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Why currency volatility could make a comeback

A decade of low inflation and interest rates smothered forex markets. Now consumer prices and rates are going up



Foreign-exchange markets were once a hotbed of lively, speculative activity. 

But today traders seeking an adrenalin fix must turn to assets like cryptocurrencies instead. 

Barring a brief surge early in the pandemic—and isolated goings-on in the Turkish lira—currency markets have gone quiet. 

Macro-trading funds no longer strike fear into central bankers and finance ministries with speculative attacks. 

The last sudden end to a major currency peg—that of the Swiss franc in 2015—was a result of the central bank taking investors by surprise, rather than the other way round.

Rock-bottom inflation and interest rates over the past decade helped smother swings in exchange rates. 

Deutsche Bank’s cvix index, a gauge of forex volatility, has been above its current level more than 90% of the time over the past 20 years. 

By contrast, the vix, which measures expected volatility for America’s s&p 500 index of stocks and is often used as a measure of overall market sentiment, has so far spent October at roughly its long-term average. 

But as consumer prices and interest rates go up, currency volatility could well stage a return, with potentially unwelcome consequences for some investors.

The strangeness of the recovery from the pandemic makes predicting the path of policy especially hard. 

Yet some divergences seem likely to reassert themselves. 

Countries are recovering at different speeds, and central banks are displaying varying levels of discomfort with inflation. 

Policy in America is especially important, given the pivotal role of the dollar: 88% of over-the-counter foreign-exchange trades in 2019 involved the greenback, according to the Bank for International Settlements. 

The chances that the Federal Reserve turns more rapidly to policy tightening are rising. 

Break-evens (the gap between yields on inflation-protected Treasury bonds and conventional ones of the same maturity) point to annual inflation of around 3% over the next five years, the highest reading since at least 2003. 

By contrast, no one is expecting interest-rate rises for decades in Japan, where year-on-year inflation, excluding food and energy, is negative.

Long periods of low volatility are understandably regarded as a good thing by most investors. 

But they can have less desirable side-effects. 

Hyman Minsky, an economist, suggested that periods of financial stability and sustained profits can change the behaviour of market participants, by pushing them to adopt riskier strategies that could in turn destabilise markets. 

The danger is that, as currency markets return to life, the shortcomings of these sorts of strategies are exposed.

The boom in Asian economies in the 1990s, which led to enormous unhedged dollar borrowing by governments and firms, is a case study in how the perception of safety, once overturned, can cause violent market reactions. 

Faced with steep currency depreciation in 1997-98, that borrowing proved impossible to service, spurring defaults and bail-outs. 

Today emerging-market governments issue far more of their debt in their own currencies, and when they borrow in foreign currency, do so at longer maturities. 

Still, weak spots remain. 

Dollar borrowing by non-banks in the developing world has almost doubled to over $4trn in the past decade, much of it reflecting bond issuance by companies, rather than governments.

Creditors, too, are vulnerable to exchange-rate risk. 

Working out the extent to which asset-owners hedge their exposures is tricky. 

But the available figures indicate that falling volatility tends to cause companies to reduce hedging. 

Large Japanese insurers have tended to hedge more over the past two decades whenever volatility has risen, suggests Fed research published last year. 

Insurers bought far more currency forwards and swaps during and immediately after the global financial crisis, when volatility peaked, and a declining share relative to their foreign assets thereafter. 

Unhedged net foreign assets in Australia, too, have risen in the past couple of decades, in part reflecting the rise of non-bank borrowers that are unprotected.

An optimist might point to the market stress of the early days of the pandemic, when volatility surged without causing big currency-market blow-ups. 

If the system was able to weather acute distress then, why worry now? 

But placidity was restored in short order last year because central banks were unusually co-ordinated in their easing. 

Now, by contrast, they are preparing to go their separate ways. 

Currency markets may no longer be an oasis of calm. 

The Path to Climate Credibility

Green capitalism can work only if governments eventually keep their climate promises – and the current picture is one of massive credibility failure. Accelerating the green transition will require like-minded countries to form a “climate club” and impose import tariffs on trade partners not contributing to the collective effort.

Jean Pisani-Ferry


PARIS – On October 25, the electric-vehicle producer Tesla’s market capitalization reached $1 trillion – more than the combined value of the next ten global car manufacturers. 

Even after discounting for exuberance, this is a strong indicator of how the threat of climate change is triggering a transformation of capitalism. 

To be sure, polluters still abound, and greenwashing is pervasive. 

But it would be a mistake to dismiss the changeover underway.

Governments, however, are not on track to deliver on their promise in the 2015 Paris climate agreement to limit global warming to “well below” 2° Celsius relative to pre-industrial levels. 

According to the International Energy Agency, meeting the national pledges made so far within the framework of the Paris accord would lead to an increase in global temperature of 2.1°C. 

Moreover, actual policies fall short of even these insufficient pledges: under the IEA’s “stated policies scenario,” global warming would reach 2.6°C.

