Jean Claude Trichet

The world’s two most important central banks have lately become used to entering unexplored territory. Emergency steps taken to avert economic catastrophe since the financial crisis erupted almost two years ago were largely untested and their impact was unclear.

Now, as the world economy shows signs of stabilising, the terrain is arguably as unfamiliar as ever. At both the European Central Bank, which meets this Thursday, and the US Federal Reserve there is a sense that the extraordinary easing cycle is over, though they will continue to implement and tweak announced plans. While uncertainty remains high, external attention and internal debate has switched from what they can do to fight the crisis to one of exit strategy: when and how to unwind the measures now in place.

The market pressures are arguably greatest on the Fed, which took the most radical and unorthodox steps during the easing cycle, including a programme to purchase up to $1,450bn (£877bn, €1,031bn) of mortgage-related securities and $300bn in Treasury paper.

Yet the ECB also faces a tough predicament. Last week, it extended €442bn in one-year loans to more than 1,100 eurozone banks in an effort to get credit flowing – the largest amount it had ever injected in a single operation. Like the Fed, it now has to judge when – and how – to pull back the exceptional policy measures without wreaking further economic damage. “We worked our way up the mountain without actually knowing the path we were taking in advance. Now we have to work out how to get down – and most mountaineering accidents happen on the way down,” says Julian Callow of Barclays Capital.

Since the start of the crisis, there have been clear differences between the two central banks. Ben Bernanke, the Fed chairman and an expert on the 1930s Depression, has been aggressive and experimental, in spite of concerns from some of his officials. The instinctively more conservative ECB, headed by Jean-Claude Trichet, has not been shy in adopting unconventional approaches. But it has chosen policy steps that are more in line with the operating rules it had in place before the crisis – making the extraordinary measures easier to unwind.

Rather than launching large-scale asset purchase programmes that bypass the banks as the Fed has, the ECB has focused on pumping liquidity into the banking system. “The Americans are more pragmatic – if they see something wrong they think they have to fix it. The ECB is more principles-based,” notes Jörg Krämer of Commerzbank.

In coming months, transatlantic approaches to policy will again be tested under different circumstances. Below are four scenarios of how economic events could unfold – and how the two central banks would be likely to react.

Scenario one: Steady as she goes – inflation and interest rates low

This baseline scenario for both Fed and ECB involves a period of stabilisation followed, in the case of the eurozone, by a return to quarterly growth in mid-2010 and, in the US, slightly positive growth from the second half of 2009 but gaining force only some way into 2010.

In this eventuality the Fed is likely to be a good deal more patient in raising rates than the market expects. Its leadership puts a lot of weight on staff estimates that a large output gap between demand and supply will provide an effective safeguard against inflation – even though many regional Fed presidents have little confidence in the projections of spare capacity, fearing that the crisis has damaged the supply potential of the economy.

After the downturn, where next?

Still, even the most dovish Fed officials are troubled by signs that the market is concerned about deficits and inflation, which Janet Yellen, San Francisco Fed president, recently described as “disconcerting”.

Rather than accept the market’s timeframe for raising rates, Mr Bernanke will probably try to boost confidence that the Fed has a workable plan that will allow it to raise rates again when the right time comes. In this case, the Fed is likely to wind down its emergency support programmes first, before raising rates.

The next stage is likely to be a refinancing of some of its long-term assets through reverse repurchases, mopping up excess reserves, though in principle this could be done in tandem with or even after the first rate increase. The US central bank will probably end up raising rates before it has reduced the reserves all the way back to normal levels – relying on its ability to pay interest on reserve deposits to put a floor under interest rates at the desired level.

So the Fed may not raise rates until late 2010, though it could be forced into an earlier boost if inflation expectations drift higher or Mr Bernanke loses confidence in the estimate of a large output gap.

For the ECB, the likely response will be to sit on its hands and not do very much. Keeping interest rates at the current 1 per cent, the lowest ever, for a considerable time is seen as a distinct possibility at the Frankfurt institution – even if its officials will not admit publicly that is its intention. Overnight interest rates are even lower than the main rate, in effect pretty near to zero, so would probably have to rise before any further cuts in the main interest rate.

The ECB has started a modest asset purchase programme, announcing it will buy €60bn of covered bonds. But Mr Trichet makes clear this is not “quantitative easing”. The banks from which it buys the bonds will bid for less in regular liquidity operations, meaning the overall impact should not prove inflationary. There is a lot of nervousness, especially in Germany, about the long-term inflationary dangers posed by the actions central bankers have taken so far.

“Even though you see all these ‘green shoots’ all over the place, they are pretty flimsy when it comes to Europe – and yet the talk about the need to have an exit strategy appears to be more prominent among European and ECB policymakers than elsewhere,” says Jim O’Neill, Goldman Sachs’ global economist.

