Quick Snapshot on Currency War

* As the Federal Reserve has prepared the ground for another round of monetary policy easing (QE2), the foreign exchange value of the US dollar has fallen. In the US, this is seen as a normal channel of transmission of monetary policy easing that is aimed at bolstering a weak recovery and keeping deflation risks at bay. But some US trading partners see this as an unfriendly act. Hence, there have been warnings of a "currency war" and rising protectionism.

* In our view, however, countries affected by the fall-out from QE2 in the US are more likely to react defensively rather than aggressively. Such reactions are likely to include constraints on capital inflows (mostly in some emerging market countries), foreign exchange intervention with an associated easing of monetary policy, and a managed appreciation of currencies. Since some countries are likely to be more reluctant than others to intervene and match the US monetary easing, some currencies will appreciate by more than others. Presently, the euro seems to be the currency with the largest upside potential.

* The easing of global monetary and financial conditions as a result of QE2 in the US is likely to lift financial asset prices and pave the way to higher inflation, first in the faster growing emerging market countries and finally also in the industrial countries. Depressed interest rates at first and higher inflation later are likely to lead to a misallocation of capital. Hence, the desired short-term GDP gains from the policy of easy money are likely to be offset by long-term losses due to lower capital productivity.

Source: Deutsche Bank