July 2009

Given the recent tentative signs of recovery in the global economy, investors' focus has somewhat shifted away from how the financial authorities should tackle the impact of last year's financial meltdown to how they can unwind the measures adopted to do so. These so-called "exit strategies" will be vital in maintaining confidence, since the markets are well aware of the potentially disastrous inflationary consequences engendered by extraordinary monetary easing.

The policies currently pursued by central banks and governments have never been fully tested before; they have taken the world economy into unchartered territory and there is a great deal of uncertainty as to how events will now unfold. Analysts see a number of possible scenarios going forward. The most desirable of these is arguably a gradual economic improvement around the world within a low-inflation environment. The pace of any recovery will determine how relaxed the authorities can afford to be in adjusting their policies, especially with regard to interest rates: the gentler the upswing, the more leeway central banks will have.

Of course, governments in particular (especially in pre-election Germany and the UK) hope for a rapid rebound in economic recovery, although the metrics do not currently indicate such an outcome. Should this nevertheless come to pass, central banks will have to time an interest-rate response very precisely; if inflationary pressures remain muted, suggesting no monetary urgency for tightening policy, there are likely to be accusations of “jumping the gun” and posing a threat to any nascent economic upswing.

Nevertheless, either of the two scenarios outlined above are preferable to other forecasts, such as a resumption of the recession accompanied by deflation. Although unlikely under present circumstances, the danger of this happening remains real. Such a situation would likely see: interest rates fall to near-zero in those jurisdictions where this has not already happened (such as the Euro-zone), at which levels they would probably remain for some time; further, massive, central bank asset purchases and additional liquidity-boosting programs. But even this would be better than stagflation, in which lacklustre growth is accompanied by a rapid rise in inflation, perhaps due to soaring oil prices driven by geopolitical factors.

Whatever the outcome, the timing of any response by the financial authorities will be crucial for success in dealing with whatever the future holds. Inflation is not a threat for now, but it will be sooner or later. Central banks have been very much focussing on a return to economic growth, but they should not forget their commitment to maintaining price stability if any recovery is to be sustained.