Forex Flash: Is balance sheet expansion a deflation remedy? – UBS (Barcelona) - In looking at individual monetary policy, especially localized to the G5, the actual influences on exchange rates recently – on an absolute level – have not exactly been clear-cut. According to Research Analyst Gareth Berry at UBS, “There is no firm relationship between outright balance sheet expansion and currency strength or weakness. Japan and Switzerland have actively expanded their balance sheets with little success of escaping disinflation/deflation (until recently), while every instance of the ECB purporting to 'do the right thing' via balance sheet expansion has also been greeted with the market returning to bidding the euro.”

On a relative level however, it does matter. Taking the relative balance sheet growth between the ECB and that of the Fed and the BoJ, indexed to January 2009 when global central banks first began to deploy the balance sheet in earnest, exchange rates have tracked relative growth quite closely.

Pre-crisis, relative money supply differentials were often used to proxy for exchange rates: stronger money supply growth would imply higher inflation expectations, translated into a stronger exchange rate either through REER, or higher rates which would attract inflows. In the current environment this relationship has reversed, where 'money supply' has been taken more literally for the amounts being printed; debasement differentials would be a better description of current dynamics.