Hamish McRae: Free money could fail to ease the world's problems

The worst case of all would be a recovery that faltered and then flopped back
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The Independent Online

"Miss Smarty gave a party; no one came.

Her brother gave another; just the same."

The US party that successive interest rate cuts sought to promote has certainly fallen pretty flat, for we now know the US economy was shrinking even before the attacks of 11 September. The danger now is that the party for which the European Central Bank is sending out the invites will fall equally flat. In Japan they haven't partied for years, and here ­ well, let's see.

My point is simply that though all our experience shows that interest rates are an immensely powerful weapon, at best the lags before they kick in are uncertain and pretty long. And at worst, perhaps our experience (mostly in a high inflation era) may be wrong. Maybe cutting interest rates in a period of deflation is "pushing on a string".

It seems to be wrong as far as Japan is concerned, but then there are special reasons for that ­ the most serious being the burden of bad debts being carried by the banks. Having lent recklessly to associated companies many are in effect bankrupt and so cannot lend to other, more creditworthy ventures. The cycle of falling prices and in particular falling asset values increases the real burden of indebtedness even at near-zero interest rates. Falling prices mean that even very low interest rates in money terms may appear quite high in real terms.

The US is different. There is still positive inflation at a retail level, though there is so little pricing power that there is just a possibility that prices may suddenly flip negative. And at an asset level? Well shares are down but in general property prices have held up. So as yet there is no immediate danger of that particular aspect of the Japanese disease infecting America. US consumers, too, are unlike Japanese: they are spending rather than saving.

But now US rates are down to 2 per cent, you have to ponder. There seems to be two main concerns. The first is the string of rate cuts that started in January ought to have been showing some effect by September: you would expect something after about six months and that is eight. But as you can see from the graph on the left, which shows the new Goldman Sachs forecast for the US, the eurozone and the UK through next year, they really do not seem to have had much effect at slowing the decline. There were just a few signs that by August manufacturing was beginning to turn up ­ but not many.

That is not to say the Fed was wrong, nor indeed that it was ill advised to cut again this week. Had the Fed not cut so aggressively things would certainly have been much worse. But the worry must be there that the upside of the sharp and nearly symmetrical V-shaped recession predicted by Goldman will not materialise as forcefully as sketched. Once you are down to 2 per cent, there is not much ammunition left to fire. In fact you may even have a perverse effect: by cutting short-term rates so low you may worry people and drive up longer-term rates. One of the concerns of the Fed has been the refusal of longer-term rates to fall much.

The ECB, by contrast, has kept most of its shells in its magazine. It has popped off the occasional sighting shot when least expected and then refused to follow up when urged to do so by worried European finance ministers. Expect a bang today, for this time the ECB does seem to have enough good news on inflation to justify a cut on its own stringent criteria. But, assuming there is a cut, watch the impact on the markets. If there is no fall in long-term rates then its impact will be muted.

The eurozone seems to be following the US into a shallow recession, with the trough in the first quarter of next year rather than the last quarter of this (see the Goldman prediction). But for Germany the picture will be worse than that, for this relatively benign outlook will be heavily influenced by the smaller, faster-growing economies on the fringe of Europe. So an apparently mild recession for the eurozone as a whole conceals much misery in several other countries, including the largest one. The conventional view that the ECB is cutting too late is probably right.

Here? Well, that dotted line ­ if it is right ­ does not look too bad, does it? Saying that the UK will be the fastest-growing of the Group of Seven economies next year sounds impressive until you realise just how bad the others are likely to do. For the moment the signs of strong consumption are all about us: retail sales continue to boom and car sales are at record levels. Thanks to our propensity to finance home purchase on floating rate mortgages, lower interest rates feed directly into household finances. Whatever the Bank of England's monetary committee does today, it will still have plenty of shots left.

The UK apart, there is a potential nightmare. It is that the upswing charted here won't happen. There will be some sort of bounce next summer and autumn, but it may be a weak and ill-tempered one. The worst case of all would be a recovery that then faltered and flopped back, the W.

The problem for the world is that there will be no monetary shells left to fire. Look at the graph on the right. Suppose the US holds rates through the winter; suppose the ECB cuts to 2.5 per cent by the middle of next summer. Pretty impressive, eh? Not if you look at the graph and see that line scurrying across the bottom: Japan has had near zero rates through the second half of the 1990s. Money is free, but that makes no difference.

My guess is this particular nightmare will not happen. Instead there will be halting, uncertain recovery for both the US and the eurozone, with the US leading Europe out. So there will be a recovery but one that will take a less steep profile than the one charted here. The import of that is short-term interest rates will stay low for a long time.

Indeed we could have a long period, maybe years, when not much happens to short-term interest rates. That steep fall of US rates that took place this year will seem an interesting historical phenomenon. And our rates here, too, will tend to trickle down. Great news for borrowers? Yes ­ but see that in a context of flat, or maybe even declining house prices as inflation is remembered as a feature of the 20th century, just as stable or gently falling prices were a feature of the 19th.

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