Why does a stronger currency have a tightening effect on economic conditions?

Question

http://www.economist.com/blogs/buttonwood/2015/12/central-bank-predictability

Ever since 1987, banks have been willing to cut rates when markets have wobbled. Driving down bond yields has been an explicit aim of QE (and pushing up stockmarkets an implicit one). Currencies move in anticipation of interest rate divergence (hence the strength of the dollar this year) and a stronger/weaker currency has a tightening/easing effect on economic conditions.

A related question is what exactly is meant by tightening effect on economic conditions. This term is meant loosely in financial media and I do not know exactly what it means.

Answer 1

Tight monetary policy reduces the amount of money available in the economy and strengthens the currency. It is usually implemented by raising interest rates, increasing capital requirements for banks, or sometimes selling government bonds.

When there is less money and credit to go around, business activity slows down, economic growth slows down. Businesses that could have expanded by taking out loans do not do so; consumers who could have purchased more with their credit cards can't do so; investors who could have invested more money into businesses (equities) put the money into government bonds.

Answer 2

The primary goal of quantitative easing was not to affect the bond market nor the stock market. But rather to save the banking system. All other goals to the Fed are a distant second to this.

The banking system is very dependent on a consistent and reliable source of short term debt (like deposits). This is because they make money by borrowing short term and lending long term (maturity mismatching). If in the aggregate, the public stops rolling over their short term debt the banking system is in grave trouble and could face a bank run. They can't convert long term assets into short term. So to avoid insolvency they need to refinance withdrawn short debt with another source of short term debt. The Fed usually provides a reliable source of short term debt through open market actions. But when banks stopped lending to each other in 2008+, the Fed decided more needed to be done to replace short debt (financing) that had bled out of the banking system. Hence QE, which allowed banks to unload long term assets to the Fed in exchange for reserves which they could lend to each other on the money market.

What does tightening mean? If you as a bank make money by maturity/yield mismatching and short term interest rates go up (and by extension maturity) then banks can not create as much broad money as they had. Yet in the aggregate long term debt remains constant. Less money + same amount of long term debt = a constricting effect on the economy. But some of this is complicated. When banks are allowed to create money, they create inflation which is also bad for the economy. So it is a situation that has to be handled very carefully.

Answer 3

To add to the previous answers, and to directly answer your question with respect to a tight/loose policy and its relationship to currency, I think it is best to first define loose monetary policies as those which increase demand for goods and services and/or leads to inflation and tight conditions as those which reduce demand for goods and services and/or leads to price deflation.

Thus, policies which tend to increase the value of a country's currency will cause a decrease in import prices, lowering prices in the economy, which is price deflationary. Additionally, a strong currency reduces demand for a country's goods/services, i.e. exports, as they become more expensive. Both effects fit our definition of "tight" monetary conditions.

Alternatively, a weak currency boosts demand for a country's exports and causes import prices to rise, leading to price inflation, these effects both fit into our definition of "easy" monetary conditions.