Why central bankers will lose more sleep

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As if the lives of central bankers haven’t been hard enough. First they had to ride cavalry-like to the rescue as financial markets went into full-fledged meltdown and economies sank into the Great Recession. Ever since, they’ve been faced with that tricky game of figuring out when to start reversing the super easy monetary policy used to unlock credit and support sagging economic growth. Now it seems to me that the weight of sustaining the entire global recovery is getting hoisted onto their shoulders.

Why is that? Blame the austerity bandwagon.

Financial markets, jittery about rising government debt in the wake of the Greek crisis, are pushing politicians across the planet to scale back fiscal spending, perhaps before the recovery is really strong enough to handle it. The U.K. and Japan have become the latest to jump on board. Though there is no full agreement on the impact such budget cutting will have on the recovery, most economists believe the austerity measures are coming too soon and see it as a negative for growth. Here’s what BofA Merrill Lynch economist Ethan Harris wrote on the matter recently:

Coming out of the biggest recession in the post-war period and with a much weaker than normal recovery, 2011 is too early to start the tightening cycle—the Keynesian demand concern far outweighs the debt sustainability problem. Policy makers are risking making the same mistake as Japan in 1997 when it tightened fiscal policy despite a crippled banking system, a slow economic recovery and near-zero inflation… We continue to expect a moderate global recovery even as fiscal policy tightens. However, the risk of a double dip next year has risen.

With fiscal stimulus being prematurely taken off the table, monetary stimulus becomes the main tool policymakers can use to support the rebound. That means interest rates will likely stay lower for longer, with central bankers more willing to set aside concerns about inflation as a result. Here’s what Barclays Capital said in a recent report:

A crucial question is how willing and able monetary authorities will be to accommodate a move to a tighter fiscal stance. In our view, the signs to date are encouraging. The Bank of England, for example, has made it plain that it sees fiscal consolidation as the number one policy priority and is willing to hold monetary policy on an ultra-loose setting to facilitate this. This stance comes in spite of uncomfortably high inflation prints…We have pushed back our expectation of overt policy tightening by the ECB (European Central Bank) to June 2011 from March previously.

In fact, as The Wall Street Journal noted, economists in recent weeks have been busy extending out their forecasts for when the Federal Reserve will raise rates from their current near-zero level. Now some don’t expect the Fed to move until 2012! The Fed offered evidence for this view in the statement issued Wednesday after its policy meeting:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

What impact will long-term loose monetary policy have? In theory, it would allow inflationary pressures to pick up, but that doesn’t seem to be much of an issue now in many developing countries. Japan is still grappling with deflation. Here’s what the Fed had to say about inflation in the U.S.:

Prices of energy and other commodities have declined somewhat in recent months, and underlying inflation has trended lower. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

But that’s not true everywhere. One of my concerns about looser-for-longer monetary policy in the West is the impact it will have on emerging economies, where inflationary pressures and potential asset bubbles are a bigger worry. Traditionally, central bankers in most parts of the world are wary of breaking too much from the policy of the big boys, mainly the Fed and to a certain extent the ECB. If they do, the interest rate differential can have all kinds of unwanted side effects. In Asia, the fear is usually that higher interest rates at home attract inflows of money, causing currencies to appreciate and making their all-important exports more expensive. So if the Fed & Co. hold rates lower for longer periods, the choices of central bankers in Asia will get more difficult. Wait and run the risk of a build up in inflationary pressures; hike now and suffer other potential consequences. Inflation in most of Asia remains more of a future than current concern (except in India, where the central bank has already raised rates) but central bankers across Asia are unlikely to have the luxury of putting off higher interest rates for as long as the Fed. That means they’ll have to deal with the potential fallout of deviating from Fed policy.

But the world’s reliance on loose monetary policy to sustain the recovery is much more stress-inducing for another, more important reason: Will it work? By removing fiscal spending from the stimulus equation, we’re left standing on only one leg of policy to support the rebound. And that one leg is already pretty tired. Interest rates across the industrialized world are remarkably low and in some places (like the U.S.) can’t really be reduced further. If we do see the recovery falter – and there are some signs that the pace of the rebound is moderating – central banks will have to resort to less traditional ways to stimulate growth (i.e. quantitative easing).

So if I were a central banker (and thankfully for all of us I’m not), I’d be warming up the milk and cookies or stacking up sleeping pills next to my bed. It’s going to be an especially sleepless few months.