Sunday, November 30, 2008

Global monetary policy zero limit bound problem


Most of the G7 central banks will have policy meetings in the first half of the December. All of the central banks are facing slowing economies and lower inflation. In fact, there is a growing concern about deflation. The key issue will not be whether there will be easing but how much. This leads to the bigger question of what will happen when you force rates closer to the zero limit bound (ZLB).

Now we will not dwell on the deflation issue. Core inflation for most countries are still within their targeted zone after excluded food and energy. Much of the decline in CPI and PPI is a reversal of the short-term commodity spike. The spike was not an inflation problem as much as a price shock issue. It now seems obvious that inflation taregtting is out the window and economic stimulus is the problem.

The issue for many central banks is that we still are relatively early within the recession cycle and interest rates are falling to extremely low levels. Major cuts in many of these countries will take short rates down to levels where there will a concern about what some have called the ZLB problem. What are the policy choices of the central bank if we you are or approaching zero interest rates?

The problem is facing a number of central banks this month. Japan has seen a growing decline in economic growth. Rates are at 30 bps and have limited room for further decline after rates were cut 20 bps in October. The Fed has rates listed at 1% but another Fed cut is expected to bring the Fed funds target down to 50 bps. The Fed funds rate is already trading below one percent. The Fed seems to have changed to a quantitative easing policy. The Swiss National Bank has a target rate set at 1% but will meet again in December under a declining environment. Bank of Canada has argued earlier that the economy is still doing ok, but the tight relationship with the US and its commodity focus will place further pressure to lower rates. Bank of England is behind the curve with an economy that is growing worse every month. The same could be said for the ECB.

Expect to see further rate cuts across the board but there will be more discussion about quantitative easing and non-standard monetary policy. We know the global economies are in recession so there will be more focus on what will be the monetary and fiscal stimulus alternatives in the coming weeks. The equity markets will sell-off on anything other than strong easing.

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