In
this week’s note, we take a look at some recent monetary policy trends in
advanced economies. This content is excerpted from a longer piece, “Global
Monetary Policy Review” (requires login), which includes in-depth analysis of when the
world’s emerging markets might shift interest rate strategy. This longer piece
is available exclusively for the use of RGE’s clients.

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 U.S., 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 U.S. 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 U.S. dollar and thus import U.S. monetary policy. Meanwhile despite the
inflationary impact of a weak dollar, tight domestic credit conditions will
restrain a liquidity surge.

–

 * As of Sept. 30, only 100
billion yen of commercial paper (CP) was offered for the BoJ to purchase – just
3% of the 3 trillion yen allocated by the BoJ for the CP purchasing program.
Only 300 billion yen of corporate bonds was offered for the BoJ to purchase -
just 30% of 1 trillion yen allocated for the corporate bond purchasing program.