Fed’s back to back rate cuts in October 2008 have caused a sense of uneasiness among GCC (Gulf Cooperation Council) central banks deciding whether to follow suit. For the first time in decades, we are watching some differences in monetary policymaking among GCC central banks. Thus following Fed’s 8 October 2008 rate cut by 50 basis points, all but Qatar central bank have matched Fed’s move. By contrast, Fed’s latest (29 October 2008) round of rate cut by 50 basis points has so far been implemented in Bahrain, Kuwait, and Saudi Arabia, while UAE officially left its rates untouched, and Qatar is yet to decide on a move.
Refuting the impossible trinity
It is well known that due to the dollar-peg system, GCC central banks have no choice but to follow Fed’s move when it comes to monetary policymaking. As there is no restrictions on capital movement in GCC economies, according to the impossible trinity GCC central banks lack independent monetary policy making. Yet, recent moves by Qatar and UAE central banks show that this needs not be the case.
In the past when inflation rates between GCC countries and United States were at similar level, it was okay for GCC central banks to blindly mimic Fed’s move. Amid today’s financial crisis, GCC central banks can exercise some independence over their monetary policies for the following two important reasons:
- Even so interest rates in the GCC region are higher than that of the U.S., capital is not expected to flow in the GCC area due to ongoing liquidity crisis in mature and emerging markets.
- The double-digit inflation in some GCC economies implies real interest rates are highly negative, which should discourage capital inflow.
Until very recently, GCC financial markets were flooded with hot money due to persistent speculation about revaluation of GCC currencies against the U.S. dollar. However, capital started to flow out from the region on the back of waning revaluation expectations.
In light of these developments, GCC central banks can afford to pursue their own monetary policy without undermining the fixed exchange rate system. Unlike the U.S., most banks in the GCC region are relatively well capitalized. For GCC central banks, the main issue is thus not to fix a liquidity crisis, rather it is to curb inflation. Mimicking Fed’s near-zero interest rate policy will only intensify the regional inflation problem. GCC central banks should capitalize the time to fix domestic inflation problem.