As the Asian-led global recovery consolidates and job shedding in industrial countries slows, central banks and finance ministries in several countries are signaling intentions to begin phasing out emergency stimulus measures. At the same time, authorities in the large economies hit hardest by the crisis—including the United States, the UK, and Japan—emphasize that expansionary monetary policy and fiscal stimulus measures will remain necessary well into 2010, or even longer. For now, the risks of reversing policies too soon continue to outweigh those of exiting too late, but the time for a general policy shift may come sooner than markets are expecting.

Stimulus Withdrawal Has Begun Selectively

Some central banks are phasing out emergency measures and sending signals that monetary policy will tighten soon.

  • The European Central Bank (ECB) will issue its last 12-month loans to banks tomorrow. Switzerland’s central bank recently announced its intention to stop purchasing corporate bonds.

  • First to raise its principal policy rate in August, Israel raised it another 25 basis points to 1 percent in November. Australia raised its rate to 3.75 percent in December, marking the third consecutive increase. Norway increased its rate for the first time in October, raising it 25 basis points to reach 1.5 percent.

  • The central bank of India took the first step towards tightening in October, raising its Statutory Liquidity Ratio, the percentage of liquid assets that banks must hold, one percentage point to 25 percent, and is expected to tighten other rates in January. China plans to slow new lending to between 7 and 8 trillion yuan next year, down from 8.9 trillion yuan in the 10 months through October.

  • While the ECB maintained its 1 percent rate for the eighth month in December, the flexible rate on its last issuance of 12-month loans hints at a rate hike soon. Statements by New Zealand and South Korea indicate plans to raise rates in the first half of 2010.

On the other hand, several other central banks plan to maintain low rates and inject more liquidity. New fiscal stimulus measures are also being introduced.

  • The Fed and the Bank of England have confirmed their intention to maintain low rates for an extended period. The Bank of Japan committed an additional 10 trillion yen in short-term funding and the Bank of England will continue its £200 billion asset purchase program over the next two months.

  • Japan announced a new fiscal stimulus package worth 7.2 trillion yen, while the Obama Administration has indicated that part of the TARP’s $200 billion underspending will be devoted to supporting small businesses and job creation.

What Factors Support a Moderation of Stimulus Now?

Stimulus policies are becoming less necessary in Asia as manufacturing continues to recover, consumer spending improves, and strong job growth resumes. Recent U.S. data also points to a stronger-than-anticipated fourth quarter, and banking sectors across the United States and Europe are returning to health.

  • China’s industrial production climbed 19.2 percent in November (y/y), marking the fastest growth since June 2007. India’s industrial production rose 10.3 percent in October (y/y) after gaining 9.6 percent in September.

  • U.S. retail sales climbed 1.3 percent (m/m) in November—more than double market expectations—and rose 1.9 percent (y/y), marking the first annual gain since August 2008. The U.S. Reuters/University of Michigan index of consumer sentiment rose to 73.4 in December, up from 67.4 the month before.

  • U.S. industrial production rose 0.8 percent in November, the most in eight months. Prominent analysts are upgrading their fourth quarter forecast for the United States to 4.5 percent (saar) from 3.5 percent.
  • As they begin to feel healthier, banks are repaying loans and their ability to raise the necessary capital suggests that the market shares their view. Bank of America fully repaid its $45 billion TARP loan last week and Citigroup reached an agreement yesterday to repay $20 billion, citing measures of financial strength, while Wells Fargo announced plans to pay back its $25 billion share of TARP. ING plans to pay back half of the $14.6 billion bailout it received from the Dutch government. Lloyds was the first British bank to begin repaying its bailout loan in June. BNP Paribas repaid the $7.4 billion it borrowed from the French government in March.

Why Wait?

Despite these signs of strength, global aggregate demand remains fragile and reliant on stimulus policies. Growth is still sluggish in some mature economies.

  • World trade is recovering but remained 11 percent below the 2008 average in September. World industrial production in September was still 7.1 percent below the 2008 average.

  • The UK’s GDP fell 0.3 percent (q/q) in the third quarter. Japan’s economy expanded only 0.3 percent (q/q) in that same period, far below last month’s initial estimate of 1.2 percent. Brazil's GDP grew 1.3 percent (q/q) in the third quarter, well below market expectations of 1.9 percent.

  • Nearly all industrial countries are seeing inflation near zero at present. Most large developing countries are experiencing low or moderate inflation of less than 5 percent (y/y). However, inflation is near 10 percent or higher in several large developing countries, including Russia, India, Pakistan, Venezuela and Egypt.

  • The number of unemployed in the Euro area reached 15.6 million in November. Though unemployment in the United States declined from 10.2 percent to 10 percent in November, the job market remains weak and needs support. After five weeks of decline, initial jobless claims rose to 474,000 last week.

  • Credit remains tight for many small businesses and households. Commercial and multifamily mortgage lending in the United States fell 12 percent in the third quarter (q/q) and is down 54 percent from a year ago.

What Should Policy Makers Do?

As always, country situations vary and there is no one-size-fits-all answer. Given the weakness in aggregate demand, the downside risk associated with maintaining moderate fiscal stimulus—a marginal increase in already high government debt levels—is small. The contribution to growth of a constant stimulus injection tends to decline over time, and additional fiscal measures may be warranted.

Additionally, the large industrial countries are not in a position to raise interest rates yet. The risks of abandoning loose monetary policy too early—a second dip into unemployment and slow growth—continue to outweigh those of tightening too late—inflation and asset bubbles. However, the liquidity overhang is already large, and long, unpredictable lags occur between rate changes and their economic effects. As a result, the downside risk of overly loose monetary policy must be carefully managed, particularly in emerging markets that are seeing high inflation and/or large surges in asset prices.

  • Consensus Economics predicts 2010 unemployment will remain high, on average 10 percent in the United States, 8.5 percent in the Euro area, and 5.5 percent in Japan.

  • Though 2010 will see a global recovery, growth rates are expected to remain well below their 10-year averages, one proxy for potential output growth. Recent polls conducted by the Economist predict that growth in 39 out of 42 major economies will be positive in 2010, but, despite the severity of the current downturn, will exceed 10-year average growth in only three countries—Japan, Brazil, and Indonesia.

In countries where inflation remains low and there is no clear evidence of asset bubbles, a useful rule of thumb may be that monetary policies should become less expansionary as soon as the unemployment rate (a lagging indicator) is seen to be on a firmly downward path.

Looking Ahead

For the latest monetary policy decisions, look for Norway’s announcement on December 16 and Israel’s on December 28.

This analysis was produced by the editorial staff of the International Economic Bulletin, including Shimelse Ali, Vera Eidelman, Bennett Stancil, and Uri Dadush.