through to consumers. And weak productivity in the distribution sector may have prevented retailers from driving down prices to the same extent as in the UK. Does the current ECB action form the start of a prolonged tightening cycle as seen in the US? Despite worries over asset price and credit growth ‐ and here we argue that the ECB's reliance on monetary aggregates as a signal of impending inflation is misguided ‐ there is a possibility that the ECB has acted at the same time that inflation is finally set to subside. Consequently, we expect a "wait and see" approach to further moves, and unless growth comes in much stronger than the 2.2% we expect in 2006, rates should end the year at around 2½%.     

Tighter labour markets to finally lift global wages

• Wage growth has been relatively slow since 2007 in advanced economies, but an upturn may be in sight. Slow productivity growth remains an issue but tighter labour markets make a positive response by wages to rising inflation more likely and there are signs that compositional and crisis‐related effects that dragged wage growth down are fading – though Japan may be an exception.
• Overall, our forecasts are for a moderate improvement in wage growth in the major economies in 2017–18, with the pace of growth rising by 0.5–1% per year relative to its 2016 level by 2018 – enough to keep consumer spending reasonably solid.
• Few countries have maintained their pre‐crisis pace of wage growth since 2007. In part this reflects a mixture of low inflation and weak productivity growth, but other factors have also been in play: in the US and Japan wage growth has run as much as 0.5–1% per year lower than conventional models would suggest.
• The link with productivity seems to have weakened since 2007 and Phillips curves – which relate wages to unemployment – have become flatter. A notable exception is Germany, where the labour market has behaved in a much more ‘normal’ fashion over recent years with wage growth responding to diminishing slack.
• ‘Compositional’ factors related to shifts in the structure of the workforce may have had an important influence in holding down wage growth, cutting it by as much as 2% per year in the US and 1% per year in the UK. There are some signs that the impact of these effects in the UK and US are fading, but not in Japan.
• The forecast rise in inflation over the next year as energy price base effects turn positive is a potential risk to real wages. But the decline in measures of labour market slack in the US, UK and Germany suggests wages are more likely to move up with inflation than was the case in 2010–11 when oil prices spiked and real wages fell.

     

International competitiveness of japanese manufacturing

This paper deals with the effect of corporate management practices on the efficiency of Japanese manufacturing and their international trade performance. It also looks at the relative cost position in comparison with the major industrialized countries. Such cost comparisons reflect changes in productivity performance, inflation and exchange rate changes that have been so marked that the United States has become the lowest-cost producer of manufactured products recently for the first time in the post-war period. Some effects of these changes on the trade and balance of payments positions of Japan in relation to North America are outlined. The paper includes data for selected years from 1950 to 1988 for real GDP per employed person, real output per hour for manufacturing, and unit labour costs for manufacturing for the United States, Japan, Canada and six of the major European countries.     

The Dollar, the Oil Price and Policy Divergence

There is currently a clear divergence of policy between the United States, Japan and Germany. With the US in recession and concern growing over the severity of the slump, interest rates have been cut in a move to revive the economy. In contrast Japan and Germany are both experiencing strong growth and monetary policy remains tight to combat inflation. This divergence was seen most clearly when the Federal Reserve Board lowered its discount rate to 6 per cent on 1 February, the day after the Bundesbank had raised its Lombard rate to 9 per cent. With G7 increasingly concerned about domestic factors, less emphasis is placed upon stable exchange rates and as a result the dollar is at an all-time low. The last two G7 communiqués have stressed ‘stability oriented monetary policies’, an ambiguous phrase which fails to define ‘stability’ either in terms of exchange rates, inflation or growth. Thus both the German and Japanese policy of high interest rates to reduce inflation and low US interest rates aimed at stimulating the economy can be termed as ‘stability oriented’. This analysis focuses on these divergent policy responses in two alternative scenarios to the world forecast we presented last month. The first scenario considers what might happen if the Federal Reserve Board were to stimulate the US economy by further cuts in interest rates, whilst Japanese and German rates were unchanged in the face of inflationary pressures. This case may be relevant if the recent US loosening of monetary policy is not sufficient to encourage growth because of a ‘credit crunch’, so that a more expansionary policy is required by the Fed. As a consequence, policy diverges further and the dollar weakens. The second scenario focuses upon a reduction in inflationary pressures in Japan and Germany brought about by an oil price fall. In this case we assume that US policy is already loose enough to avoid a prolonged recession, but that German and Japanese monetary policy is relaxed as inflationary forces recede. In this case policies converge. Each scenario thus concentrates on one of !he two features which are causing the policy divergence amongst G3 countries: recession in the US, inflation in Germany and Japan.     

