Roubini’s RGE: Global monetary policy outlook
The report below comes courtesy of Nouriel Roubini’s team of analysts at RGE, taking a look at some recent monetary policy trends in advanced economies. This content is excerpted from a longer piece, “Global Monetary Policy Review,” which includes in-depth analysis of when the world’s emerging markets might shift interest rate strategy. However, the longer piece is available only on a subscription basis.
Last week was a busy one for the Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BoE). Policymaking is tricky when different asset classes are sending very different signals about the economy. However, those different signals are themselves a byproduct of policy. In the US, bond markets are discounting a sluggish U-shaped recovery or even a double-dip recession, while risky markets are signaling a strong V-shaped recovery ahead. Which is right? While RGE leans towards the U-shaped camp, we do not expect risky assets to invert their course as long as the Federal Reserve commits to maintaining “exceptionally low levels of the federal funds rate for an extended period.”
So the policy dilemma is one of having to maintain “exceptionally low rates” given the still very difficult real economic conditions, but with the danger of an increasing disconnect between risky asset valuations and the economy-which could eventually snap back and compromise economic and financial stability in the medium term. While this environment reignites the debate on whether central banks should target asset prices or not, RGE maintains that Fed fund hikes are a story for end of 2010 or Q1 2011.
The Bank of England kept its rate on hold at 0.5% for the 8th consecutive month in November with another hold almost certain in December. As the UK economy failed to pull out of recession in Q3 2009, a rise in interest rates is unlikely to occur before Q2 2010; a view supported by evidence in the money markets. The Monetary Policy Committee did move to increase the program of quantitative easing, asking the Chancellor of the Exchequer, Alistair Darling, for an extra £25 billion to be pumped into the economy, bringing the total amount to £200 billion. With interest rates remaining at a historically low level and public finances precarious, quantitative easing has replaced traditional monetary and fiscal policy as the favoured tool of policy makers. The extra £25 billion is likely to act as the final push with the Bank of England attempting to revive an economy operating with spare capacity. It is unlikely that any further increase in quantitative easing will occur, barring a severe economic shock.
The ECB, meanwhile, stayed on hold at 1.0% in November. ECB president Jean-Claude Trichet expressed concern over the excess volatility and strength of the US dollar. Nonetheless, further rate cuts seem unnecessary as signs of economic stabilization and a deceleration of deflation have emerged. Broad money supply growth continues to decelerate and credit to households and non-financial businesses is contracting. The ECB will continue conducting the QE operations it started July 6, but December may be the last tender for its 12-month refinancing operation. Trichet signaled as much, saying “not all our liquidity measures will be needed to the same extent as in the past.”
While global monetary policy easing was synchronized, tightening does not need to be. Australia embarked on its rate tightening phase earlier than other developed world central banks. It raised rates twice, in October and November, by 25 basis points each. Australia avoided a recession in 2009 thanks to commodity restocking and prompt fiscal and monetary easing. Australia will likely remain on a gradual easing path, however, until the strength and sustainability of its recovery becomes clearer. Extra government subsidies for home purchases sparked a buying boom that raised Australia’s mortgage debt level to a new high. The expiry of those subsidies at the end of 2009 and the increases in interest rates could restrain the recovery of domestic demand. On the other hand, recovering export demand and the expansion of a Treasury program to buy resident MBS may help offset the decline in direct support to home buyers.
Following in the footsteps of the Reserve Bank of Australia, which was the first among advanced economies to hike rates, Norges Bank (Norway’s central bank) recently increased its key policy rate by 0.25 percentage points to 1.5%. The executive board’s strategy sets the key policy rate interval at 1.25% – 2.25% until its meeting in March 2010. Given the Norwegian economy’s mild downturn and strong recovery prospects, monetary tightening was expected. Norges Bank cautioned that a stronger krone could slow its expected pace of rate increases.
