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Tuesday June 30, 2009 - 23:46:38 GMT
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Forex Blog - Central Banks Weigh Exit Strategy and Timing amidst Poor Track Records

As a dispenser of advice I often remind myself or and reminded that if I really knew what was going to happen before it happened I would be running a large hedge fund carefully guarding my ideas (less so after trade is on)  from the competition and broader market.  And much the same can be said about central bank counter cyclical policy success…business cycle volatility would be compressed if central banks could really get it right most of the time.  And now we are expecting central banks to not just get the right level of rates right for price stability (and growth in the US) but to move against asset bubbles before they become systemic risks.  The Black Swan author Taleb has pointed out the track record of central banks on doing the most simplest of tasks – like forecasting macroeconomic data –is horrible.  Only shock is that markets don’t seem to learn this truth and lend c banks all sorts of unwarranted credibility. 

So here we are in a world where unconventional monetary policy is conventional, the global banking system largely impaired by unprecedented losses (many requiring government bailouts) and official interest rates for all intents and purposes at the zero rate bound. And countercyclical policy is a dual approach with fiscal policy fully deployed to support growth. 

Not only do central banks have to move to unwind emergency monetary policy measures and rate cuts at the optimal moment (and optimal scale), but so too do government authorities in terms of fiscal stimulus unwinding –getting the timing and scale of spending cuts and tax hikes just right (failure to do so would see market rates rise and this risks choking off any chance of a recovery). 

If central banks and at times fiscal authorities can’t get the timing and scale of countercyclical policy measures right in normal business cycle swings, why should we think that they can in the current unprecedented cycle swing?  If anything the odds are greater central banks (and fiscal authorities) will get this one wrong than say a “normal”exit from anti-recession posture.

And as BIS noted this week the track record in exiting accommodation is being too late rather than too early leading to periods of elevated inflation.  Surely the extended period of low US interest rates through 2003 may not have generated a jump in the level of prices for goods and services in any meaningful way (outside commodity prices), this approach did lead to asset inflation (real estate) and credit creation.  On the other hand the only example we hear of regularly of an earlier-than-optimal exit from accommodation was Japan in the 1990’s when the government raised taxes and the BOJ lifted rates too soon extending the period of stagnation and forcing a late stage round of quantitative easing (unconventional monetary policy) before the economy recovered.    And this happened when the global economy was growing – Japan decoupled.  The notion of decoupled recoveries in 2009 are typically dismissed outside of more closed economies (relatively speaking) like India or export economies with vast government resources to allow the government to grow the economy in place of trade –yes China.

And complicating Fed policy exit strategy are ongoing problems for the banks still saddled with poor performing loans (commercial real estate, some corporate loans and consumer credit including residential mortgages and credit cards) and could be in need of even more capital raising efforts ahead assuming banks have more significant losses to write off. Can the Fed normalize policy when banks on balance are struggling?  Can banks turn the corner on consumer loan losses without the housing sector bottoming? 

My point is there is a high probability that policy accommodation will outlive its usefulness and this is from a person who thinks there is a strong case to keep rates unchanged well into 2010 and keep the monetary and fiscal spigots running.  A Japan early exit error is very unlikely –BIS has this one right.  That said there is a case that ultra accommodative fiscal policy (like a second stimulus package on top of a record FY2009-10 budget deficit) may force the Fed to move on inflation earlier than optimal and pose something of a Japan risk assuming Fed and US gvt can’t coordinate the exit strategy sufficiently well. 

Finally as Fed’s Bullard noted today, there is palpable pressure from the Congress and White House today to reduce Fed independence…most clearly in regulatory reform measures to make the Fed seek approval from the Legislative or Executive Branch for emergency policy measures under Federal Reserve Act’s Article 13.3.  Politicization of exiting accommodation is one thing (recall too Bernanke’s term is up at the end of January 2010), but the politicization of Fed independence is another in the very difficult period ahead for policymakers. 

I have more confidence the Fed gets it right than the US government.  But I also don’t like the choice set the Fed is likely to face as pressure to unwind accommodation builds…constrained by a banking system in rehab, big government, Chairmanship succession, Japan risk, Greenspan risk and deleveraging of the household balance sheet. 

If there is any certainty ahead on the policy front it is elevated uncertainty and will make for higher volatility (note VIX is down to where it was pre Lehman) in asset prices and FX.  The longer-term direction is another story – though the consensus view of weak US Treasuries and dollar is compelling…only difference for me from mainstream is I would throw lower stocks in as well.

David Gilmore


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