LOWER OIL PRICES AND THE UK ECONOMY

Demand for oil remains weak, and OPEC production is running ahead of quota in most member countries, so the possibility that oil prices could fall in the near future has increased. In this Forecast Release we examine the medium-term impact on the UK economy of lower oil prices. We find that, if the government does not intervene to protect the exchange rate, there is an immediate stimulus to output growth. The inflation rate, though, is 1–2 percentage points higher after three years.     

WORLD OUTLOOK

After six years of steadily rising OECD output, fears of a significant rise in world inflation are now increasing. In the last year there has been a slight pick-up in inflation with producer prices up nearly d per cent. But prompt action by the Federal Reserve to raise interest rates before the presidential election appears to have damped inflationary expectations in the US and has given Japan and Germany an opportunity to tighten monetary policy without causing major currency fluctuations. It is also apparent that the other possible source of world inflation, commodity prices, is not a problem. OPEC over-production has ensured that the oil price remains weak and other commodity prices appear to have stopped rising after a brief acceleration at the beginning of the year. Nevertheless the major imbalances in world trade are declining only slowly and without a change in fiscal policy in the major economies it is difficult to believe that minor changes in monetary policy will be sufficient if the process of adjustment begins to falter. Despite these risks, we take a sanguine view of world prospects. Tighter monetary policy should effect a slowdown in world growth next year (already indicated by recent developments, particularly in the US) and this should be sufficient to control inflation which we expect to peak at just under 5 per cent at the beginning of next year. From 1990 onwards we see steady growth accompanied by low inflation.     

Fiscal Explanations for Inflation: Any Evidence from Transition Economies?

Recent arguments, motivated partly by the new fiscal theory of price level, suggest that fiscal deficits undermine price stability in transition economies. This paper addresses these claims by examining vector-autoregressive models of inflation for three transition economies (Bulgaria, Romania and Russia). The results indicate that fiscal deficits have increased inflation in Bulgaria and Romania but not in the case of Russia. In Bulgaria and Romania, money aggregates and exchange rate have also been more influential to inflation than fiscal deficits. The analysis based on this method therefore suggests that while fiscal deficits have some influence on inflation, monetary factors mostly determine inflation in these three countries.     

Heterogeneity dependence between oil prices and exchange rate: Evidence from a parametric test of Granger causality in quantiles

This paper re-examines the nexus between crude oil price and exchange rate by investigating their heterogeneity dependence structure within the framework of Granger causality in quantiles for a sample of developed and emerging economies (namely UK, Canada, Brazil, Russia, Mexico, Norway, India, Japan, South Africa, South Korea and European Union (EU)). The results indicate no distinct causality between the crude oil price changes and the real exchange rate returns for all countries besides Russia at the median of the conditional distribution. Besides, the crude oil price changes influence the exchange rate returns in all countries, except Norway and EU, particularly around the tails of the conditional distributions of exchange rate returns. This suggests that the oil price changes influence the real exchange rate returns when the real exchange rate returns are either in extreme appreciation or depreciation. Moreover, the crude oil price movement can be explained by the exchange rate returns for most oil importers only when the crude oil market is bearish or bullish. By contrast, the real exchange rate can permanently affect the crude oil price for most oil-importing countries irrespective of the crude oil market's state. Finally, our findings provide an essential reference for managing the extreme risk dependence between the exchange rate market and the crude oil market.     

