Monetary Policy in Scrutiny

Policy-making is tricky when different asset classes are sending very different signals about the economy. However, these signals are essentially a by-product of policy. US 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.

I doubt 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 against 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.

In the case of US, I maintain that Fed fund hikes are a story for end of 2010 or 1Q2011 and in the case of UK, as the economy failed to pull out of recession in 3Q209, a rise in interest rates is unlikely to occur before 2Q2010. 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 pound to be pumped into the economy, bringing a total amount of 200 billion pound.

The ECB, meanwhile, stayed hold at 1% in November and the ECB president Jean-Claude Trichet expressed concern over the excess volatility and strength of the US dollar. However, further rate cuts seem unnecessary as signs of economic stabilization and a deceleration of deflation have emerged. Broad money supply growth continued to decelerate and credit to real economy is contracting.

On one hand, we had seen synchronized global policy easing, but on the other hand, tightening does not need to be. Australia embarked on its rate tightening phase earlier and it raised the rates twice, in October and November by 25 basis points each. Following the footsteps of the Reserve Bank of Australia, Norges Bank (Norway’s central bank) recently increased its key policy rate by 25 basis points to 1.5%.

And in Asia, it is very likely that the central banks will be the first among emerging markets to tighten policy as capital inflows and loose policies since late 2008 are raising liquidity and asset inflation. But as good inflation is under control amid a slow recovery in domestic demand, relatively weak credit growth and an output gap, this will delay interest rate hikes in mid to late 2010, especially in the export-dependent economies and constrain aggressive tightening until domestic and external demand improve further. Until then, the central banks will 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 like India, South Korea and Indonesia will be the first ones to hike rates and allow currency appreciation.