Two years on from the depth of the economic crisis, policymakers in advanced economies are still searching for the right moment to head for the exit – while their emerging-market counterparts fret that they have already missed the boat.
Such is the difficulty of timing monetary and fiscal policy tightening that no one is sure they are not making big new policy errors.
For 2011, the easiest area of policy to predict is monetary policy in emerging economies. This is almost bound to tighten, as economic growth rates remain strong and inflation rises to dangerous levels.
Already this year, surging demand has led food prices to new highs and crude oil prices to flirt again with $100 a barrel, raising inflation rates in some emerging economies into double-digit territory.
Many emerging economies have responded with higher short-term interest rates, but this has exacerbated the potential problem of destabilising capital inflows.
Emerging economies worry that if they raise interest rates further, a wall of money escaping the extremely low cash returns in the advanced world will force their currencies artificially high and undermine their long-term growth prospects. Their concerns received a boost this month when the World Bank endorsed the use of “as broad as possible countermeasures”, including capital controls and reserve accumulation.
Although markets also predict monetary policy tightening in advanced economies, such is the continued uncertainty over the strength of the recovery that betting on rate rises by the end of the year in the US, the eurozone, Japan and the UK remains a very risky business.
Until the second quarter, the US is still loosening its monetary stance after its decision in October last year to inject another $600bn into the economy by creating money and purchasing government securities.
If advanced economies continue their recovery, it is likely that interest rates will start the long journey higher from close to zero, but in the middle of January, even Jean-Claude Trichet, president of the European Central Bank and widely seen as the most trigger-happy central banker, was not threatening a rate rise in the near future.
He warned investors that the central bank’s actions on interest rates were “disconnected” from its steps to prop up the eurozone banking system, but added that the rise in European inflation was “short-term” and that “price developments will remain in line with price stability over the [medium term] policy-relevant horizon”.
Similar language has been evident in the UK, where the Bank of England has become more concerned about inflation, but still believes that spare capacity in industry and high unemployment “is likely to bear down on inflation and bring it back towards the target in the medium term once the temporary impact of one-off factors [has] waned”.
One of the problems for advanced-economy central banks in moving away from ultra-loose monetary policy is that 2011 is the year in which fiscal policy in most economies moves from stimulating economic activity and growth to restricting it. Fiscal stimulus is now a thing of the past.
The US is again something of an outlier, with Congress approving the continuation of the George W. Bush tax cuts in December in a fiscal package that also included further extensions in unemployment benefits and a one-year reduction in payroll taxes. But even with this relaxation in the fiscal stance, the US Federal budget deficit is likely to come down this year from 8.9 per cent to 8.1 per cent, according to Moody’s, the rating agency.
Elsewhere in advanced economies, public spending cuts and tax increases are firmly on the menu for 2011. Some countries are pursuing austerity with relish. In January, the German government said it hoped its budget deficit would fall firmly below the European 3 per cent limit after breaching the rules for only one year.
The UK coalition government, with a much worse starting-point, has put deficit reduction at the centre of everything it does. In 2011, it has raised value added tax to 20 per cent and is raising employee and payroll taxes in April. Government capital projects are being slashed and public employees are embarking on a two-year pay freeze.
Elsewhere in Europe, austerity is even tougher, but has been forced on countries that had few options left after hitting the limits of investor willingness to finance their fiscal deficits at reasonable cost.
Greece and Ireland have already accepted severe spending restraint and rapid deficit reduction as conditions for receiving loans from the International Monetary Fund and the European bail-out fund. Portugal, Spain, Belgium and Italy are taking similar measures to avert a similar fate.
Few know the degree to which public-sector austerity will affect the wider economy. The IMF estimates that the impediment to growth in both advanced and emerging economies will be larger than usual because the fiscal tightening is happening simultaneously and at a time of general fragility.
That uncertainty and the experience of 2010 – when policymakers wanted to begin to exit from the policies of the crisis, but found the outlook was still too weak – should make people pause before predicting policy will be well on the way back to normality by 2012.
The hangover from the financial and economic crisis appears to be bad and long-lasting.
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