The London Business School with Gower Publishing

This forecast release examines the latest monthly indicators. In general there are few surprises although total output in the economy is showing signs of moving upwards more rapidly than we had expected, with the underlying trend in industrial production showing a 1½ percent increase over the last three months. Retail sales are currently running at over 3 per cent above the 1977 level. The underlying rate of retail price inflation is now under 8 per cent although the input price figures are showing some increase after the earlier falls. The balance of payments continues to be very erratic with monthly oscillations of up to £500m. The most recent figures showing a sharp fall in imports are consistent with the view we expressed last month that much of the rise in imports in the first quarter reflected stock- building of imported goods as companies took advantage of the strong pound. The money supply figures continue to be disturbing with recent growth over 12 months at 16 percent while the six-monthly figure has been close to 20 per cent; compared to our major industrial competitors this puts us back towards the top of the league on monetary growth and in this light it is not surprising that the exchange rate has fallen.     

WORLD OUTLOOK

The strength of US domestic demand is exerting a very strong pull on the world economy. Japan in particular is benefiting from soaring export demand, but the effects on European exports have been offset by weak domestic demand and, in the case of West Germany and the UK, by damaging industrial disputes which have interrupted supply. Over the next 12 months we expect the US economy to slow down under the weight of the financial and external balance pressures, which two years of very rapid but unbalanced growth have built up. For the world economy, however, we expect the slowdown in the US to be counterbalanced by expanding domestic demand in Europe and Japan, especially if a lower dollar permits reductions in interest rates. We forecast world output growth of about 3 per cent next year, well below the near-5 per cent projected for 1984 - the cyclical peak. By the second half of 1985 the world recovery will be three years old and we expect a pause in the growth of output. Against a background of stable monetary growth we expect world inflation in the 5–6 per cent range over the medium term. This is consistent with some increase in US inflation, low and stable inflation in Japan and West Germany and further progress in reducing inflation in countries such as France and Italy. Our forecast is based on the assumption that the dollar falls next year. If it does not fail we believe there is a significant risk of slower growth.     

World Economic Prospects Monthly

Overview: A recovery in trade

• ? Our world GDP growth forecasts are unchanged this month, at 2.6% for 2017 and 2.9% in 2018. Similarly, our outlook for inflation has remained stable and we expect consumer price inflation to accelerate to 3.3% in 2017 owing to the effect of higher oil prices. Despite the multi‐year highs shown by global surveys, we remain cautious about further upgrades to our growth forecast, as we believe that the they may be overstating the pace of growth .
• ? Global indicators continue to point to a pick‐up in activity, driven by stronger manufacturing. The global manufacturing PMI remained at its highest level in almost three years in January, while the composite index – which includes services – was at a 22‐month high. Underpinned by stronger manufacturing activity, global trade is also recovering, with trade volumes rising a strong 2.8% on the month in November.
• ? After a disappointing 2016, we expect US growth to rise to 2.3% from an estimated 1.6%, bolstered by the anticipated effects of President Trump's expansive fiscal policies. However, uncertainties around our central forecast are unusually high given the major doubts about the new president's policies. The first days of the Trump administration have shown that he does not intend to tone down his rhetoric and we believe there is risk of a general underestimation of the economic risks derived from protectionism and his anti‐immigration stance.
• ? We still expect two increases in the Federal funds rate this year and US bond yields are likely to continue to rise. Despite some recent dollar weakness, the widening of interest rate differential between the US and the Eurozone, where rates are likely to remain unchanged, will drive the euro down to parity with the US dollar by end‐2017.
• ? Emerging market growth overall will improve in 2017, but performance will differ across countries. Countries with weak balance of payments positions, high dollar debt and exposure to possible US protectionist actions will be at risk. Our research shows that Turkey, South Africa and Malaysia are most at risk from potential financial turmoil.

