THE SORDID LIFE OF MONETARY POLICYMAKERS

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Monetary policy has never been easy. Interest rates must be set today based on expectations of how the economy will be doing 18 months in the future. So, decision making in the face of uncertainty is nothing new for central bankers. However, there was generally a belief that given the economic forecast, the choice of the appropriate level for interest rates was much less uncertain. Discretion was bad. Rules were good. That textbook is now in flux, and the sordid life of monetary policymakers has been on display recently in Australia, the U.K., Brazil, and China. In spite of the volume of discussion over the decision by the Australian central bank to raise interest rates, that did not represent such a regime change. The near-term hit to inflation and the economy was less severe than elsewhere. Headline inflation fell to a positive 1.3% y/y pace as of September and Australian GDP contracted for only one quarter - avoiding a technical recession. So, the amount of spare capacity now bearing down on inflation is much less than elsewhere. But as insurance against the worst, the RBA had cut interest rates by 425 basis points, so textbook central bank policy mandated that interest rates should start to rise to reflect the better realities. Textbook central bank policy also places inflation expectations on a pedestal, which may prove to be problematic for the Bank of England. The first reading on Q3 GDP came in at -1.6% (SAAR), vastly underperforming the expectations for +0.9%. This caps off a third quarter in which much of the hard data was rather anomalous, deviating fairly significantly from where forward-looking surveys of producers and consumers suggested economic activity would be. Our initial expectation is that we will see the fourth quarter make up some of this discrepancy, and the Bank of England has signaled they are likely to revise up their expectations for the economy in the medium-term, but they may also revise down the near-term (www.td.com/economics/comment/boe_oct09.pdf).

This is important because the BoE's decision on how much government debt to purchase is based on the cumulative deviation of GDP, not just on expectations for growth. So less growth now and more in the future could actually translate into more government debt purchases now, but interest rates rising a bit more quickly in 2010. This is complicated by growing hawks on the Council. Inflation expectations are actually creeping up in the U.K., with our estimates suggesting that the current level of inflation priced into financial markets would be consistent with a 2.5% y/y headline inflation rate 12 months from now. Central banks take anchored inflation expectations seriously, and faced with rising inflation expectations now and an academic debate over how much slack there is in the economy and how that may or may not impact inflation down the road, persistently high inflation expectations will win every time. That is why the BoE could hike rates in the face of economic slack and why the Fed and Bank of Canada are still much more comfortable where they are. For emerging markets, the tendency remains.