Up but Not Tight

Up down under:

So, the Reserve Bank of Australia (RBA) became the first G10 central bank to hike rates in this cycle on Tuesday, following the example set by the Bank of Israel (BoI) in late August, which serves to underscore our view that, slowly but surely, the global monetary policy cycle is turning (see "As the Policy Cycle Turns...",

The Global Monetary Analyst, September 30, 2009). But, interestingly, global markets didn't seem to attach much significance to this move, with risky assets continuing to rally. In fact, our updated liquidity metrics suggest that global excess liquidity has continued to grow until recently and looks set to rise further in the foreseeable future, even though more central banks look set to join the BoI and the RBA over the next several months.

Still, the RBA's move offers an interesting lesson that is worth keeping in mind when thinking about other central banks' prospective behaviour in the upcoming tightening cycle: strongly rising asset prices may induce central banks to start lifting rates early from record-low emergency levels even if growth is still below-trend and inflation below-target

Excess liquidity still making new highs:

We have updated our favourite metric of excess liquidity for the five-biggest industrialised economies and the four-largest EM economies to include 2Q09 data. Unsurprisingly, with the growth rate of the monetary aggregate M1 (cash and sight deposits held by non-banks) outpacing nominal GDP growth, excess liquidity has risen to yet another record-high both in the G5 and in the BRICs. As we have argued repeatedly, this has been the main driver behind the impressive rally in risky assets over the past six months, in our view.

As we see it, excess liquidity has probably continued to grow during 2H09, though likely at a slower pace than previously. M1 growth is likely to continue to surge for now, reflecting super-low short rates and a continuation of QE in the major countries. In fact, banks have been big buyers of government bonds until recently, which is one way how banks create deposits.

At the same time, some of this liquidity is likely to have been absorbed by the ongoing economic recovery, which should have led to a pick-up in nominal GDP growth. Still, with rates in the major economies unchanged for some time to come and QE still ongoing, we see no early end in sight for the global liquidity bonanza.

Asset prices more important in the future:

The RBA's move holds an interesting lesson that is worth keeping in mind when thinking about other central banks' prospective behaviour in the upcoming tightening cycle: strongly rising asset prices may induce central banks to start lifting rates early from record-low emergency levels even if growth is still below-trend and inflation below-target. The RBA expects growth to return to trend next year, and also remarks that "dwelling prices have risen appreciably over the past six months".

On the opposite corner of the globe.

Norway's Norges Bank is even more articulate in its concern about house prices. In an important speech last week, Governor Gjedrem stated that "house prices in Norway have risen sharply and probably excessively". He then went on to note that the Norges Bank reaction function "already gives weight to asset price movements and credit growth", even if asset prices are not part of NB's objective function (which only includes output and inflation).

We expect Norway's central bank to be the next one to hike (on October 28), and even see risks for a 50bp move.

Of course, Australia and Norway can afford to worry about asset prices at the moment since their economies have been the least affected (in the G10) by the global crisis. Still, we think that the emphasis the RBA and Norges Bank place on asset prices is important.

In the past, smaller central banks have often pioneered significant institutional or operational changes in monetary policy. For example, New Zealand's RBNZ was the very first central bank to convert explicitly to inflation targeting, while the Bank of Canada is currently giving price level targeting a serious consideration. And Sweden's Riksbank has, in the past, justified policy rate increases by pointing to house prices even though consumer price inflation was expected to be on target.

Other central banks haven't voiced concerns about asset prices yet, but this could change soon. With the asset price channel having done most of the work so far, the interest rate and the credit channel should pick up the baton soon to restore a better balance between the different monetary transmission mechanisms (see "Between a Rock and a Hard Place",
The Global Monetary Analyst, August 19, 2009).

Sometime in the new year, if risky assets keep feasting on the liquidity glut, equity and house prices could come into focus as runaway asset price inflation creates a dilemma for central banks: hiking into a weak economy could stall or even reverse the recovery; but staying on hold for too long would risk inflating the next bubble.

With the ‘mop up after the bubble bursts' orthodoxy having fallen victim to the crisis, at the very least the risk exists that central bankers will be forced to sound hawkish - even if not ‘leaning against the wind' outright.

It is also worth bearing in mind that the arrival of the first hikes, at this stage, simply means ‘less easy' rather than ‘tight'. We expect few central banks to rush back to neutral. Even out of the early hikers, our colleague Gerard Minack thinks that the RBA will increase rates only by another 25bp by the end of this year, and then pause for two quarters.

For the major central banks, an orderly exit from their extraordinary policy measures will likely require even more caution (see "QExit", The Global Monetary Analyst, May 20, 2009).

Last point - watch the currencies:

Both early hikers' currencies - the Australian dollar and the Norwegian krone - have rallied recently. Further strong appreciation may well reduce the appetite of other CBs to move early, at least for those who preside over export-oriented economies
(e.g., Sweden's Riksbank or Canada's BoC).

Yet another asset price to worry about!