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Reduction of Global Liquidity and Its Impact

Reduction of Global Liquidity and Its Impact

KWON Soon-Woo

Aug. 7, 2006

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The central banks across the world have maintained a low interest rate policy since 2001 to deal with economic slowdown caused by bursting of bubble in the information and technology industry. The US maintained a low interest rate policy until June 2004, the EU until November 2005 and Japan until March 2006. The low interest rate policy sustained for a prolonged period of time has resulted in global excess liquidity. In the first quarter of 2006, the liquidity level was 21.5% higher than the long-term trend in the US and Japan as well as in the Eurozone.

The protracted maintenance of low interest rate policy and the ensuing excess liquidity have prevented the global economy from falling into recession. However, it has caused real estate prices to soar around the world and sent stock prices higher in emerging markets that have absorbed excess liquidity. Alan Greenspan, former chairman of the Federal Reserve Board, said the current excess liquidity and the ensuing asset price surge are a once-in-50-year phenomenon. Excess liquidity and oil price hikes have put upward pressure on consumer price. The US consumer price now grows by more than 4% and Japan's consumer price has ended its downward trend and has increased for the past six months in a row. An increase in core inflation (a measure of inflation excluding price movements from external shocks) has put more upward pressure on consumer price.

Concerned by the negative effects of excess liquidity, the US and the EU raised interest rates. The US, which had aggressively cut its interest rate, was quick to change this policy. It has raised the federal fund rate 17 times since June 2004, increasing the rate from 1% to 5.25%. As a result, the US has already reduced a considerable part of excess liquidity. Since December 2005, the European Central Bank (ECB) has raised its policy interest rate three times from 2% to 2.75%. Japan, a main source of international liquidity, eventually joined the global move by raising interest rates on July 14, 2006. The Bank of Japan ended the quantitative easing policy on March 9, 2006 and raised the benchmark overnight lending rate by 0.25% on July 14, 2006. With Japan raising its interest rate, global efforts to reduce excess liquidity will be accelerated.

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