Great Graphic: Shifting Trade-Weighted Exchange Rates

For businesses and investors, bilateral exchange rates are important. However, for policymakers, when thinking about the impact of exchange rate moves, it is better to use trade-weighted indices.

Depending on the openness of an economy (exports plus imports as a percentage of GDP) and the elasticity of important and exports, an appreciating trade-weighted currency is tantamount to some degree to tightening of monetary conditions. Similarly, a depreciation of a trade-weighted currency is the rough equivalent of some degree of monetary easing.

The Great Graphic, created on Bloomberg, depicts the Bank of England's trade-weighted indices for four major currencies indexed, so they all start at 100 six months ago.

The Japanese yen is the white line at the top of the chart. It has fallen about 10% since early-September to near four-month lows. This offset the part of the tightening impulse generated from the appreciation earlier in the year. The yen's trade-weighted index is about 12.5% higher than it started the year.

The US dollar's trade-weighted index is tracked by the yellow line. It has been trending gently higher since mid-August and has appreciated by a little more than 5% since then. That includes the roughly 2% gain this week. It fell 1.6% last week, and the loss snapped a five-week advancing streak. The Bank of England's trade-weighted dollar index is at its best level in eight months. The operative forces suggest further gains are likely. A 13-year high was set in January at 107.40. Today the index is a little above 103. Despite the recent rise, the dollar's TWI is still about 2.5% below where it began the year. The impact on financial conditions is minimal.

The euro's trade-weighted index as calculated by the Bank of England is the purple line. It appreciated at the start of the year and traded broadly sideways until the UK's referendum and sterling's slide. From the end of June through early-November, the euro appreciated around 4.8% on a trade-weighted basis. This is equivalent to a small (may around 10-12 bp of tightening). It is at six-week lows. It is likely to fall further in the coming weeks as investors anticipate that the Italian referendum will lose handily in early December. The European project assumes nationalism can be sublimated through economic and monetary integration. This is being openly questioned. The ECB says it does not target the exchange rate, but includes it in its economic assessment. Draghi may not say it in so many words, but a weaker euro on a trade-weighted basis is a constructive development for EMU.

The green line is sterling's broad trade-weighted index. Sterling's trade-weighted index has already begun depreciating before the UK referendum. Those losses accelerated afterward. It stabilized in from mid-July through the end of September. It posted another leg lower amid concerns that the UK's emphasis on limiting immigration would deny it access to the single market. It bottomed in the middle of October and had been gradually moving higher. It has risen by roughly 3.8% of those mid-October lows. The High Court ruling that requires Parliament authorization for invoking Article 50 helps sterling recover. The Bank of England shifted from an easing stance to more neutral posture. Before the recent recovery, sterling trade-weighted index dropped nearly 18.5% from the year's high. So far this month, it has appreciated by about 3.7%. The pass-through to inflation has already begun. At the end of last year, the UK's headline CPI stood at 0.2%. By July it had risen 0.5% and in September 1.0. It is expected to tick up to 1.1% when it is reported next week.