When the central banks tighten the monetary policy

One of the Big Kahunas out there in the financial markets is what will happen once the central banks begin to tighten the monetary policy. The simpler version is what will happen once the policy rates begin to creep upwards. Somehow this fear misses the points. We are way past the point of further policy easing and of course the interest rates will begin to climb upwards.

As central banks introduced their various programs to save the financial sector from self-inflicted injuries, they made tons of liquidity available to the banks. And they lowered the interest rates to zero or thereabouts. When trying to follow the various reports from the central banks, it is clear that the banks do not any longer use the total amount of liquidity put at their disposal. It is a good sign since it indicates that the bank's health nominally has moved out of the danger zone and is moving in the direction of normal business.

The next thing that will happen is that the central banks will reduce the amount of extra liquidity available to the banks. I am sure it will be understood as a "tightening move". It isn't – it is just the retraction of extra facilities that nobody uses anyway. And that is not really a tightening.

Once the interest rates begin to move higher it will be almost the same. Interest rates are currently very low and they can increase quite a bit before they begin to bite. The relevant point for the financial markets should not be when the markets move up the first time, nor when they move into neutral territory but when they cross into tightening territory.

However, it is not that clear where that territory is. But it is possible to have a good estimate, since there are more or less well-established principles for calculating the "equilibrium" or "target" interest rates. One of those rules is the so-called Taylor rule (named after John B Taylor, an academic economist who also served as member of the Council of Economic Advisors to US presidents and as an Undersecretary of the Treasury). Taylor proposed that the central banks adopt a rule fixing the target interest rates as a simple function of observed inflation, target inflation, economic output as measured by GDP, and potential GDP.

While these ingredients appear complicated, there are many economists, including those from the financial sector, who do a quite good job of estimating the target rates, using this rule. In general Taylor's rule has proved to be a good indicator of short term interest rates, and economists have in general been on the ball in predicting the change in the interest rate trends. The same thing will happen this time. There will be ample indications of the need to tighten (which is not the same as increasing the interest rates over and above the current very low interest rates), once that begins to emerge.

I am afraid that this point will be missed on most market participants. They have their eye firmly on the short term interest rates, and as soon as they begin to move it will be presented as an impending disaster and what not. It will probably create some market movements but it will only be in the short term. There is no doubt that the world economy is recovering pulled by massive public spending and a profit recovery fuelled by massive spending cuts in the past 12 months. The consumers are not following through yet, spooked by increasing unemployment. So in that sense, the recovery will remain subdued.

All of these factors point to an extended period before the central banks begin to tighten – as opposed to hiking interest rates. My best guess is that H2 of 2010 is the relevant time horizon.
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BTW notice that US central bank director Bernanke in this weekend gave a talk, warning about the return of international imbalances, explicitly mentioning the falling US savings rate. To readers of this blog, this should come as no surprise, given our post from 14 October..... I am just afraid that US politicians eager for reelection next year are unwilling to introduce economic and tax reforms in order to increase the Savings Rate. Even if it certainly would be the right thing to do.