The art of a graceful exit

Being a central banker is not easy, especially in this type of economic environment. The job requires a strong mental capacity, good judgment, the ability to make hard decisions in short periods of time and the adeptness to handle tough questions or pressure from government officials and the media. So far, the central bankers of the largest economies in the world including Bernanke, Trichet, Stevens and Bollard have done a fantastic job – but the real test of their acumen has yet to come.

Over the past year, governments around the world have delivered an extraordinary amount of monetary and fiscal stimulus in response to the worst crisis since the Great Depression. At the time, they received a lot of criticism about the costs and effectiveness of their programs. Fast forward to the present and we are finally seeing the fruits of their labour in the fourth quarter. The global economy has stabilised, the recession in Germany, France, New Zealand and Canada has ended and there is a good chance that the U.S. economy will grow in the fourth quarter as well. Now that the recovery story is underway, it is time to talk exit strategies.

However as difficult as it may have been to develop the proper fiscal and monetary stimulus to deal with the current recession, implementing an exit strategy may be an even taller task. The challenge for central banks around the world is to remove the unprecedented amount of monetary stimulus while at the same time maintaining growth and price stability. The timing has to be perfect and the process has to be precise. It will be a difficult task and that is why many nations prefer a fragmented rather than a collective exit strategy. Some of their programs will expire naturally but others may require an outright sale of assets or reverse repos. Ultimately, exit strategies will be more of an art than a science whose worth may not be determined until years from now.

For currency traders, the focus is not so much on the proper implementation of exit strategies, but rather which country will tighten monetary policy first. When it comes to trading, expectations always drives price. A perfect example can be found in the British pound. By September of 2009, all major central banks except for the Bank of England were no longer looking to increase stimulus, but the Bank of England had just boosted their asset purchase program by 40% and because of that, the British pound sold off aggressively against both the U.S. dollar and the euro.

Another reason why it is more of an art than a science is because not all countries experienced the same degree of contraction and therefore they will not experience the same upturn. As a result, some countries will be more aggressive than others with removing their policy accommodation and returning to interest rate normalization. The key is to figure out who will do it first and do it the fastest.

One of the ways to figure that out is to look at employment and consumer prices. It is no secret that central banks watch capacity utilization and inflation very closely. The following chart compares the latest unemployment rate for all of the major countries with that of its 17-year average (which is as far back as our data goes). The unemployment rate in the U.S. as of August 2009 is 9.7% compared to an average unemployment rate over the past 17 years of 5.5%. The difference of 4.2% suggests that there is a lot of additional slack in the U.S. economy. In contrast, the average unemployment rate in Germany is 9.83% compared to a current unemployment rate of 8.3%.  This suggests that over the past 17 years, more people have accumulated jobs in Germany. The same is true for Australia and New Zealand, which both benefitted materially from China’s rapid development over the past two decades. Therefore we have good reasons to believe that the countries with the greatest excess capacity and the highest differential between the current unemployment rate and that of the 17-year average is most likely to keep interest rates on hold for the longest period of time. In contrast, for the countries where the unemployment is below the average, the central bank may be itching to raise interest rates. Perhaps this helps to explain the European Central Bank’s lack of concern about the euro’s strength and the hawkish comments from the Reserve Bank of Australia.

Interestingly enough, the countries with the greatest excess capacity are also the ones with the lowest inflation rates. Year over year inflation in the U.S. and Japan is still negative while inflation in New Zealand and Australia is positive (German CPI for the month of August was flat).

The current state of unemployment and inflation suggests that as the global economy continues to recover, countries like Australia or New Zealand will face the greatest inflationary pressures. Before inflation becomes a big problem, they also have the greatest flexibility to hike interest rates since they have tight employment and less spare capacity. If inflation starts to become a big problem, they may also be forced to hike interest rates more aggressively than everyone else.  It is no coincidence that Australia skirted the recession while Germany and New Zealand became one of the first countries to come out of recession in 2009.  The currencies that stand to gain the most in the fourth quarter and in 2010 should be ones whose central banks will be the most aggressive in tightening monetary policy. However things could get messy if central banks do not implement their exit strategies effectively, which could also have an impact on their currencies.