On Exit Programs and Central Bank Tightening (22 Feb 2010)

The US Federal Reserve increased its discount rate on Friday from 0.5% to 0.75%. This is the interest rate which it charges banks for emergency loans. The move set the market abuzz last Friday and contributed to the fall in markets on Friday as there were fears on whether this was a shift in monetary policy for the Federal Reserve. (Currently the Fed Fund rate stands at a historic low of 0.25%).

Many investors are currently worried about changes in policy from central banks. In a way, the many measures taken by central banks across the world in the aftermath of the Lehman Brother’s crisis has fostered a certain amount of expectations. The perception is that the whole world was in danger of plunging into a deep crisis, a deep depression, so extreme measures had to be taken.

Now, though we have clearly put the worst of the crisis behind us, we still want those extremely loose monetary policies to continue. We want rock bottom interest rates to continue, and we want central banks to continue to keep the tap open, and to continue to inject tons of money into the system. In a way, its like falling down, and ending up in crutches. Doctors will recommend trying to walk even while our legs hurt, but initially, we want to stay in our crutches because it hurts. We may even end up relying on them if we don’t recover well precisely because we did not exercise them enough while recovering. As a result, those crutches, which should have been temporary, become permanent.

We are facing the same situation right now. Stock markets, used to the extremely loose monetary policies and massive stimulus packages rolled out by governments all over the world are now reacting negatively at the various pullbacks. So far, the pullbacks have actually been fairly mild. The Fed has not even raised its actual Fed Fund rate. Only the discount rate was raised, and banks these days are hardly utilising it in the first place. Yet, the reaction was still negative.

In my mind, I see it as necessary, and in fact, I would rather it happens and take any correction that comes with it. While we remain at an unrealistically low interest rate environment with loose policies, there will always be the nagging fear of bubbles developing, and any recovery will never be complete, since it was achieved with the “crutches” of government aid. Only when we are back to a more “normal” interest rate environment, and when government policies are lesser based on a crisis type of environment, and yet, the global economy demonstrates that it can still grow, will there be a more sustained increase in markets.

So, my sense is that I would rather not fear any upcoming change of government policy towards tightening. It was good while it lasted, but everyone knows it would never be permanent. Let any jitters and corrections happen now, it will only allow the market recovery later to be longer, and more sustained. Most importantly, keep the bigger picture, and longer-term target in mind.