Add to this the fact that – as the Energy Transitions Commission has documented – most governments have committed to achieving net-zero emissions only by 2050 or 2060, and plan to postpone major mitigation efforts until after 2030, and the emerging picture is one of massive credibility failure.

The root of the problem is well known. 

The Paris agreement was based on the realistic judgment that governments could not agree on a precisely defined allocation of climate-change mitigation efforts. 

This conclusion had emerged from the collapse of the 1997 Kyoto Protocol (which involved such an allocation but left out emerging economies, including China) and the failure of the 2009 United Nations Climate Change Conference in Copenhagen (where an attempt to muster a global Kyoto-type agreement ended in dispute).

So, the world tried a different approach: experts would assess the climate efforts needed, governments would formulate pledges, and civil society would scrutinize them. 

No one expected the initial pledges to be sufficient. 

But the hope was that peer pressure, the weight of public opinion, and relentless warnings by the scientific community would gradually put policies on the right track.

Economists were skeptical. 

Christian Gollier and Jean Tirole of the Toulouse School of Economics warned early on that the strategy was “doomed to fail.” 

And William Nordhaus of Yale University showed that voluntary climate coalitions are vulnerable to free-riding and prone to instability.

The Paris agreement nonetheless achieved something that simple economic models could not reflect: the beginning of a change in business attitudes. 

Notably, the Paris accord encouraged investors and managers to ponder the risk of being left with stranded assets or an obsolete business model. 

Mark Carney, then-governor of the Bank of England, added that regulators would hold financial institutions accountable for hidden climate risks. 

Such considerations generated private-sector momentum toward decarbonization.

But green capitalism can prosper only if governments eventually keep their climate promises. 

Most investments in renewable energy, energy-efficient buildings, or zero-emission vehicles require carbon pricing, tight regulation, or both. 

Forward-looking investors may well bet on the eventual enactment of such measures, but only up to a point, and not without consequences.

An insufficiently credible decarbonization policy implies both higher overall costs (because it leads investors to hedge by combining brown and green investments) and recurrent imbalances between demand and supply. 

Balancing an accelerated transition away from fossil fuels is challenging in any scenario, but even more so if future policies are uncertain. 

The current rise in energy prices might therefore presage rougher times ahead.

The lack of climate-policy credibility partly reflects domestic political considerations, because governments simultaneously promise a green future and the continuation of the status quo. 

US President Joe Biden lacks a congressional majority in favor of penalizing fossil-fuel use, Chinese President Xi Jinping is afraid of jeopardizing his country’s energy-hungry economic growth, and French President Emmanuel Macron knows from experience that middle-class households are hostile to carbon taxation.

Such concerns are understandable. 

But if investors conclude that governments are not serious about achieving global climate goals, they will spend less on green initiatives, and the Paris agreement’s core mechanism will collapse.

One solution would be for governments to tie their own hands by giving the mandate to set the carbon price to an independent institution, in the same way that they previously delegated responsibility for controlling inflation to central banks. 

Alternatively, governments could commit to paying a penalty if they fail to adhere to a given future path for the price of carbon (for example, by issuing certificates whose value would depend on the difference between the announced and actual prices). 

The question, however, is whether institutional or financial engineering could solve a deeply political problem.

Moreover, governments will deliver on climate goals only if a critical mass of countries remains on track to do so. 

Even more than domestic politics, this is at the core of the current credibility deficit. 

Nordhaus has therefore proposed that a group of like-minded countries form a “climate club” and apply a tariff on imports from trade partners that are not contributing to the collective effort. 

Today, for example, this would mean punishing Brazil for President Jair Bolsonaro’s irresponsible climate policies.

The idea makes perfect economic sense, and the outgoing German government took it up in a softer form in a recent paper. 

The difficulty is that although a mechanism to offset the trade implications of differential carbon pricing should be compatible with World Trade Organization rules, an outright penalty would be in conflict with them.

The European Union’s decision to push ahead with its European Green Deal is a stepping-stone. 

Provided the EU sets aside sufficient resources to compensate vulnerable households, the program’s common character will help member states solve their own climate credibility problems. 

In time, the EU will probably form a climate club of sorts with selected trade partners and push for ambitious goals. 

The question is who the other members will be. 

As things stand, both the United States and China fall short of the ambition required for such an alliance. 

That makes this a narrow path to climate credibility. 

But it is the only one.


Jean Pisani-Ferry, a senior fellow at Brussels-based think tank Bruegel and a senior non-resident fellow at the Peterson Institute for International Economics, holds the Tommaso Padoa-Schioppa chair at the European University Institute.

A Progressive Monetary Policy Is the Only Alternative

Torn between inflationary jitters and fear of deflation, central bankers in the major advanced economies are taking a potentially costly wait-and-see approach. Only a progressive rethink of their tools and aims can help them play a socially useful post-pandemic role.

