This is a piece of logical thinking and quiet reasoning from someone whose views I respect. My one reservation is that I wonder if he has not underestimated the power of external forces to force policy changes through. Things like rising yields - on coupled with falling value of - gilts and pressure from the IMF and S&P may dictate the speed and direction of change.
Christina
KLEINWORT BENSON - Market Update August 2009
Leaving quietly - Central Banks and their "Exit Strategy"
Jeremy Beckwith, Chief Investment Officer
In recent weeks, as markets have recovered their poise, and economists have begun to hope that very soon economies will actually start growing again, more and more attention has turned to the "Exit Strategy" of the Central Banks. Between October and May, the major Central Banks undertook the most extraordinary and substantial set of policy initiatives that have ever been seen. The policy easing was achieved with all the subtlety and panache of an elephant trying to tap-dance (interest rates were cut to nothing and lots of brand new money got printed), but in the circumstances this was precisely the right thing to do. The policy tightening to reverse this however, will need to be far more carefully handled, if it is not to terrify markets.
The recent history of the Bank of Japan trying to extricate itself from a world of zero interest rates and zero growth and inflation does not bode well for the Federal Reserve, the ECB and the Bank of England. Every attempt at reducing the Quantitative Easing policies or to raise interest rates back towards "normal" levels in Japan led to substantial setbacks in the equity market and renewed slowdown or recession in the economy. In a world of over-leveraged banks and consumers scared of their job security, the merest hint of policy tightening sent markets and business confidence back down. And yet today many observers are criticising the Central Banks for having eased so much that inflationary problems could emerge at any time, and they are demanding that a clear and credible exit strategy must be articulated.
The Central Banks of the US, UK, Europe and Japan have however been very consistent in their rhetoric, with comments along the lines of "a highly accommodative stance will be appropriate for an extended period" (as Bernanke said to Congress). They believe that very low interest rates for a very long period of time are what the Western economies require to offset the structural weaknesses caused by excessive debt in the financial and consumer sectors.
Their preferred exit strategy is fiscal tightening, i.e. governments addressing the very large budget deficits that this crisis has produced, either by raising taxation or by getting on top of government spending or, ideally, both. Bernanke, Trichet and King are all trying to say to governments that these budget deficits pose far greater risks to the health of their economies than excessive money supply and zero interest rates, and that they are quite prepared to keep interest rates at very low levels for a very long time provided that the governments do the policy tightening first.
In normal times, Central Banks ritually take any opportunity to criticise governments for running budget deficits that are too large, and governments ritually ignore them because to do anything about it usually leads to lost votes. Today though this may be different; the budget deficits expected for this year and next are so large that they are starting to worry voters and hence politicians and more than usually loud cries of intent from politicians about reducing government spending are now being heard. Of course when the time comes to actually enact and implement such policies, it may be that the political costs are seen as too great, but for now such moves seem much more plausible than normal.
If so this would be very positive for markets, as it was in Britain in the 1980s. Government spending was brought down as a percentage of the economy over time, which allowed the private sector to expand, generating profits growth, and the Central Bank to be very light on the controls of monetary policy, so that real interest rates were able to fall steadily. This was a dream combination for financial markets, and could yet be again for the US and Europe.
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