Giving thanks, despite the monetary murk

Nov 24th 2005
From The Economist Global Agenda

The past week has brought signals of a shift in monetary policy in both Europe and America, leaving traders anticipating higher rates in the euro area and a levelling-off across the Atlantic. Monetary guardians are struggling to read the outlook for inflation, but things could be worse

THE day before Thanksgiving is generally a dull time in American offices, as workers lackadaisically shove papers around their desks until it is time to knock off early for the holiday. But on Wednesday November 23rd, currency traders were kept busy trying to predict which way interest rates were going to go. A flurry of news out this week about the plans of central bankers in America, Britain and the euro area brought about a swift change in expectations that had seemed set in stone for the past year.

The euro area’s monetary guardian, the European Central Bank, which has kept interest rates at 2% since June 2003, is finally preparing to raise them as Europe’s economies begin moving out of the doldrums. Last Friday, Jean-Claude Trichet, the ECB’s president, signalled that the bank would start tightening at its next meeting, on December 1st. And this week, the minutes of the most recent meeting of the Federal Reserve’s governors suggested that American monetary policy might be heading in an unexpectedly mellow direction. Foreign-exchange markets reacted immediately, sending the dollar lower against the euro.

But as more information surfaced, the market calmed down a bit. The Fed may be preparing to end its “measured” monetary tightening—12 quarter-point increases since June 2004—in the not-too-distant future. But most people still expect that its benchmark rate, currently 4%, will reach at least 4.5% before the increases stop. This is thanks in part to Jeffrey Lacker, the president of the Richmond Federal Reserve, who will be a voting member of the Fed’s rate-setting body next year. After the minutes were released on Tuesday, he said it was clear that the Fed was not done tightening. In Europe, Mr Trichet has also rushed to calm fears of change, assuring markets on Monday that the ECB’s proposed tightening does not necessarily constitute a trend. So the interest-rate spread between America and the euro area may remain roughly the same for a while yet.

Meanwhile, Britain’s central bank has signalled that it is in no hurry to move rates in either direction. On Wednesday, the Bank of England released the minutes from its November meeting, revealing that its decision to leave rates at 4.5% was unanimous. Though inflation slackened in October, to 2.3%, it is still above the Bank’s target of 2%. But after more than ten years of robust economic growth, even when America and the rest of Europe were decidedly anaemic, Britain’s economy has faltered over the past year. This prompted the Bank’s monetary policy committee to lower rates in August. Since then, however, it has sought to dampen market expectations of further cuts. It wants to be sure that the rise in consumer prices does not trigger a rise in wage inflation.

Core issues

All of the central bankers may soon find themselves confronting a growing problem: what to do when core consumer-price inflation (excluding volatile energy and food prices) diverges from the all-inclusive headline figure. In all three monetary areas, core inflation is relatively low. But high energy prices, driven by roaring Chinese demand, security concerns in the Middle East and hurricane damage in the Gulf of Mexico, are putting substantial upward pressure on the headline figure. In the year to September, it was 4.7% in America, the highest level since 1991—though it dipped to 4.3% for the year to October. This raises the spectre of Alan Greenspan’s leaving office with a higher rate of inflation than when he entered it.

Central banks usually focus on core inflation, because energy and food prices, which tend to swing more than the cost of other goods, can distort the picture. What central bankers want to know, above all, is whether the supply of money is big enough to meet the demand for money, without exceeding it (which is what leads to inflation). If the prices of a few commodities rise while other prices stay low, this indicates that short supply of those commodities, rather than excessively loose monetary policy, is the culprit. This has certainly been the case in America, where September’s soaring inflation was due largely to high petrol prices at the pump.

Over time, however, things get more complicated. Because energy is such a crucial part of the economy, if prices stay high for a prolonged period, they will both raise the inflation rate and lower the rate of economic growth. In extreme situations, this can result in the “stagflation” that afflicted the rich world during the 1970s, in which growth stagnated while inflation soared into double digits in many countries.

Once inflation has started to race away, it is hard to stop. After inflationary expectations take hold, they get built into contracts for labour, goods and services, perpetuating a vicious cycle. As Fed chairman in the early 1980s, Paul Volcker had to raise rates to nearly 20% in order to convince markets that he was serious about fighting inflation. The gambit worked, but it plunged America into its worst recession since the second world war.

That is why the ECB is determined to raise rates, even though the recovery in several of its largest economies is still fragile. Once credibility as an inflation hawk has been lost, it is devastatingly expensive to regain, and the euro area’s central bank wants to make sure that in its first years of life it develops a reputation for being tough.

Thankfully, although high oil prices are undoubtedly having an effect on economic growth in rich countries, it has so far been limited—thanks, many think, to the energy-saving policies implemented in the 1970s, particularly in Europe. In America, where petrol usage is more profligate, the pain may be felt more keenly. But so far growth remains strong, giving the Fed leeway to resume tightening if the situation calls for it. Central bankers face some difficult choices in the months ahead. But for now, they still have much to give thanks for.

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