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Global Economy: Surprise tactics sweep central banking

A general view of the U.S. Federal Reserve building as the morning sky breaks over Washington, July 31, 2013. REUTERS/Jonathan Ernst
A general view of the U.S. Federal Reserve building as the morning sky breaks over Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Andy Bruce

LONDON (Reuters) - After slashing interest rates to almost nothing and printing trillions of dollars, central banks are becoming increasingly reliant on another policy weapon: sucker punching markets.

The European Central Bank shocked investors and forecasters last Thursday by cutting its main refinancing rate to a record low, reacting to a shock decline in inflation.

It was the second big central bank surprise in less than two months, after the U.S. Federal Reserve decided in September not to trim its monthly bond purchase stimulus.

And beyond the immediate impact on financial markets, central banks' shock therapy tactics have also had a lasting effect.

The yield on the U.S. 10-year Treasury bond -- one measure of government borrowing costs -- fell sharply in the aftermath of the Fed's decision, and it shows no signs of revisiting September's peaks for the year any time soon.

The ECB's rate cut helped weaken the euro more than 1 percent against the dollar, and most economists polled by Reuters reckon it will put the currency on a firmly lower path from here -- huge help for the fragile euro zone recovery.

With scant room left to cut interest rates again and appetite for more rounds of money printing waning, economists say surprising markets will increasingly feature in policymaking.

"It makes sense that with the artillery becoming depleted, central banks want more bang for their buck now. One way of doing that is to launch surprises in markets," said Philip Shaw, chief economist at Investec in London.

"It wouldn't be a shock if the ECB was pleased that it surprised markets," he added, noting the ECB managed this without breaking its guidance to keep interest rates low or lower for an extended period of time.

AN OLD TOOL, BUT A GOOD ONE

Jolting markets with an unexpected decision has always been in the central bankers' toolkit.

Germany's Bundesbank, for instance, was famed for its sudden moves when it set monetary policy for Europe's biggest economy in the pre-euro days, said Elwin de Groot, senior market economist at Rabobank in Amsterdam.

But there are good reasons why bolt-from-the-blue policy moves are even more effective today.

"In recent years, the trend in central bank policymaking has been for more transparency, more guidance, and trying not to surprise the market," said de Groot.

"But occasionally you can surprise, and it works better. It keeps the market sharp; it sends a strong signal to the market that its assumptions were wrong."

This year has been peppered with such instances.

Back in April, economists expected the Bank of Japan would ease policy -- but few dreamed it would unveil a plan to unleash $1.4 trillion worth of monetary stimulus into the economy over less than two years.

And wrong-footing markets has become a defining policy tool for the ECB since Mario Draghi became its president.

The ECB cut rates unexpectedly at the first meeting where Draghi was in charge, two years ago this month.

His shock announcement last July that the ECB would take on rising government borrowing costs and do "whatever it takes" to save the euro proved decisive in easing the region's debt crisis.

It remains to be seen whether Draghi's incoming counterpart at the Fed, Janet Yellen, will share his penchant for surprise.

Markets might get a better sense of that when the U.S. Senate Banking Committee vets Yellen's nomination as Fed chairman on Thursday to replace Ben Bernanke, whose term expires on January 31.

In a quiet week for international economic data, focus will also rest on the Bank of England's quarterly Inflation Report outlook for the UK economy, due on Wednesday, the second since Mark Carney's appointment as governor.

"What markets will be looking for is where the new forecasts lie, and in particular, where the Monetary Policy Committee views the unemployment rate is going," said Investec's Shaw.

The Bank of England left interest rates at record lows on Thursday, but is likely to suggest next week that borrowing costs could rise sooner than it had forecast as the economic recovery gathers pace.

(Reporting by Andy Bruce; Editing by Leslie Adler)

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