August 21st 2009

FROM THE ECONOMIST INTELLIGENCE UNIT

With the global economy now seemingly having bottomed out, and with many economies now showing signs of recovery, the question of when the current phase of extraordinarily loose monetary policy might end is coming to the fore. Given the mix of orthodox and unorthodox monetary-policy approaches in use in virtually all major economies, this is no longer a straightforward interest-rate question. Rather, as economic conditions improve, central bankers are likely to tighten some policy components while keeping others very loose. Specifically, the Economist Intelligence Unit expects most major central banks to keep conventional policy rates unchanged until the end of 2010. We do, however, expect them to begin retreating much earlier from some unorthodox programmes, including aspects of quantitative easing.

It is with such issues in mind that central bankers from around the world have descended on Jackson Hole in the US state of Wyoming for their annual meeting. The aggressive policy responses of central banks around the world over the past year have helped to contain the financial and economic crisis. Policymakers’ efforts have been more effective for occurring in tandem with heavy fiscal stimulus—although the combined measures have still not prevented dramatic declines in GDP. Considerable excess capacity remains in the world economy, suggesting that a very substantial recovery could take place without creating inflationary pressures.

Nonetheless, there is a fear that ultra-accommodative policy, if maintained for too long, could lead to runaway inflation. (This fear gains added traction from the widely held view that excessively low interest rates in the aftermath of the dotcom crash in 2001 and the terrorist attacks on the US in September of the same year contributed to the build-up of imbalances that caused the current crisis.) At the same time, there is a concern that tightening too soon, at the first sign of a build-up of inflationary pressures, could nip a fragile recovery in the bud. Therefore, the challenge for central bankers is to determine the timing and extent of policy tightening, and to ensure that the shift in policy is as orderly as possible to avoid creating fresh turmoil in financial markets.

In reality, the policy responses to improving economic conditions are likely to be more nuanced than simply timing interest-rate hikes. This partly reflects the fragility of any recovery and our view that inflationary pressures will remain subdued even as growth picks up in 2010. It also partly reflects the fact that monetary policy itself has become more multifaceted as a result of the big increase in the use of unorthodox tools. Consequently, we expect central banks to balance the need to respond to a gradual increase in risk appetite (which would imply the need for some tightening) with a desire to avoid measures that might undermine the recovery in the real economy. For the latter reason, we believe that most major central banks will keep their policy rates on hold throughout the rest of 2009 and probably the whole of 2010 as well. Policymakers will be highly reluctant to raise benchmark interest rates, as such increases would ripple through into commercial interest rates and could stifle investment and lending.

Thus, an earlier “tightening” of sorts is more likely in the form of a partial exit from unorthodox measures, many of which have involved central banks providing liquidity support through the purchase of securities from the banking system. This has helped to replace the liquidity that banks took away from the real economy in order to bolster their balance sheets. As commercial banks are becoming less risk-averse and more capable of lending again, central banks can withdraw liquidity without actually tightening access to finance for the real economy.

Indeed, in its August 12th policy statement the US Federal Reserve said that it would reduce its purchases of US Treasuries and that it expected to end the US$300bn scheme in October this year. However, it also made clear that it intends to keep its policy rate, the federal funds rate, “exceptionally low” for an “extended period”. We believe this means the Fed intends to keep the federal funds rate at its current level of 0-0.25% until the end of 2010, with only moderate increases to 0.75% by the second half of 2011 as the Fed starts to “normalise” policy. In Europe, too, we expect the European Central Bank (ECB) to keep its reference rate at an ultra-low 1% until end-2010, although again the ECB may start scaling down unorthodox measures at the end of this year or in early 2010. We also expect the Bank of Japan to stick with ultra-low rates for a considerable time; indeed, our latest global forecast revises our interest-rate forecast for Japan to envisage a more gradual normalisation of monetary policy than we had previously expected.

Yet central bankers continue to have their differences. Most conspicuously, the Bank of England (BOE) has just decided to expand quantitative easing, with the BOE’s governor, Mervyn King, even advocating (unsuccessfully) a bigger increase in asset purchases than the bank has approved. Such decisions underline the scepticism that still surrounds the robustness and durability of any economic recovery, in particular reflecting concerns that recent improvements in economic data are the temporary products of massive policy support. In particular, fiscal stimulus will have to be withdrawn. Once this happens, there is a risk that economic output could weaken again to produce what many describe as a “W-shaped” recovery. Although this is not our core forecast for the world economy, we do expect the US to suffer just such a slowdown in 2011, following a forecast pick-up in growth in 2010.

The Economist Intelligence Unit
Source: ViewsWire