Two roads diverge on central bank exits

October 6, 2009

And they’re off.

The Reserve Bank of Australia’s surprise quarter-point interest rate increase has put the rest of the world on notice that the great global monetary policy tightening has begun.

It’s understandable that many are now casting around for the next central banks to follow Australia’s lead. After all, the burning global policy question is when and how industrialized nations should exit what have been unprecedented measures to shore up the financial system and global economy.

Norway figures high on the list, as does South Korea. But it’s not yet a game changer for the Big Three — Japan, Europe and the United States — where still-weak economic conditions and worrying unemployment should keep a lid on rates for longer than usual.

Goldman Sachs chief interest rate strategist Francesco Garzarelli said in a note today that central banks and their approaches to exit strategies can be divided, crudely, into two camps: sooner but more slowly, and later but faster. In the first, he lumps Norway, Canada and the UK as well as India, China and Turkey.

In the larger Big Three economies, rate increases will come only when policy makers are convinced that the recovery has deep enough roots — an improving jobs market, more private borrowing and easing of disinflationary pressures — to withstand the headwind of tighter monetary policy, he noted.

And that means the dollar, which has already taken a beating, isn’t likely to suffer new humiliations for a while — at least not at the hands of interest rate differentials.

Denominating the cost of oil, if it ever happens — and that’s a big if — is another matter.

U.S. Federal Reserve officials have insisted that there are no plans afoot to raise rates any time soon. The most recent one to grab the microphone, New York Fed President William Dudley, hit the point again Monday, noting a weak labor market, disinflationary pressures and a weak banking system as factors likely to keep the central bank from reversing course in the foreseeable future.

But when the central bank is ready to exit, it could be explosive. Rather than follow the gradual approach adopted by the Greenspan Fed when it raised rates at a tortuous quarter-point clip, Fed Governor Kevin Warsh has said that policymakers could move more aggressively. And that’s when the real fireworks will start for currencies. Australia may have been first, but its interest rates were already nearly 3 percentage points above those in the United States and Japan and 2 percentage points above those in Europe. That means many traders favoring higher-yielding currencies already tilted toward the Australian dollar.

The second road will be the tricky part and should make for some violent moves in foreign exchange when the time comes for action. There’s a good chance that when the Big Three start to tighten, it will look very different than the steady-as-she-goes incremental increases. But that’s for another day.

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