Reluctant party-poopers

Sep 21st 2005
From The Economist Global Agenda

Despite the economic impact of Katrina, which dealt a stiff blow to America’s oil markets, the Federal Reserve has once again raised interest rates by a quarter of a percentage point. With high fuel prices threatening to bring on both inflation and recession, being a central banker is harder than it used to be

WILLIAM McCHESNEY MARTIN, a past chairman of America’s Federal Reserve, famously observed that the job of a central banker is to “take away the punch bowl just when the party is getting started”. Unsurprisingly, this often generates quite a bit of hostility from the party-goers, who would prefer a few more shots of low interest rates to really get things going. This accounts for the tendency of many central bankers in years past to err on the side of easy money, resulting all too often in double-digit inflation.

Of course, if the party gets out of hand, and the house is wrecked, the central banker can expect to come in for plenty of censure, even from those who were previously begging him to give them just one more for the road. After the excesses of the 1970s, and the hangover of the early 1980s, it was thought that monetary authorities had learned their lesson. Twenty years on, most developed countries seem to have built a solid reputation for inflation-fighting; even lax Italy has been brought under the discipline of the European Central Bank (ECB). And developing countries, seeing the results, seem to be genuinely interested in keeping inflation in check.

And yet this is a worrying time to be a central banker. Though global economic growth is strong and inflation tame, powerful imbalances are building beneath the surface, and they threaten to throw the world economy off course. The fight against inflation is, it turns out, just one battle in a wider war.

It is hard, of course, to feel too sorry for the Fed’s Alan Greenspan, who enjoyed rock-star-like levels of popularity in the late 1990s, when America happily handed him the credit for its long economic boom. Nonetheless, he now finds himself deep in uncharted waters. After cutting short-term interest rates to just 1% to help ease the country out of the 2001 recession, he has been raising them at a measured pace, trying to keep the economy from overheating. The Fed’s hawkish credibility, along with cheap goods from China and other low-wage countries, has helped to keep consumer-price inflation relatively tame despite exceptionally loose monetary policy.

Asset-price inflation is another story. Though America’s stockmarkets are quiet compared with the go-go 1990s, its housing market looks decidedly frothy. Consumers have tapped into home equity and cut back saving to virtually nothing in order to finance their continued spending. As a result, they are dangerously overstretched and vulnerable to any change in interest rates. A sharp correction in the housing market could give the economy convulsions. There are similar worries in Britain, whose central bank cut interest rates in August as the (so far) gentle deflation of the country’s housing bubble contributed to a sharp slowdown in consumer spending. The Bank of England left rates unchanged this month, but with fears growing that economic expansion will fall short of expectations, it may soon have to choose between fighting inflation and staving off Britain’s first recession in over a decade.

The Fed may well face the same tough choice. Hurricane Katrina roared into already tight oil markets, damaging much of America’s oil-pumping and -refining capacity, and another hurricane, Rita, threatened to wreak more havoc along the Gulf coast this week. With the petrol price hovering around $3 a gallon and America’s consumers already living beyond their means, another recession no longer seems impossible. Nonetheless, the Fed continued to play the party-pooper this week, raising rates by another quarter of a percentage point, to 3.75%, at its meeting on Tuesday September 20th. Katrina’s inflationary effects, it concluded, were more worrying than its direct impact on GDP growth.

Nonetheless, both effects are causing concern, and this has led to renewed talk of stagflation, a central banker’s worst nightmare. With its combination of slow growth and fast inflation, stagflation presents the monetary authority with a dreadful dilemma: lower rates and let inflation run away, or raise them and throw even more people out of work. So far, there is little evidence of real danger. But given that higher energy prices generally boost inflation and shrink demand, it is not unreasonable to worry about the future.

Yet Mr Greenspan and Mervyn King, the Bank of England’s governor, have it easy compared with Jean-Claude Trichet, the head of the ECB, monetary guardian of the euro area. Mr Trichet presides over a currency zone more diverse than America’s, but without the fiscal stabilisers that help smooth over regional variations. In 2004, Portugal’s economy grew by 1%, Ireland’s by almost 5%, but both had the same nominal interest rate. This has the perverse effect of giving higher real (inflation-adjusted) interest rates to slow-growing, low-inflation countries, and lower real rates to booming economies with rapid inflation—precisely the opposite of what a sound monetary authority would prescribe.

Yet Mr Greenspan and Mervyn King, the Bank of England’s governor, have it easy compared with Jean-Claude Trichet, the head of the ECB, monetary guardian of the euro area. Mr Trichet presides over a currency zone more diverse than America’s, but without the fiscal stabilisers that help smooth over regional variations. In 2004, Portugal’s economy grew by 1%, Ireland’s by almost 5%, but both had the same nominal interest rate. This has the perverse effect of giving higher real (inflation-adjusted) interest rates to slow-growing, low-inflation countries, and lower real rates to booming economies with rapid inflation—precisely the opposite of what a sound monetary authority would prescribe.

The Fed’s hawkish credibility has helped to keep consumer-price inflation relatively tame despite exceptionally loose monetary policy. Asset-price inflation is another story
Moreover, the euro area as a whole has grown slowly: by just 2% in 2004, according to statistics from the Organisation for Economic Co-operation and Development, compared with 3.1% in Britain and 4.2% in America. For this, the central bank has taken a disproportionate share of the blame. Critics say that the ECB, which has left interest rates unchanged at 2% for more than two years, is paralysed, unable to look beyond its inflation-fighting mandate to deal with Europe’s economic malaise.

The reality is more complicated. The euro area’s economic woes have much more to do with tight fiscal policy and structural rigidities in its markets, particularly those for labour, than with any bottlenecks in the money supply. Real interest rates have actually been near zero in the euro area for much of the past two years, making monetary policy relatively loose. But because continental Europe’s mortgage markets are less sophisticated than those in Britain and America, changes in interest rates do not filter through as easily to consumer demand, limiting the effects of monetary loosening. And the ECB, like its American and British counterparts, must contend with high oil prices pushing up the inflation rate and hindering growth.

In Asia, too, central bankers are having to deal with the fallout of higher oil prices. In Indonesia, rising prices for the country’s oil imports, paid for in dollars, recently sparked fears of a currency crash. The central bank seems to have staved off the crisis, but only by raising interest rates three times in the past month.

China’s central bank faces a different set of problems. To keep the yuan cheap enough to subsidise China’s massive export industries, it has had to buy billions of dollars and pour them into American bonds. The longer this goes on, the more vulnerable the bank is to a fall in the value of the dollar, which would in turn sharply decrease the value of its bond stockpiles. But fears of the domestic political unrest that might occur if the export sector faltered keep the bank from reducing its exposure to the dollar. Moreover, the massive currency operations create domestic inflationary pressure, which the bank struggles to contain given the primitive state of China’s financial markets. No matter where you are, it seems, being the central banker is no party.

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