Central Banks: Exit Strategy Far from Certain

by: Matteo Radaelli

Despite signs of caution coming from last week’s macroeconomic data, major international economies are likely to have recorded positive growth rates in Q3 and to continue to trend upward in the coming quarters, as the Fed acknowledged in the statement released after the September 23 FOMC meeting (“Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn”).

Therefore, there are increasingly stronger expectations that leading international central banks will start to plan an exit strategy following the sharply expansionary monetary policies implemented over the course of the past two years. Looking ahead, the financial market trend, currency and bond markets in particular, will depend on the timing and strength of the announced end to government assistance.

But the removal of ultra-expansionary monetary policies has already begun with the decision of the Bank of Israel to raise interest rates from 0.5% to 0.75% on September 7. The Norwegian Central Bank seems to be one of the most likely candidates to follow the route taken by the Bank of Israel. In the statement released after the September 23 meeting, Norway’s Central Bank said that it was considering lifting rates, currently at 1.25%.

The decision to increase rates will be likely made at the next Norwegian Central Bank meeting (scheduled October 28), when the Monetary Policy Report 3/09 (the last for this year) presenting new growth and inflation projections for the quarters ahead is due for publication.

As shown in the chart below the upward phase of the interest rate cycle could be very marked, considering that the previous expansionary phase was much stronger than indicated by the model used as a benchmark by the Norwegian Central Bank and built along the lines of the Taylor rule. Interest rates might reach 1.75% by year-end from the current 1.25% and hit 2.25% in mid-2010.

Nevertheless, all leading western Central Banks are highly unlikely to implement exit strategies for some considerable time - the only exception being Israel and Norway. According to some Fed, ECB and Bank of England officials, the three central banks appear to be in no hurry to hike rates.

First, Central Bankers want to make sure that the economic recovery is solid and broad-based for not running the risk of addressing a fresh economic contraction once the monetary stimulus is halted (the much-feared W-shaped scenario).

Second, they acknowledge that the banking system has yet to pull itself completely out of the crisis of the past two years. What is more, a new inflationary spiral should not materialize any time soon. Benchmark for the behaviour of central banks will once again be the Fed, which has already started ending the government assistance granted during the most acute phase of the financial turmoil.

To understand what the Fed Fund rates outlook might be like we used, as in the case of the Norwegian Central Bank, a benchmark model derived from the Taylor rule: inflation expectations (based on PCE deflator projections), output gap and Fed fund rates in the previous quarter are the independent variables included in the model output.

One side of the chart below shows that rates should be negative in the face of the high level of spare capacity within the system (the Fed solved the problem by implementing a quantitative easing programme); the other side it shows that interest rates should start to increase in Q2 2010.

Based on the GDP and inflation forecasts presented in the Fed Monetary Policy Report to Congress in July, Fed Fund rates might rise to 0.5%/0.75% by the end of the first half of 2010 and to 1.5% by year-end 2010.

More moderate and more distant in time should be the rate hikes that will be likely implemented by the ECB, whose meeting on October 8 is expected to provide limited disclosure of the outlook for monetary policy in the short term.

The chart below, which compares the trend of the Refi rate with the that of the rate prescribed by the Taylor rule using the latest ECB estimates for the coming quarters, illustrates that rate interventions should not be needed before end 2010.

A quicker removal of monetary policy stimulus is unlikely due to the euros uptrend, particularly against the dollar. The continued rise of the euro, in fact, is already playing a restrictive role for the euro area and a hasty rate increase by the ECB would end up pushing the single currency even higher.

It is therefore not surprising that Trichet said that a strong dollar is very important for the economic system, suggesting that exchange rate movements will play a key role in monetary policy decisions throughout 2010.

More uncertain are the monetary policy prospects for the Bank of England. Governor Mervyn King voiced concerns about the economy and inflation despite a higher-than-expected rise in consumer prices in recent months.

The weakness of the pound may have helped keep inflation at a higher level than estimated by the Bank of England, whose inflation projections in the latest inflation report for August showed that, after a temporary increase in the first half of next year, the CPI should stay moderate until the end of 2010.

Should this be the case, the Bank of England would find it hard to lift rates although this seems to be necessary using the Taylor rule based on the inflation report estimates. Under the report, inflation would come in at 2% at the end of a two-year time horizon with rates steady at 0.5%.

By contrast, inflation would stay below 2% should rates be increased. Therefore, a rate hike in 2010 will materialize if inflation is higher than predicted by the BoE, leading to an upward revision of the inflation report estimates due in November.

Nevertheless, the Monetary Policy Committee meeting scheduled October 8 should offer little new information to markets.