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Central bank doves in the ascendancy

Business surveys suggest the economy may be heading for a harder landing than predicted
ONE OF the reasons why monetary policy is superior to fiscal policy as a mechanism for the short term management of the economy is that interest rates are much more able to respond to changing circumstances than tax rates and government spending plans. In recent months, circumstances have been changing very rapidly, both in the UK and in the rest of the world, and the case for higher interest rates anywhere in the world has evaporated. The question on the table today is whether the major central banks should now be cutting rates.

Let us start with the UK. How does the debate on the conduct of monetary policy since the election now look? As usual, it is only possible to make definitive judgments on these matters several years after the event, so the following assessment is still very tentative. In my view, there remains a good case for arguing that base rates should have been increased more rapidly in 1997 in order to hit the consumer earlier and to persuade the foreign exchange markets that rates had well peaked before the start of 1998.

However, given that this was not achieved last year, it is no longer clear to me that the hawks on the MPC were right to argue for higher rates in the first half of this year. Without any doubt, Eddie George and DeAnne Julius, who were reluctant to raise rates from February onwards, have had their case strengthened by recent events.

When I last wrote about UK monetary policy a couple of months ago, I said that the case for higher base rates depended on assessment of the relative strength of two conflicting forces.

First, the increase in average earnings suggested that unemployment had fallen below its equilibrium rate, and that this implied that output was running as much as 2 per cent above its normal trend. Output would need to be brought back down to its trend level if inflation were to be controlled, and there was no case for delaying this correction.

Second, however, there was the question of whether output was already embarked on the necessary decline in response to earlier increases in base rates and the strength of the pound.

My conclusion was that output was indeed falling rapidly enough to control inflation on existing policy, so that further base rate increases were not needed. In August, the MPC concurred with this assessment.

Since then, new evidence has emerged on both the key questions outlined above. On the first, latest average earnings figures have been less worrying, and Robin Marris has presented evidence to suggest that much of the earlier rise in earnings was due to bonus payments. If he is right, then it is possible that earnings might decline more rapidly than normal as the economy slows.

Furthermore, the government statisticians are apparently preparing to reduce their previous estimates of GDP growth during the recent upswing by a cumulative 1-2 per cent. This would call into question whether output is as far above trend as had seemed likely on previous figures.

Meanwhile, on the second question, business surveys have continued to be very bleak indeed, suggesting that the economy may already be embarking on a harder landing than has been built into consensus projections. The CBI, which had previously remained quite sanguine in the face of plummeting confidence readings in its own survey, is now talking of three successive quarters of zero growth in the economy, which would be more than enough to achieve the necessary correction in output.

Consequently, both of the key forces have moved in a direction which is dovish for UK interest rates. The question of rate cuts will soon be on the agenda, and how soon we will see them announced depends largely on the path for sterling. This in turn hinges to an important extent on what happens to interest rates in the rest of the world.

For most of this year, it seemed very obvious that the relative balance of domestic monetary conditions in the major economies needed to be altered. Given the sharp tightening in labour market conditions in the US, the Federal Reserve was seeking an early opportunity to raise the Fed Funds rate. Equally obviously, Japan and the rest of Asia were desperately seeking ways of easing domestic monetary conditions, but were being thwarted by the chronic weakness of Asian exchange rates. While it was very apparent that this change in relative monetary conditions was desirable, it was not so clear whether the overall stance of monetary policy in the OECD as a whole needed to be tightened or eased.

This has now been clarified - it needs to be eased. This is because the possibility of new shocks emanating from the financial markets has significantly increased the risk of a global recession in the next couple of years.

Financial markets have lately been characterised by an increase in risk aversion by global investors, especially in the area of emerging markets. With investors asking for higher returns for holding emerging market assets, the cost of capital has risen sharply in Asia, Latin America and Eastern Europe. Individual episodes such as the collapses of Indonesia and now Russia should be seen in this light. As these collapses have occurred, there have been important contractionary effects on the developed Western economies, initially working through trade linkages, but potentially later beginning to affect business and consumer confidence in the Western economies themselves. Eventually, these emerging market shocks have undermined confidence in western equity markets, causing a rise in risk aversion in these marketsas well..

The table shows how the prospects for world growth in the next two years could be eroded by a succession of emerging market and stock market shocks. In the absence of any such shocks, growth in the developed countries would have been a healthy 2.7 per cent next year. The Asian shock that has already happened ( "Asia 1") is likely to reduce this to 2.2 per cent. If there were further disorderly devaluations in Asia and Latin America, this would reduce the OECD growth rate to only 1.8 per cent. And if this were enough to trigger a sustained 30 per cent correction in global stockmarkets (compared with the July peak), the global growth rate would drop to only 1.0 per cent next year. This would be the third worst out-turn in any calendar year since the war, and suddenly talk of outright price deflation in the Western economies would no longer look so fanciful.

Fortunately, none of this has happened yet, and all of it is amenable to correction by timely action from the central banks. They essentially have two options. One is to wait and see whether financial market turbulence will quieten down of its own accord, and only to reduce interest rates if there are further major accidents, such as a devaluation in China, Hong Kong or Brazil. The other is to seek to head off the risk of such accidents by easing monetary policy in the US and Europe in a pre-emptive fashion, essentially seeking to give currency and equity markets a clear signal to calm down.

Central bankers are a cautious breed but even they might soon begin to think that just such a pre-emptive easing might be a prudent stitch in time.