I have come to know more about Cincinnati house prices in the past month than any sane person could wish for in a lifetime. For all of us in financial markets today, the US is central to our understanding of what is going on, with the eurozone somewhere just behind. But sometimes we need to take our eye off what is happening centre stage, and check in the wings. No more so than at present.
The Federal Reserve rate cut was the turning point in global markets this year. Will the gamble work? My money is on a broadly favourable outcome. Critics of the Fed argue the opposite – that there is a danger a measure taken to restore confidence among bankers will have unforeseen macro-economic consequences, mainly letting the inflationary genie out of the bottle. Balderdash. Sure, the dollar depreciation that this move ushered in will add marginally to inflationary pressures. But as most US imports are priced in dollars, not least oil and other commodities, this pressure will be minimised. The deflationary impact of the US housing slowdown, on the other hand, is huge. As is the dent to confidence that this and the financial gyrations will cause in the coming months.
Beyond this, a very significant factor is the continuing tightening of monetary policy, not just in official interest rates but also the prevailing market rates. This is deflating euroland and the US by an additional, hidden, 0.8 per cent and 0.4 per cent respectively above their official lending rates. In the UK the figure has been even higher at some points, coming close to 1.2 per cent above base rate. This means the Fed cut takes actual US rates barely back to where they were in July, while those in the eurozone and the UK remain way above.
No wonder Jean-Claude Trichet, President of the European Central bank, left rates on hold last week and removed the key word "accommodative" from his commentary. Accommodative, my eye! Euroland has had the equivalent of three rate hikes since July, a massive deflationary squeeze from the appreciation of the euro, and knocks to confidence in Germany, its largest economy. As the French leadership has been pointing out, in seeking to save "Wall Street's skin", the Fed may have transferred problems to Europe by way of the dollar. The need for the ECB to start cutting is clear.
The party is over in the world's two largest economies. The same is not true in emerging markets, which are roaring ahead. So far this year, Shanghai is up more than 107 per cent. And since the lows of the credit crunch, Hong Kong has rallied by an incredible 40 per cent. There are similar tales in Latin America, emerging Europe and the Middle East.
This would all be fine – indeed understandable given excellent long-term growth prospects – if we were not seeing worrying signs of inflation across these markets, particularly for those trapped in the dollar zone. Exactly the same factors that are operating in the US – which give me confidence the economy will weather this storm –are acting in reverse here.
All of these markets are seeing strong growth in local demand reflecting their economies (the opposite to US factors). Chinese GDP growth at a massive 12 per cent has ushered in a 15 per cent rise in retail sales. India is growing at 9.3 per cent, Russia at 7.8 per cent, most of Latin America at between 5 and 8 per cent. Crucially these rates often lead to a worrying pick-up in inflation, dwarfing US levels; China's has now reached 6.5 per cent.
For many in the dollar zone, interest rates should be going in the opposite direction to the US. The Fed's action will make exports cheaper, boosting growth ansd exacerbating the inflationary risks. The risks of overheating are severe, and will only be successfully navigated where manufacturing price deflation can be delivered by productivity growth. This is working for the moment in China – producer prices are growing at only 2.2 per cent. But for a host of weaker economies, currency depreciation at a time of overheating could lead to a loss of control of the inflationary spiral.
The Fed acted correctly, and MrTrichet will follow. If anyone, it will be the jobless of the emerging world who "pay for saving Wall Street's skin".Reuse content