Scenario two: The only way is up – recovery faster than expected

The policymakers’ dream – and it is not seen as impossible among central bankers. The collapse in global output after the failure of Lehman Brothers last September was so severe; maybe the rebound will also be impressive?

However, the economics do not suggest it is likely. Europe’s economy will be weighed down by banks’ weakness, which will restrict the availability of credit, and by rising unemployment. Moreover, a dream scenario could quickly turn into a nightmare. It has become accepted wisdom that the Fed’s decision to keep rates low for so long after the collapse of the 1990s dotcom bubble contributed to the current crisis. But would the ECB or Fed now really dare to raise interest rates rapidly after such a severe economic shock?

“Raising interest rates pre-emptively, when middle-term inflation developments do not suggest it is necessary, would certainly create communication challenges,” admitted Axel Weber, Germany’s Bundesbank president, this month. “But that could be mastered,” he argued.

ECB-watchers are sceptical. “I can’t really see that they would tighten earlier than a standard economic analysis would suggest,” says Julian Callow at Barclays Capital.

In a rapid rebound the Fed would face accusations that it is “behind the curve” with policy. Indeed, such talk is likely even if there is a false dawn with a strong single quarter of activity, for instance as the inventory cycle turns and car production picks up again. The US central bank might simply accelerate the implementation of the base case plan. However, depending on the relative strength of financial markets and the real economy, it might adopt a different exit sequence in the V-shaped recovery scenario, tightening rates before financial market support is fully withdrawn or asset purchases refinanced.

The introduction of paid interest on bank reserves in theory gives the Fed latitude to do this. But there are problems, including restrictions on its ability to pay interest to some big participants in the money market and balance sheet constraints among the primary dealers with which it works.

Scenario three: Back to the pump – deflation, ongoing recession

This is the scenario that central bankers have feared for months – and few would say with any confidence that the dangers are over. The risk is that the recent rebound in confidence proves short-lived, that economic output takes another big lurch downwards and prices start to fall on a general and protracted basis – in turn wreaking further economic damage.

Some think the likelihood of this happening is lower in the US than the eurozone, in part because of the more aggressive fiscal and monetary stimulus in the pipeline. But if it did, the Fed would resort to further unconventional actions including large additional asset purchases to mimic sharply negative interest rates.

If markets relapsed into dysfunctionality, it would continue to emphasise interventions in private credit markets – so-called “ credit easing” – to lower private borrowing rates, probably adding more Treasury purchases as well.

But if credit markets were working well, the opportunities for credit easing (which is premised on abnormal liquidity and spreads) would be limited and the Fed would shift emphasis to focus on the risk-free rate. In this scenario, as well as buying more Treasuries, the US central bank would probably overcome a reluctance to make any explicit commitment to hold its rates near zero for a very long time, to push down long-term rates.

At the ECB, a deflation scenario could change the debate completely – and see it quickly expending the remaining ammunition it believes it has. Its main interest rate could fall to zero, perhaps buttressed with an unprecedented pledge to keep interest rates at that level for a long time.

Liquidity-providing operations could be expanded further. So, too, could the so far modest ECB asset purchase programme. In a deflationary scenario the ECB might quickly have to overcome the technical problems it has seen in programmes to buy corporate debt and commercial paper across 16 countries.

But one taboo would remain: the ECB would almost certainly not buy government debt. That would blur the boundaries between politicians and central bankers, jeopardising its independence.

Scenario four: Burnt by hot oil – stagflation

The latest worry for some central bankers. The danger is that growth remains sluggish but soaring prices for oil and other commodities result in inflation taking off again.

Instead of the current zero inflation, the ECB could see headline consumer prices rising above its target of an annual rate “below but close” to 2 per cent. The ECB could decide that the rise was temporary and that it did not therefore have to react. But there would be some nervous moments. In 2008, when soaring oil prices sent eurozone inflation to 4 per cent, the ECB feared the effects would become permanent and in July last year it raised its main interest rate to 4.25 per cent – the highest for seven years.

With hindsight, the ECB rate rise, just weeks before the Lehman collapse, appears a policy mistake. But for the ECB there is now a big advantage: few will question in the near future the priority the ECB attaches to combating inflation. “Last July’s interest rate hike was very important from the point of view of the ECB’s credibility,” argues Jörg Krämer of Commerzbank.

The Fed would instinctively look through the impact of higher commodity prices on headline inflation and focus on the rate of core inflation, which it sees as the best guide to the underlying trend in overall prices. This is what it did during the inflation scare of 2008 and policymakers believe that its approach was vindicated by events. Yet some Fed officials worry that its radical actions to combat the crisis might have lessened confidence in its commitment to low and stable inflation. This could mean it has less scope to exploit its accumulated credibility.

Mr Bernanke would strenuously resist this logic – but would be in a difficult position if inflation expectations did become unmoored by a combination of high headline inflation and doubts over Fed strategy.

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