Tuesday the US dollar index traded at its lowest level since September 2008 and gold traded above $1000. The USD decline and gold rally is fueled by investor diversification. Diversification out of USD to gold may partly reflect concern about the risk of inflation. At last weekends meeting, the G-20 pledged to maintain expansionary fiscal and monetary policy until the global recovery is secured. The timing of an exit strategy from these policies will be key to whether the G-20 policies fuel inflation. Ahead of last weekend's G-20 policy meeting, there was anticipation that the G-20 may begin to discuss the possibility of a coordinated exit strategy from stimulus. Instead, the G-20 reaffirmed commitment to expansionary fiscal and monetary policy. This helped spark rallies to new highs for the year in Asian equity markets, a sharp selloff in the USD and a surge in commodity prices. The G-20 decision to maintain current fiscal and monetary stimulus fuels optimism about the global recovery and contributes to improving risk appetite. It also increases the risk of inflation and pressure on central banks and governments to begin to consider exit strategies from stimulus.
Last Friday, ECB president Trichet outlined the ECB's plan for an exit strategy from unconventional monetary policy measures. ECB President Trichet said that it was too soon to declare the financial crisis over and that the ECB would continue credit support measures for now. Trichet said the EU economic recovery is expected to be uneven and it was too early to remove monetary stimulus measures. The ECB enacted non-conventional measures to combat the financial crisis mid 2008. In last Friday's Financial Times, ECB president Trichet outlined a strategy to exit unconventional stimulus. According to the Financial Times, Trichet said that inflation risk would be the key reason to exit credit support. Trichet went on to say that several credit measures are set to unwind naturally. The ECB would unwind immediately any non-standard credit measures if there is a threat to price stability. Trichet says any non-inflationary measures will be kept in place as needed. It appears that the ECB is separating an exit from non-conventional policy measures from monetary policy decisions. This sets up the possibility that the ECB could raise interest rates while at the same time allowing non-conventional stimulus measures to remain in place. It all depends on inflation risk. Trichet says now is not the time for the ECB to exit unconventional policy measures but a strategy for exit from unconventional policy is in place. This is a modest positive for the EUR. The timing of the ECB's exit strategy is linked to inflation risk. The ECB will be in no hurry to exit stimulus as long as inflationary pressures are subdued. The ECB can hold off tightening policy too soon which hopefully will avoid choking off the EU economic recovery. The ECB expects inflation to turn positive as the EU economy rebounds into 2010. The ECB is expected to begin mopping up liquidity mid 2010 but the timing depends on inflation. ECB's Weber says that removal of credit support will be gradual and interest rates are not expected to reach pre-crisis level any time soon. Weber went on to say the ECB will respond quickly to upside inflation pressures. Note in the graph below that EU inflation pressures remain subdued.