Stephen King: Fasten your seatbelts: the road could get bumpy

We may have just discovered that the global economy is like a car without a driver
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The Independent Online

It's that sickening moment when you hear the crunch of metal and glass, a sudden emptiness in the pit of your stomach as you step out of your car to inspect the damage. Car crashes are never fun, even if you're lucky enough to escape without any serious injuries.

We've just been through four years of excellent economic performance. The global economy has been expanding at a fast pace. Policymakers neatly sidestepped the deflationary risks that dominated economic thinking in 2002 and 2003, paving the way for a solid rebound in economic activity. Financial markets have shown a strong recovery, helped by buoyant corporate profits. And fears of a major dollar collapse have been held at bay, despite the ongoing rise in the US current account deficit.

Too good to last? Are we at the beginning of an economic car crash? These are not the same as your normal car crash: they often happen in slow motion. The 1987 stock market crash may have been quick, but the 2000 crash went on for months. Quick or slow, though, economic smashes are unpleasant affairs.

There's little evidence of a pile-up from the data: business surveys are strong, consumer confidence has been buoyant, labour markets have strengthened and growth has been encouraging. If there are clouds, they're associated with rising inflationary pressures: higher oil prices, a bit of pressure on wages and higher headline inflation. Yet, as the Federal Reserve is keen to remind us, so-called core inflation, excluding food and energy prices, has been mostly well-behaved.

Financial markets, though, are looking jittery. This nervousness was first seen in government bond markets, where long-term interest rates have been rising. Ten-year Treasury yields ended 2005 at a little under 4.4 per cent but they're now approaching 5.2 per cent. Currencies came next: the dollar is now down about 7 per cent against the euro, yen and sterling. And, right at the end of last week, the anxiety spread to the world's stock markets.

If, though, the economic data has been so benign, why are financial markets so nervous? My sense is that this anxiety recognises two truths: first, the economic challenges facing policymakers have got trickier in recent months and, second, markets are beginning to lose confidence in the ability of our policymakers to deal with these challenges.

The challenges are the old chestnuts: inflation and global imbalances. Policymakers, though, are finding it difficult to get the right message across. The Federal Reserve wants to indicate that US short-term interest rates are close to a peak. As its Governors put it after last week's rate increase: "Some further policy firming may yet be needed to address inflation risks but the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information."

Put another way, the Federal Reserve thinks it's achieved its strategy of getting rates back to neutrality and is happy to allow interest rates to meander around in line with the volatility of economic data from one quarter to the next.

The difficulty with this approach, however, lies in communicating an appropriate message to the markets. For the Bank of England and the European Central Bank, sending out a message is straightforward: it's all done with reference to the inflation target. For the Federal Reserve, however, there's no specific objective and, hence, no benchmark against which to judge changes in policy actions. The Federal Reserve may believe that rates should peak soon but, at this stage, it's not obvious why.

The topic of global imbalances went into hibernation last year, largely because the dollar strengthened despite a widening US current account deficit. Higher US interest rates played a role, although the dollar's 2005 rebound was modest when benchmarked against the dollar's performance during earlier periods of sustained monetary tightening. Underneath the surface, therefore, the threat coming from global imbalances lingered on.

As a topic, imbalances have made a return for three reasons. First, if US rates are going to peak sooner rather than later, the dollar's vulnerability to trade imbalances will be revealed more clearly. Second, the G7 is signalling not only that it is concerned about imbalances but also that it knows who has to adjust: as the 21 April G7 statement put it: "Greater exchange rate flexibility is desirable in emerging economies with large current account surpluses, especially China, for necessary adjustments to occur." Third, if China really is the G7's culprit, why did the US Treasury Department refuse to label China a currency manipulator last week, despite threats to the contrary?

All of this smacks of policy confusion: mixed messages that leave markets feeling anxious. Put another way, we may have just discovered that the global economy is like a car without a driver: it can accelerate down a straight road but, come the next bend ... well, you can guess the rest.

What are the chances of finding a driver that can put the global economy, and markets, back on track? Another few lines from the G7 statement provide a possible answer: "We support a new remit for bilateral and multilateral surveillance by the IMF. An ad hoc quota increase would help better to reflect members' international economic weight. We agreed on the need for ... reform of the IMF."

The IMF is, therefore, to be rebuilt to play a new role in the 21st Century. Not so much the world's economic driver, more its traffic policeman, with responsibilities to ensure that all its members play by the rules. The difficulty with this ambition, though, is that the IMF has little credibility in some parts of the world, particularly in Asia where it is seen as the rich industrialised world's mouthpiece.

And that may be one reason why the US Treasury Department refused to label China a currency manipulator. Better to leave any assessment of China to a restructured IMF than have an IMF that parrots a view already expressed by the US: that wouldn't look like independence at all.

If the IMF is to be successful in performing its new functions, quotas - which determine voting power - need to be changed. There are oddities in the relative weights of different countries within the Fund. The US quota is 17 per cent, followed by Japan and Germany with 6 per cent. China has a quota of 3 per cent, which puts it behind Saudi Arabia, on a par with Canada and not very far ahead of the Netherlands or Belgium. And, as these countries have no desire to give up their quota shares, it's going to be tough to achieve the necessary reforms.

Hopefully the big car smash will be avoided but you should fasten your seatbelts because, unless the global economic policeman becomes a reality, it's going to be a bumpy road ahead.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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