Has OECD monetary tightening peaked?

Surprises never cease. Not many might have expected the diverse fallout effects of the French and Dutch public voting down the EU Constitution, certainly not this columnist. One fallout is that it has facilitated criticism of the interest rate policy of the European Central Bank (ECB). At the peak of the previous interest rate cycle in 2000, when the US Fed had hiked the rate to 6.5%, the ECB had stayed at 4.75%. When the easing began, particularly after 9/11, the ECB also reduced rates, but at a slower pace than did the Fed. By June 2003, the Fed rate was down to 1.25% and that of the ECB to 2%. Thereafter, while the US Fed went down a further 25 basis points (bps), the ECB stayed at 2%. Since June 2004, the US Fed has raised rates on eight successive occasions, in steps of 25 bps. And is widely expected to do so once again in its meeting on June 29-30, bringing the policy rate to 3.25%.

Much has changed in economic conditions over the past couple of years. Almost all major western economies have passed through a recession, followed by a recovery, tepid on the average. The pace of recovery in economic growth has been strongest in the US and the weakest in most other large economies?Japan, Germany, France and Italy. Moreover, in the US, the recovery has not been able to significantly create new jobs. In the Euro-zone, the rate of unemployment has continued at a level of 9-10%, unprecedented in recent times.

Australia and Britain, the best-performing OECD economies (other than South Korea), with relatively low levels of unemployment, were the first to begin the monetary tightening. By early 2004, interest rates in the UK and Australia were amongst the highest in the developed world, at 4% and 5.25%, respectively. The immediate outcome was a sharp run-up in the two currencies vis-a-vis the US dollar and the euro. The Reserve Bank of Australia, after keeping rates level through 2004, raised the cash rate by 25 bps in March 2005, to 5.5%. The Bank of England raised its repo rate in June and August 2004, to 4.75%, but has left it there since.

All this transpired in the backdrop of a yawning US current account and budgetary deficit. And in the context of swelling Asian (especially Japanese and Chinese) official foreign currency assets, with seemingly unlimited appetite for US dollar securities. This came in handy, as private investor interest switched from the dollar to euro, sterling, Swiss franc and other assets.

The large shifts in foreign currency exchange rates over the past few years have, however, not had much effect on the size of the US current account deficit. Most of the US deficit is with China, Japan and the OPEC nations. China has a dollar peg, Japan?s managed not to stray too far and petroleum imports have their own logic. Meanwhile the Euro-zone has been hurting badly, faced with lukewarm domestic demand and declining, currency-induced, export competitiveness. The euro (and sterling and other European currencies) have picked up the entire burden of the US dollar?s weakening, even as they accounted only for a small part of the US trade deficit. In the interim, the fact is that member-countries of the Euro-zone have not been quite converging. The embarrassing fact is that non-Euro economies ?UK, Sweden and Denmark?have been doing better than the principal Euro-economies ?Germany, Italy, France and the Netherlands.

Till the ill-fated referendum, doubts about the common currency had been spoken of only in whispers. It was fairly obvious that convergence was not at hand, that the constituent economies were moving at different paces and had different national consensus on priorities and policies. If these things were not to change, then an instrument of adjustment was required and only an exchange rate could provide it. In which circumstance, the common currency was bang in the way. These whispers have now become quite audible. Maybe the euro will hold for quite some time yet, but the enlargement of the common currency is no longer so certain. And the very doubts that assail the dialogue have taken the sheen off the euro. And with it, some of the self-evident certainties of the pre-euro period, such as the unquestionable merit of straightforward inflation targeting.

The question now being asked is, if monetary policy is at all relevant to the macro-economic process, then is not the fact of a 10% unemployment rate, struggling economic growth and a possibly over-valued currency, not good enough reasons for the ECB to cut rates? The Swedish central bank, on June 21, decided to cut the repo rate by 50 bps from 2% (same as the ECB) to 1.5%, stating that GDP growth (has) slackened more than anticipated in both, Sweden and the euro area. The Monetary Policy Committee of the Bank of England, in its meeting earlier in the month, voted down a cut in the repo rate. But that does not mean it will not cut rates in the coming months. Conventional wisdom does not see the US Fed continuing with its rate hikes much further. The expectation is that it will cease after, perhaps, two further rate hikes, stopping at 3.5%, a full 100 bps lower than what was being widely perceived to be the rate at the end of 2005.

That the present cycle of monetary tightening would come to an end early in the summer of 2005, rather than six months or a year later, underscores that while most things today happen as anticipated, they do so much earlier than expected.

The writer is economic advisor to Icra