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Mopping up liquidity is a tricky balancing act

Bank of Canada Govenor Mark Carney

Kevin Coombs/Kevin Coombs/REUTERS

They are the two words on the lips of every major central banker these days: Exit strategy.

Having flooded the global financial system with trillions in cash and loans, policy makers are now obsessing about how to mop up the excess, lest the torrent of money blow the lid off inflation expectations.

U.S. Federal Reserve Board chairman Ben Bernanke told lawmakers at the end of April that he's focused on the issue "like a laser beam." On May 11, European Central Bank President Jean-Claude Trichet said an "exit strategy, or path to a sustainable mode, is absolutely of the essence." That same day, Argentine central bank president Martin Redrado said finding the way back to "long-term sustainability" is the "key question" facing policy makers.

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While few investors doubt the central banks' commitment, many are uncertain the banks can deliver.

South African billionaire Johann Rupert, who controls luxury-goods giant Compagnie Financière Richemont SA, recently predicted that unprecedented spending and lending by governments and central banks could "flat out turn into big inflation if not managed properly over the next two or three years."

What's missing from the commitment to forge solid exit plans are details about how it might be done.

So investors have little choice but to take Mr. Bernanke and Mr. Trichet and their colleagues at their word. But many are reluctant to give central bankers the benefit of the doubt, given their failure to foresee the carnage of the financial crisis.

There also is a worry that policy makers will come under tremendous pressure from politicians to keep stimulus in the system.

"I'm quite skeptical Bernanke and company are going to be able to engineer an exit strategy in the way they would want," said Daniel Bain, president and chief investment officer at Thornmark Asset Management Inc., which manages about $460-million in Toronto. "I am skeptical they can do this in a timely way."

Making believers out of people like Mr. Bain is crucial to the effort to reverse the deepest global recession since the Second World War.

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If investors doubt central banks' ability to rein in stimulus measures, they are bound to demand higher yields on bonds they buy to compensate for the corrosive effect they believe inflation will have. That would raise borrowing costs across the lending spectrum, muting policy makers' attempts to reduce the cost of credit.

Bank of England Governor Mervyn King said recently that it will be "very simple" to remove the excess money from Britain's economy. And economists tend to agree that the exit routes are fairly straightforward - at least on paper.

The most obvious step will be lifting benchmark lending rates, which are near zero in Canada, the United States, Britain and Japan. Financial assets that central banks have either bought, or intend to buy, can be sold or allowed to expire. Cash auctions that central banks are holding can be stopped, and the collateral returned to the former borrowers. And if too much cash remains in the system, governments can issue debt.

It will be trickier, however, to decide when to act.

"The only hope is that once things stabilize, the central banks shrink their balance sheets in time so that inflation doesn't take off," said Paul Masson, an economics professor at University of Toronto's Rotman School of Business and a former adviser at the Bank of Canada.

"I am not confident, given the lags in monetary policy, that they can exactly get it right," he said.

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If this were a typical recession, it might not be as difficult to determine when to begin exit strategies. But the overall deterioration of financial markets, combined with a general collapse in demand and production, makes this one hard to predict.

Normally, economies jump back to life after a recession. But few think that will happen this time. The Bank of Canada, for example, has slashed its estimate of potential output - the speed at which the economy can grow without sparking rapid inflation - by half for 2009.

Given the drop in personal wealth as markets fell and house prices slumped, many anticipate that, even as economies improve, consumers will focus on rebuilding their savings rather than spending. Central bankers have little to guide them on when consumer spending might bounce back and, thus, when to begin withdrawing stimulus.

"The problem is to know when to do it," said Chuck Freedman, scholar in residence at Carleton University in Ottawa and a former deputy governor at the Bank of Canada. "Because of the financial strains, it's harder to figure out what to do."

To be sure, central banks aren't the only ones who will have to mop up the excess money in the system. According to the International Monetary Fund, governments in the Group of 20 will spend $820-billion (U.S.) this year and $660-billion in 2010, widening their collective deficits to 6.6 per cent of gross domestic product in 2009 (up from 2.3 per cent last year), and 6.5 per cent of GDP in 2010.

So Finance Minister Jim Flaherty and his counterparts also face the challenge of persuading investors that government spending binges are temporary.

But the difference between reversing monetary stimulus and reversing fiscal stimulus is comparable to the difference in turning "a motor boat and a big cruise ship," Mr. Freedman said.

Central bankers can raise interest rates whenever they want. But governments aren't likely to stop construction on an unfinished bridge just because the economy is starting to heat up.

Then there's the political pressure. Germany will elect a new government in September, the United States has a congressional vote next year, and British Prime Minister Gordon Brown must hold an election by May, 2010. Prime Minister Stephen Harper's hold on power relies on deterring the opposition from forcing an election.

This sort of combustible political environment causes economists and investors such as Mr. Bain to worry that central banks won't be able to avoid getting sucked in.

"It's very difficult to be the guy who has to pull the punch bowl away just when the party is getting boisterous," said William Robson, president of the C.D. Howe Institute. "That is particularly dangerous when you are filling gaps in the credit markets."

Mr. Freedman, who spent 15 of his 29 years at the Bank of Canada on the policy-setting Governing Council, said central banks have worked too hard to earn their independence to sacrifice it now. He believes that there's every reason to feel confident that policy makers have things in hand; and that with the amount of production capacity in use at record lows, there is little reason to fret about rapid inflation.

Mr. Bain agrees with that analysis, but still expects all the stimulus will create an inflation problem. "Policy makers generally aren't good at calling these things," he said. "You don't need any greater evidence than what we've seen in credit markets over the last year."

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More

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