Implications of Central Banks' Exit Strategy

This week will be busy for market analysts with four major central banks holding their scheduled monetary policy meetings: the Reserve Bank of Australia on Tuesday, the Federal Reserve on Wednesday, and last but not least, the Bank of England and the European Central Bank on Thursday.

The RBA stands predictably ahead of the pack

The Reserve Bank of Australia is likely to be the only one among these four central banks to raise its interest rate target up by 25 bp to 3.50, following a first hike of 25 bp one month ago.

This is widely expected and should not have per se a major impact on markets although it can modestly boost the Aussie dollar which has embarked on an appreciation trend against the other major G10 currencies.

What will be more market moving for the Aussie and more generally for the FX market is the release of RBA's quarterly monetary statement on Friday. This is likely to shed more light on the RBA's monetary policy strategy for the coming months and put in perspective the string of favorable macro news that signal a stronger than expected economic recovery (together with rapidly building inflationary pressures) in the land down under.

The Fed: The dilemma of excess reserves

The FOMC meeting on Wednesday will be followed with closer attention by market participants all over the world as it could help clarify the exit strategy of the monetary authorities in the world's largest economy.

Again, this time around there should be no shift in the Fed's interest rate strategy. The FOMC is likely to repeat it commitment to maintain "exceptionally low levels of the federal funds rate for an extended period".

In addition, the Fed has clearly signified last month that it will carry over its long term assets purchase program of a total of $1.25 trillion of agency mortgage-backed securities and $200 billion of agency debt by the end of the first quarter of 2010. Nothings warrants a change in the tonality of this message.

However, what will be more interesting, and what only the minutes of the upcoming meeting could indicate is the extent to which the discussion among the FOMC members will have clarified the central bank's exit strategy in order to unwind the $2 trillion of assets that the Fed has accumulated on its balance sheet over the last two years.

Does this really matter any way? Well it does in a number of ways.

First, because as the Fed has purchased all these financial assets from commercial banks, the later have accumulated huge excess reserves in the magnitude of 100 times their pre-crisis level. This could prevent the Fed from using the Federal Funds rate tool as a an efficient instrument with money market rates staying desperately low in an environment awash with funding liquidity. This could severely damage the central bank's credibility, pushing higher inflation expectations and triggering a return of inflation to levels unseen since 30 years. Alternatively this could end up building another, still larger, financial bubble as the excess liquidity has to be recycled in a way or another. The bubble economy would come back with a vengeance!

Second, the unwinding of all these assets could cause significant volatility on market prices. This is a difficult question but it is clear that with its huge purchases of Agency debt and MBS securities the Fed has acted as the lender of last resort on the housing market at the time when this market was "dysfunctional" to say the least. Hence, if the Fed "dumps" all this mortgage related debt on the markets this could drive yield higher on mortgage securities and hamper the prospect of a recovery in the housing market.

The irony is that the Fed has to choose between two evils: a potential explosion of its liabilities with a consequent loss of control on monetary policy on one hand, or an asset price deflation as a result of a precipitated exit on the other hand. This dilemma can only be solved in a context of "goldilocks" recovery with firmly anchored inflation expectations. Happily for the Fed, this seems to be the case for the moment. But for how long?

The Bank of England: Are there any limits to debt monetization?

The problem for the Bank of England is at once less acute and more complicated than for the Fed, both in terms of policy decision and policy communication.

The BoE is likely to announce an extension of its Asset Purchase Program on Thursday as bad news on the macro front (ie. negative Q3 GDP growth) will likely prevent it from any shift in its communication strategy.

If you think the US is a highly leveraged economy (or was so, before the crisis) than you have not seen the UK. Its economy is highly leveraged on finance and real estate. Any shift in market sentiment or asset prices affects the real economy more than anywhere else.

With a view on stabilizing asset prices, the Bank of England has accumulated close to £150 billion of Gilts over the last six months. While it has been authorized to purchase risky securities such as corporate investment grade bonds, the BoE has instead preferred to buy almost exclusively government securities in order to lower long term interest rates, and to provide an additional stimulus to the economy. This is a strategy that is reminiscent of the BOJ purchase of GJBs in the glorious days of the Japanese quantitative easing experience (2001-2005).

This has worked quite well as yields are now close to historical lows but there is an inconvenient truth about that: a monetization of public debt in a country that is threatened of losing its AAA rating. The solution to escape this suspicion of monetization would be to swap long term government debt with short term billed issued by the central bank.

But this would take time. Hence, there is no possible unwinding for the BoE before a year or two.

The European Central Bank: Jean-Claude Trichet as the central banker of the year?

Compared to the Fed and to the BOE, the ECB has managed so far quite well to navigate through the worst financial and economic crisis since decades, and to preserve its independence and its credibility in the wake of tremendous political and market pressures.

The ECB has been built on the legacy of the conservative German Bundesbank and has applied strictly its policy mandate as an inflation watchdog with little appetite for unconventional policy measures. This has not prevented it from flooding the market with liquidity both before and after the Lehman failure, by replacing its short term lending operations with long term ones. It has also escaped the temptation of massively purchasing risky assets or offering an unlimited liquidity backstop to the modern wizards of finance, such as the securities broker dealers and their "clientèle" of hedge funds and proprietary trading desks. Instead, it engaged in a modest program to purchase select securities (mostly covered bonds).

The ECB was considered too conservative in the pre-crisis times. Now it seems its prudent policy is sparing it much of the dilemmas faced by its anglo-saxon counterparts. As a result, Jean-Claude Trichet may well win the title of "central banker of the year." Let us hope he does not trigger the interest rate weapon too early too fast.