In October, the Bank of Japan (BoJ) adjusted its policy to reflect the modest improvements in credit markets and the economy. Due to thawing corporate credit markets and very weak demand at the BoJ’s special facilities to purchase corporate bonds and commercial paper, the Bank of Japan decided to allow those programs to expire at the end of 2009 as planned. Further purchases would only distort corporate debt pricing as liquidity returns to the market.
As a safety precaution against potential disruptions to corporate credit for businesses that cannot access market funding, the Bank of Japan extended until March 2010 its program to offer unlimited low interest rate loans to banks, collateralized with corporate debt. However, at the behest of the Ministry of Finance, the Bank of Japan will keep purchasing government debt. Like other central banks that engaged heavily in unconventional easing, the BoJ will roll back its targeted easing programs before resorting to the blunter tool of rate hikes. The BoJ reiterated its view that deflation will grip Japan until 2011, hence the policy rate will likely stay on hold throughout 2010. See Bank of Japan’s Exit from Monetary Easing: Strategies and Timing.
After having to hike interest rates aggressively in the 2006- 2008 period, most central banks from emerging market economies had to undo them rapidly from the end of 2008 to Q3 2009, as output gaps widened significantly and inflation and inflation expectations collapsed as a result of the global crisis. Moreover, currencies experienced strong appreciating pressures from the end of Q1 2009 onwards, facilitating the dovish monetary policy reaction. Now that the worst of the global crisis seems to have past, macroeconomic policies are loose, and economic activities are healing, central banks are facing the difficult task of carefully implementing exit strategies, while avoiding exacerbating appreciative pressures on their currencies and trying to control asset inflation and bubbles.
Asian central banks will be the first among emerging markets to tighten monetary policy as capital inflows and loose policies since late 2008 are raising liquidity and asset inflation. But goods inflation will remain within the central banks’ target in most countries amid a slow recovery in domestic demand, weak credit growth in Asia ex-China, and an output gap. This will delay interest rate hikes into 2010, especially in the export-dependent economies, and constrain aggressive tightening until domestic and external demand improve further. Until then, Asian central banks will continue to fight credit and asset bubbles via liquidity absorption and regulatory and prudential measures, such as in real estate.
Countries that are less export-dependent and have attractive asset markets-India, South Korea and Indonesia-will be the first ones to hike rates and allow currency appreciation. In November 2009, Taiwan banned foreign inflows in time deposits and might resort to further capital controls. If hot inflows maintain their momentum, other Asian countries might use enforcement or regulatory measures to manage capital flows.
In Latin America, there is a marked differentiation on the speed of the economic recovery; however, most countries will experience slow closing of the output gaps over the next year. Moreover, stable if not strong currencies (BRL, CLP, COP, MXN, and PEN) and limited upward wage pressures should help in containing probable external supply-side shocks emerging from commodity prices and limit inflationary pressures sparked by recovering domestic demand. Although inflation and inflation expectations will bounce back, central banks will most likely achieve their inflation targets in 2010.
Nevertheless, monetary authorities will start moving away from a very loose monetary policy stance toward a neutral one in 2010 in order to safeguard medium-term inflation expectations once the recovery has gained momentum. In this light, central banks mainly will target the monetary policy rate. However, upward adjustment in other monetary policy instruments (reserve requirements and margin reserve requirements) will likely be implemented. Those central banks that have acted the most aggressively and face potential surprises to the upside in growth and inflation will initiate the mapping out of excessive accommodation sooner than the rest.
Rate hikes in Central and Eastern European (CEE) countries are expected to lag those in other emerging market regions given the particularly sharp downturn in the CEE and prospects for a weak recovery. Many central banks are still in easing mode, amid economic contractions and easing inflation. Uneven growth prospects across the region mean monetary policy paths will vary.
Aside from Israel, which in August became the first country globally to begin raising interest rates, Middle East and Africa will remain effectively on hold until late in 2010. Most of the GCC countries peg to the US dollar and thus import US monetary policy. Meanwhile despite the inflationary impact of a weak dollar, tight domestic credit conditions will restrain a liquidity surge.
Source: RGE, November 11, 2009.
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