Why Some Countries Are Stopping Their Stimulus

By Cesar Bacani / Hong Kong
A security guard looks out the window of Australia's Reserve Bank in Sydney in Feb. 2005

They first did it on Oct. 6, they did it a second time on Nov. 3 — and, oops, Australia may raise interest rates again in December this year or in February next year. "A further gradual lessening of monetary stimulus is likely to be required over time if the economy evolves broadly as expected," the Reserve Bank of Australia said last week. It expects GDP to expand 1.75% this year, more than three times its forecast in August.

Australia is so way Down Under that what happens there often seems far removed from the rest of the world. Not this time. The Aussies' aggressive tightening is seen as the start of the global exit from the unprecedented liquidity governments have injected into their financial systems to avert an economic depression.

It's a potentially dangerous step. No one knows exactly how a withdrawal will affect the tentative global economic recovery — just as it is not clear, even now, whether interest rate cuts and huge stimulus spending in the U.S. and elsewhere are resulting in sustainable economic growth. The world is in uncharted territory. Policymakers are acting on the fly, without much in the way of historical precedence to guide them.

Investors, including those saving for retirement, are on uncertain ground as well. The global crisis and the stimulatory monetary and fiscal policies that were brought to bear against it have overturned all the verities about long-term investing. Exiting from those policies is not likely to reinstate them. How will equities, bonds, commodities, oil, gold, currencies and other investment vehicles fare in the post-crisis, post-stimulus-spending world?

For Australia's central bank, inflation and asset bubbles in an environment of easy money evidently now trump worries of a second-dip recession. Its October and November decisions, which raised interest rates from 3% to 3.5%, are meant to keep inflation between 2% to 3% in 2010. The country's consumer price index as of September actually rose just 1.3%, but the fear is that the resurgent economy and government's $38 billion in cash handouts and infrastructure spending will push inflation above 3%.

Other central banks are making similar calculations, although they are not moving as aggressively — yet. The Bank of Japan will terminate its purchases of corporate debt this December. The Bank of England is cutting back on a program to buy government bonds and commercial paper with newly created money. The European Central Bank is mulling an end to its 12-month loans to banks next year. "Not all our liquidity measures will be needed to the same extent as in the past," says ECB president Jean-Claude Trichet.

The G-20, the group of developed and developing economies that has taken over the G-8 industrialized countries as the decision-maker in global economic affairs, agreed over the weekend to adopt a detailed timetable in order to coordinate the world's stimulus exit. The first steps are slated to be announced by the end of January next year. "If we put on the brakes too quickly we will weaken the economy and the financial system," warned U.S. Treasury Secretary Tim Geithner, "and the ultimate cost of the crisis will be greater."

The U.S. Federal Reserve is also talking the talk, although it is difficult to see how it can actually walk the walk. After a year of contraction, U.S. GDP grew 3.5% in the third quarter of this year, but the jobless rate has surged to 10.2%, the highest since 1983. Raising interest rates runs the risk of worsening unemployment. For the same reason, the U.S. cannot withdraw stimulus spending either, even though the U.S. budget deficit has topped a record $1.7 trillion. Last week, mortgage lender Fannie Mae reported $18.9 billion in third-quarter losses and said it needs another $15 billion in taxpayer money to survive.

Indeed, U.S. President Barack Obama wants to spend even more. "My economic team," he said last week, "is looking at ideas such as additional investments in our aging roads and bridges, incentives to encourage families and businesses to make buildings more energy efficient, additional tax cuts for businesses to create jobs, additional steps to increase the flow of credit to small businesses, and an aggressive agenda to promote exports and help American manufacturers sell their products around the world."

The potential increases in U.S. stimulus spending even as other economies start to withdraw their programs and tighten monetary policy bring more uncertainty to the prospects for the global economy. One early casualty is the U.S. dollar, which has weakened significantly against most other major currencies. A continued fall appears likely as investors park their capital in Australia and elsewhere, because interest rates are trending higher there and economic growth is far more robust than in the U.S.

For now the weak dollar is helping America's exports. But it is also spooking holders of U.S. debt, whose continued purchases of U.S. Treasury bills allow Washington to fund its deficit spending. Last week, the International Monetary Fund (IMF) announced that the Reserve Bank of India had bought 200 tons of IMF gold reserves, the biggest single purchase by a central bank in 30 years. That pushed the price of gold past $1,100 an ounce, the latest record-breaker in a string of new highs, as the market anticipated gold buying by other central banks to hedge against a falling dollar.

No one quite knows where the world will end up in this new roundelay of policy decisions and feedback loops. What is clear is that there needs to be some measure of coordination among central bankers and policy makers as they exit stimulus measures and tighten monetary policy. It is fortunate that the planet now has forums such as the G-20 and reinvigorated multilateral institutions like the IMF to help in this regard.

But at the end of the day, governments will make decisions based on what they believe is best for their economy and people. The winners will be those who can draw the correct lessons from the still unfolding economic crisis and can act on them speedily — yet also have the flexibility to change tack as the decisions of other policy makers and other external events change the economic picture. Brace yourselves for more uncertainty and volatility.