     

汇率制度选择及其通胀绩效的实证考察--以中东欧转轨国家为例

文章对20世纪90年代中东欧转轨国家汇率制度选择及其通胀绩效进行了实证考察。结果表明,这些国家在从计划经济向市场经济转轨的过程中,采取了几乎所有的汇率制度类型。对于转轨国家而言,汇率制度选择与通胀之间存在着非常密切的关系。在转轨的初期,通胀的压力和宏观经济的稳定性是政府主要考虑的因素,这些国家的政府都把稳定货币作为制定政策的出发点,汇率制度的选择也是围绕稳定货币进行的。这些国家的实践表明,钉住汇率制度反通胀的绩效要超过浮动汇率制度。     

Disaggregate productivity comparisons: sectoral convergence in OECD countries

International comparisons of productivity have used exchange rates or purchasing power parity (PPP) to make output comparable across countries. While aggregate PPP holds well in the long run, sectoral deviations are persistent. It raises the need for a currency conversion factor at the same level of aggregation as the output that is compared. Mapping prices from household expenditure surveys into the industrial classification of sectors and adjusting for taxes and international trade, I obtain an expenditure-based sector-specific PPP. Using detailed price data for up to 8 years between 1970 and 1999, I test whether the sectoral PPPs adequately capture differential changes in relative prices between countries. They work well for agriculture and the majority of industrial sectors, but not for most service sectors and for manufacturing sectors that produce differentiated products. Using the most appropriate conversion factor for each industry, productivity convergence is found to be taking place in all but a few industries for a group of 14 OECD countries. The latter results are robust to the base year used for the currency conversion.     

The London Business School with Gover Publishing

The world economy is in poor shape. OECD industrial production fell 0.5per cent in both 1991 and 1992 arid though it may now have stopped falling it is still, on our estimates, below year-earlier levels. The US recovery continues to disappoint; recession persists in Japan and Europe; inflationary pressures, already weak, are waning. Next month's UK forecast would normally be based on the world forecast published in June's International Economic Outlook, when we were looking for G7 output to rise 1.2 per cent this year, 2.5 per cent next. But this now looks on the high side and although a detailed revision to the world forecast mist wait until the December IEO, as at1 input to the UK forecast we are shading our G7 growth forecasts - to I per cent this year and 2.25 per cent in 1994. Similar downward revisions are also in train at the OECD arid IMF, according to recent press reports. The more sluggish output performance is already having mi impact on the oil price, which has fallen below £16 a barrel. Together, these developments imply lower world inflation and, particularly in post-ERM Europe, a faster easing of monetary policy than we had allowed for in June.     

The Conduct of Monetary Policy Without Monetary Aggregates

A central dilemma for the monetary authorities is how to determine monetary policy. The increasing unreliability of monetary aggregates has led over the past few years to less concern for monetary targeting, both in the UK and elsewhere, and a greater influence for the exchange rate on monetary policy. But in the UK, most recently, there has been a move away from setting monetary policy in relation to the exchange rate and external considerations in favour of setting monetary policy in relation to domestic demand. Not surprisingly, this shift has occurred at a time of rising concern about domestic overheating. It illustrates the dilemma of whether monetary policy should be driven by domestic demand considerations or by external, exchange rate considerations. This dilemma is not just confined to the UK for it is a real source of conflict underlying the Louvre Accord and its successors that seek to determine G7 exchange rates in a cooperative manner. In what follows, we argue that exchange rate developments should have an appreciable influence on monetary policy, since this is helpful in attaining stable inflation. But we also suggest that this influence should not go too far, since this stability of inflation may be at the expense of stability of domestic demand and output. Targeting of exchange rates within narrow bands is unlikely to be desirable, unless fiscal policy can be used more flexibly to stabilize domestic demand. This suggests that, in the period up to the spring, the use of monetary policy to hold the £/JDM exchange rate within narrow limits may have been overdone. More seriously, international exchange rate agreements among the G7 countries are likely to founder under adverse market pressures, unless current imbalances in fiscal policy are adjusted. In the absence of greater flexibility in fiscal policy, policy makers will have to trade off domestic and exchange rate considerations in determining monetary policy. An important outstanding issue that needs further consideration is what indicators should be used for monetary policy, in a world in which monetary aggregates provide unreliable signals.