Australia | Oct 19 2009
By Andrew Nelson
When looking at the current financial crisis and resultant global recession, past experience shows us that many of the possible pitfalls and policy problems that lie ahead still need to be dealt with. Yet given the current global downturn has far outstripped any in recent memory, the past can only offer so much help in assessing the future.
Morgan Stanley economist Manoj Pradhan believes the two cricial issues are the sustained recovery of credit conditions, and avoiding a premature withdrawal of policy support. However, when comparing the current environment and that of the “Big 5”, or five biggest financial crises in industrialised countries (Spain ’77, Norway ’87, Finland ’91, Sweden ’91 and Japan ’92) and the last four recessions in the US, or “The Last 4”, there is only limited advice it can offer to our current predicament.
Past experience tells us that recessions are generally followed by benign inflation and in fact, policy makers in the Big 5 were able to moderate policy because of the reduced risks of deflation. Meanwhile, the Fed was able to depend on a robust recovery in the Last 4. The experience of the past episodes also shows us that economic recovery leads to a resumption in lending, but that credit and output growth are linked and need each other to post a sustainable recovery.
Yet none of this can be taken for granted at the present time, says Pradhan, which makes the risks associated with the withdrawal of monetary policy that more crucial. Firstly, he points out that credit conditions may not follow what has happened in the past and this would limit any medium-term economic growth. On the other hand, if growth surprises to the upside over the short-term, inflation expectations could subsequently rise, which could see policy makers unwisely follow tradition and prematurely begin to tighten policies.
This, says Pradhan, would undoubtedly put the fledgling economic recovery at risk.
One of the main differences between now and the past incidents mentioned is that this time around GDP and inflation have fallen more quickly and further. Yet unlike those previous declines, the fall in output and inflation has been mirrored across the globe, although the recovery is admittedly beginning to vary widely from region to region.
Yet all told, economic recovery has come earlier than it did for the Big 5, with Pradhan noting that US and global economic growth has rebounded over the past months. The globally synchronised and aggressive monetary and fiscal policy programmes put into place over the last year have helped tremendously in cutting down the recovery time, he points out.
Pradhan goes on to predict that central bankers the world over will likely to keep fairly easy monetary in place for a while yet, noting some authorities have told markets that rates will remain low for longer. And even where policy rates have been raised early, like Australia, he sees the increases as being unlikely to be uniform all the way back to neutral.
In the meantime, quantitative easing programmes in the US and the UK have been extended time and again and thus still have a long way to go before asset purchase targets are achieved. And even when the stance reverses in most economies, he notes that the bulk of policy packages around the world were multi-year programmes that will continue to provide stimulus well beyond the recovery. He points out that in the US, only US$110bn of the approved package of US$787bn has been spent to date.
And thanks to all of these rate cuts and quantitative easing programmes, the fall in policy rates and bond yields has outpaced those seen in the Big 5 and the Last 4, which has helped produce even easier monetary conditions. In the Big 5, money supply increased by nearly 15% on average, but this is less than the 20% increase in the money supply under the ongoing quantitative easing regime.
In the past, policy makers started to reign in the growth in money supply about a year into the turmoil, yet this time around Pradhan expects excess reserves and money supply to continue to grow for at least two years after fixed income markets first froze up.
This has Pradhan thinking that the current economic recovery and underlying asset markets will likely continue to benefit from policy tailwinds for a while to come.
However, the strong recovery that this monetary policy now supports means that inflation risks are higher this time round. Money supply, when allowed to grow and stay large, tends to result in higher inflation, or at least has done so on more than one occasion, notes Pradhan. Policy makers over the course of the Big 5 were able to pull back the strong monetary stimulus because inflation risk were lessening, while US policy makers could tighten policy because growth had become entrenched and inflation expectations were beginning to rise.
But this time around, central bankers also have to factor inflation risks from global sources into their equations. On top of that, the difficulty in unwinding sizeable quantitative easing programmes and bringing back rates from nearly zero, at just the right time and pace, in order to keep a lid on inflation, leaves little margin for error.
Looking at the job of maintaining the recovery in credit markets, Pradhan points out a few more possible issues. He notes that recoveries lead lending, but recoveries also need lending. Credit growth tends to resume only after economic recovery has taken place. Yet once economic recovery creates better conditions for both lenders and borrowers, strong growth in credit is becomes an important factor in maintaining a sustained recovery.
Thus, while Pradhan expects credit growth will pick up as the recovery progresses, in turn improving borrowing and lending conditions, there is also a converse risk of weak credit growth, which could hamper economic recovery over a slightly longer term.
This makes a knee-jerk withdrawal of policy support if economic growth surprises to the upside and raises inflation, plus the possibility of weak credit growth the two biggest issues that could derail the fledgeling recovery. And the thing is, these two issues are not isolated from each other, as Pradhan points out that credit growth would probably suffer if policy were to be tightened prematurely.
While the rhetoric from the major central banks indicates that policy makers are aware of this needed balance, it’s a different game this time around and thus as Pradhan puts it: “the tightrope is thinner and much higher above the ground”.