Tuesday, March 17, 2009

Classifying monetary policy - the quantitative easers to constrained easers


With a global recession, every central bank wants to ease. Forget inflation targeting, it is time to get easy with as much money as possible, but this not as easy as one would think when rates move to zero. While inflation may not be a problem in the near-term, for many smaller open economies the movement to quantitative easing will have strong implications for currency rates especially if there are no capital controls in place.

There is a strong global movement to quantitative easing, but countries can be classified differently based on the state of their economy and their position in the global economy. We have classified central banks based on their movement to quantitative easing which is the new central bank trend. We have developed five classifications for central banks related to where they sit on the quantitative easing spectrum.

At one extreme are the current quantitative easers, or those who are not targeting interest rates because they have fallen close to zero. These are the central banks that have announced that they will be using quantitative action to create monetary policy easing and eliminate the credit gridlock. In this category, we have also included Canada which said they will announce their quantitative plan in April and Singapore which has been using their monetary policy to follow currency band against a basket.

The next group of central banks will be those who are moving to quantitative easing but may not have reached the point where the central bank will expand their balance sheet as the means of adding money to their economies. All of these central banks have low target interest rates and have little room to ease further on the interest rate front.

The third category will be the reluctant quantitative easers such as the ECB. Here the central bank has been reluctant to state that they will use quantitative easing tools and have made public statement that they will adhere to their inflation target and try and keep interest rates from getting too low. Given that the Czech Republic is trying to hug close to the ECB, we see them marching to the same tune. Note that the ECB is the only large central bank in this category.

The fourth category includes banks that are flexible easers. These are the central banks which have been lowering interest rates and have the flexibility to continue to cut rates. They may have more flexibility than others because their economies may not have fallen as fast as the quantitative easers. This does not mean that they will not use monetary policy to stimulate their economies just that they have more flexibility at this time.

The final category includes central banks which are constrained easer. These are the central banks which have relatively high interest rates and who would like to lower the rates but may be constrained by their need to protect their currency or at least have the currency follow more controlled behavior. South Africa is a perfect example of a country which has been trying to hold rates higher in an effort to control the decline in the currency. Under a better emerging market environment, we would see these banks ease from their currently high real levels. Of course, some of the constrained easers are still showing higher inflation versus many developed countries. These inflation rates have been falling but not as fast as many of the larger countries.

What does this mean for currency and fixed income markets? The constrained easers will actually follow the behavior we have seen in past business cycles when rates have been held high to control capital flows. The quantitative easers may not have such good behavior and may follow behavior consistent with monetary models of exchange rate determination whereby the quantity of money will determine exchange rates. However, this effect will be muted by the sharp declines in money velocity or the money multiplier. The currency decline will not occur unless the multiplier starts increase before the monetary easing is reversed.


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