Yanis Varoufakis


ATHENS – As the coronavirus pandemic recedes in the advanced economies, their central banks increasingly resemble the proverbial ass who, equally hungry and thirsty, succumbs to both hunger and thirst because it could not choose between hay and water. 

Torn between inflationary jitters and fear of deflation, policymakers are taking a potentially costly wait-and-see approach. 

Only a progressive rethink of their tools and aims can help them play a socially useful post-pandemic role.

Central bankers once had a single policy lever: interest rates. 

Push down to revitalize a flagging economy; push up to rein in inflation (often at the expense of triggering a recession). 

Timing these moves, and deciding by how much to move the lever, was never easy, but at least there was only one move to make: push the lever up or down. 

Today, central bankers’ work is twice as complicated, because, since 2009, they have had two levers to manipulate.

Following the 2008 global financial crisis, a second lever became necessary, because the original one got jammed: Even though it had been pushed down as far as possible, driving interest rates to zero and often forcing them into negative territory, the economy continued to stagnate. 

Taking a page from the Bank of Japan, major central banks (led by the US Federal Reserve and the Bank of England) created a second lever, known as quantitative easing (QE). 

Pushing it up created money to purchase paper assets from commercial banks in the hope that the banks would inject the new money directly into the real economy. 

If inflation appeared, all they need do was push down on the lever and taper the asset purchases.

That was the theory. 

Now that inflation is in the air, central banks are nervous. 

Should they tighten policy?

If they don’t, they can expect the ignominy suffered by their 1970s predecessors, who allowed inflation to become embedded in the price-wage dynamic. 

But if they follow their instincts and shift their two levers, tapering QE and modestly raising interest rates, they run the risk of triggering two crises at once: A jobs bonfire, as increasing interest rates reduce aggregate demand and dampen investment, and a financial crash, as markets and corporations, addicted to free QE money and over-extended, panic at the prospect of withdrawal. 

The 2013 “taper tantrum,” which occurred after the Fed merely suggested that it would rein in QE, would pale in comparison.

Central banks are terrified of this scenario because it would render both their levers useless. 

Though interest rates would have risen, there would still be little room to reduce them. 

And politically prohibitive amounts of QE would be necessary to reflate submerged financial markets. 

So, policymakers sit on their hands, emulating the hapless ass who could not work out which of its two needs was weightier.

But, by presupposing that the two levers must be moved sequentially and in tandem, central banks’ conundrum assumes a past that need not be repeated. 

Historically, sure, the second lever, QE, was invented only after the first, interest rates, had stopped working. 

But why should we assume that with inflation rising again, the sequence must now be reversed by eliminating QE first and then raising interest rates? 

Why can’t the two levers be moved simultaneously and in the same direction, implying a two-prong monetary policy that hikes interest rates and QE (albeit a different form)?

Interest rates should indeed be raised. 

Lest we forget, even in times of zero official interest rates, the bottom 50% of the income distribution are ineligible for cheap credit and end up borrowing at usurious rates via payday loans, credit cards, and unsecured private loans. 

It is only the rich that benefit from ultra-low interest rates. 

As for governments, while low official interest rates allow them to roll over their debt cheaply, their fiscal constraints seem impossible to loosen, so much so that public investment is constantly lacking. 

For these two reasons, 13 years of ultra-low interest rates have contributed to massive inequality.

This rising inequality has enlarged the savings glut, as the ultra-rich find it hard to spend their mountainous stash. 

Because burgeoning savings represent the supply of money, whereas puny investments represent the demand for it, the result is downward pressure on the price of money, which keeps interest rates pinned to their lower zero bound. 

Central banks must, therefore, muster the courage to raise interest rates in order to break this vicious cycle of unbearable inequality and unnecessary stagnation.

Of course, central banks fear that hiking interest rates will render governments bankrupt and cause a serious recession. 

That’s why the increase in interest rates should be supported by two crucial policy moves.

First, because a serious restructuring of both public and private debt is unavoidable, central banks should stop trying to avoid it. 

Keeping interest rates below zero to extend into the future the bankruptcy of insolvent entities (like the Greek and Italian states and a large number of zombie firms), as the European Central Bank and the Fed are currently doing, is a fool’s wager. 

Instead, let us restructure unpayable debts and increase interest rates to prevent the creation of more unpayable debts.

Second, instead of ending QE, the money it produces should be diverted away from commercial banks and their corporate clients (which have spent most of the money on share buybacks). 

This money should fund a basic income and the green transition (via public investment banks like the World Bank and the European Investment Bank). 

And this form of QE will not prove inflationary if the basic income of the upper middle class and above is taxed more heavily, and if green investment begins to produce the green energy and goods that humanity needs.

Central banks are not constrained to choose between paralysis and contraction. 

A progressive monetary policy would lift interest rates while investing the fruit of the money tree in climate action and reducing inequality. 

If it helps to sell the policy, call it “sustainable monetary tightening.”


Yanis Varoufakis, a former finance minister of Greece, is leader of the MeRA25 party and Professor of Economics at the University of Athens.