When will central banks tighten policy?
The world’s major central banks have run aggressively easy monetary policies since the onset of the financial crisis last year to forestall the risk of a downward spiral into deflation. This stance appears to have worked and the debate is now gradually shifting towards the formulation of monetary stimulus “exit strategies”.
In most countries, there is little sense of urgency. This appears to be because the recession has created a significant amount of spare capacity which should tend to keep core inflation under downward pressure for some time to come. Recent decisions, however, to raise interest rates in Australia and Norway, as well as the expiry of some of the US Federal Reserve’s unconventional policy programs, suggest that the process of policy normalisation is already underway.
The speed and extent of tightening will likely vary by country. In particular, the perceived amount of economic slack and the pace of recovery will be key considerations. In addition, central banks will try to balance the risk of removing stimulus too quickly against the need to move policy gradually to a more neutral setting.
The world’s commodity producing countries should continue to lead the pack, but pressure is likely to begin to build for the US and other nations to follow suit. Historically, the US Federal Open Market Committee (FOMC) has tended to wait about six months after the unemployment rate has peaked before raising the Funds Rate. This puts them on course to begin tightening around the middle of next year. To do so they will need to drop their current promise of no change in interest rates “for an extended period” relatively soon. We expect the move to higher rates to be relatively rapid, at least initially, for a number of reasons. First, a neutral rate is well above current levels. Second, the Fed’s gradual approach to tightening from 2004 now looks to have been a mistake, whereas the shorter, sharper rate cycle from 1993 was followed by a long period of more balanced growth. In addition, the Federal Reserve is likely to gradually shrink the size of their balance sheet as the economy moves on to a sounder footing.
The European Central Bank can perhaps adopt a more measured approach to policy tightening, partly because the European recession was deeper and the recovery may be less dynamic, but also thanks to the disinflationary headwind of an overvalued euro. It seems likely that the process will begin with a reduction in the ECB’s longer-term liquidity provision, followed by a rise in overnight rates towards the repo rate and finally increases in the repo rate itself.
The Bank of England is still in full quantitative easing mode and we believe runs the greatest risk of a policy error. By the middle of next year interest rates will need to start increasing quite quickly to counter this risk. Reversing quantitative easing will be problematic given the large amount of gilts being issued by the government and so it seems likely that interest rates will need to do most of the work.
Japan, by contrast, is the one major economy mired in deflation and it will take a protracted period of growth and positive price increases for the Bank of Japan to contemplate policy tightening.
