CENTRAL BANKS APPROACH EXIT WITH CAUTION / THE WALL STREET JOURNAL ( RECOMMENDED READING )

Central Banks Approach Exit with Caution

By RICHARD BARLEY

Two steps forward, one step back. The Bank of England is heading toward an exit from ultra-loose monetary policy. But Governor Mervyn King continues to strike a highly cautious tone given huge uncertainty over the economic outlook. The same forces can be seen in the European Central Bank's deliberations. The market should take note of that: government-bond yield curves could steepen further.


U.K. money markets dialled back their expectations of interest-rate hikes Wednesday after rushing Tuesday to embrace an apparent endorsement of their judgment by Mr. King in a letter to Chancellor George Osborne. Mr. King on Wednesday avowed he had given no such endorsement. The market pushed back its expectation of a first interest-rate hike to June from May and is now pricing in 0.5 point of tightening by year end, rather than 0.75 point.


A rate hike seems likely in the near future: the BOE's latest Inflation Report forecast is that inflation is as likely to be above target as below target in the medium term if rates rise as markets expect. Two members of the Monetary Policy Committee voted for a hike in January, and the decision for others is finely balanced.


But the Inflation Report also emphasized the risk to growth; the waverers on the MPC may be unwilling to embark on a rate-tightening cycle until they are sure that economic demand is robust. As long as that mix persists, long-end gilt yields, more sensitive to inflation, may rise faster than short-end yields, more sensitive to official policy rates.


The BOE is right to tread carefully. It has at least avoided the risk of a re-run of 1994, when an unexpected U.S. rate hike caused bond-market carnage. Yields this time started rising in the fourth quarter as investors grew less bearish on the outlook, and the market is prepared for a rise.


Now the challenge shifts to the path of rates beyond that: a sharp rise in market rates could be highly disruptive at a time when consumers still need to deleverage, governments need to reduce deficits and lending is fragile. The end point for rates and the speed of tightening may be lower than in the past.

The ECB has found that exiting from emergency measures isn't a smooth process, with each move to withdraw liquidity seeming to coincide with a worsening of the euro-zone debt crisis. As a result, it has had to pause and make the withdrawal more gradual. That may be a pattern that repeats itself as interest rates rise.


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