Stephen King: Central bankers must place bets in a game where losing is easy

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The Independent Online

As they gather around the roulette wheel that increasingly signifies the global economy, what bets will the world's central bankers be making?

We're now in a high-stakes game where losing is all too easy. Finding themselves in a Las Vegas gambling den, Messrs Bernanke, King and Trichet are discovering that the odds are very much stacked against them. They're not the only ones. Governor Zhou Xiaochuan of the People's Bank of China (PBOC) is also, no doubt, wondering whether his lucky economic numbers will still keep coming up.

To understand why life is currently so difficult, it's worth dwelling on the conflicts which are giving central bankers such headaches. After its last policy meeting, the Federal Reserve summed it all up. There were, apparently, downside risks to growth but, at the same time, upside risks to inflation. Mervyn King. Governor of the Bank of England, said very much the same thing at last week's Monetary Policy Committee performance in front of the House of Commons Treasury Committee.

Most of our central bankers are, then, busily paraphrasing Hamlet. "To cut, or not to cut, that is the question." Only Jean-Claude Trichet has remained unbending in his fight against inflation.

Why has life become so difficult? The answer is simply that central bankers are not very good at making leaps of faith. They prefer to believe that the relationships between official interest rates, economic growth and inflation are stable over time. After all, these relationships form the bedrock of inflation-targeting regimes. Without them, why would anyone believe in a central bank's capacity to meet its inflation target?

Awkwardly, though, economic relationships evolve in sometimes unpredictable ways. The developed world is facing two contrasting shocks. The collapse in the value of financial assets hitherto associated with a booming US housing market has led to money hoarding, remarkably high interest rates within the banking system and the first signs of a credit crunch. This process threatens economic growth. Meanwhile, strong activity in emerging markets is driving up oil and food prices, thereby raising import prices in the industrialised world and, hence, threatening higher inflation.

It's easy enough to argue that central bankers should look through current elevated inflation rates and that, in time, the US credit crunch will restrain growth and act as a deflationary influence. But, to date, there's little hard evidence to support this view. There may be a money market crisis but, so far, there have been few signs of a crisis in either growth or jobs. So rate cutting is not the easy choice it might appear to be. Our central banks would doubtless be blamed for cutting rates should growth subsequently rebound, driving asset prices back up and stoking the fires of inflation. Equally, though, our central banks would presumably be blamed for not cutting interest rates quickly enough should the current credit seizure lead to a recession.

The case for rate cuts is, however, getting stronger. Even without leaps of faith, there are a number of tell-tale signs that all is not well. The Federal Reserve, for example, has already been lowering interest rates, but the financial market reaction so far has been less than encouraging. If the excuse to cut rates in August was financial market turmoil, that excuse is just as valid today.

Sometimes, rate cuts act like a shot in the arm, giving financial markets a much-needed boost which quickly puts the economy back on the path to recovery. This time around, though, the Fed's actions so far appear to have come from a particularly blunt syringe. The charts show why. On the occasion of each interest rate cut, financial markets have initially reacted with some degree of enthusiasm, but like the heroin addict who cannot face cold turkey, markets continue to demand more and more. Having been hooked on credit, they cannot cope with a world in which credit is being withdrawn on an almost daily basis.

Should the Federal Reserve and, presumably, in a matter of weeks, the Bank of England be feeding the junkies' habits? The answer, I think, is "yes", but not for reasons connected with bailing out the greedy and reckless. Central banks connect with the real economy through the financial system. Their actions work only after being filtered through the banks and other financial institutions which ultimately lend money to the likes of you and me. If that filtering system becomes clogged up, monetary policy loses its power. And central banks without power are no good to anyone. Current rate actions, then, are consistent with a plumber unblocking a drain: failure to do so could lead to a collapse in the whole system.

What of inflation? In my view, this should be seen only as a secondary consideration. The primary objective must be to get the system working again. The alternative is too unsettling to think about. When financial systems implode, the economy typically follows soon after, as anyone who lived through the late 1990s Asian crisis, Japan's ongoing deflation or, at the extreme, the Great Depression would surely attest. There are, of course, those who say that feeding the credit habit will, ultimately, be of no use to anyone, but that really isn't the point. Like it or not, we're all dependent on the fluid functioning of the financial system. Without it, the connection between borrowers and lenders is severed, and economic progress becomes near-enough impossible.

Difficult decisions are not, though, confined to the US and Europe. For the emerging markets, economic life is also becoming more complicated. For months now, the People's Bank of China has been warning of inflationary excesses, a view that was spelt out particularly clearly in the PBOC's third-quarter monetary report. It's not difficult to see why: after years in which Chinese consumer prices have been more or less flat, inflation has accelerated rapidly in recent months, heading above 6 per cent. Although partly a reflection of higher pork prices in response to the spread of blue-ear disease, there's no doubt that the authorities are increasingly recognising that inflation has the potential to become a major problem.

The majority of western policymakers offer a simple answer: to deal with inflation, China should let its currency revalue at a much faster rate. But life isn't quite so simple. Imagine that China revalues significantly and then discovers that the US economy has plunged into recession. This wouldn't look too clever. Suddenly, the Chinese authorities might find themselves staring their own recession in the face. Imagine, instead, that China refuses to revalue. Meanwhile, rate cuts from the Federal Reserve prevent the Chinese from tightening domestic monetary policy (because, if they did, the exchange rate would come under too much upward pressure against the dollar) and, simultaneously, generate a strong rebound in US economic activity through 2008. Under those circumstances, it's not so difficult to imagine China's current inflation worries turning into a major inflationary crisis.

It's easy enough painting scenarios. It's a lot more difficult making a bet on one particular scenario at the expense of all others. The trouble, though, with sitting on the fence is that you're in danger of ending up in the worst of all worlds. By the time data emerges to confirm the right course of action, the opportunity to act may already have passed. Time, then, for our central banks to place their bets. The roulette wheel is already spinning.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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