Stephen King: Fed's faltering connection with economic realities
Tuesday 18 April 2006
I've been trying to sort out my broadband internet connection for the past three weeks. Sometimes it works, sometimes it doesn't. The whole thing is extremely frustrating.
Discovering why I'm having so many difficulties seems to be a case of trial and error. The boffins at BT have tried to help but have failed to come up with an answer. Meanwhile, I'm left pulling my hair out, staring at a screen that, on occasions, seems to have lost contact with the outside world.
The problems I'm facing are rather similar to the problems faced by central bankers. They, too, have to rely on connections. And these connections don't always work. I'm thinking of the linkages between changes in official interest rates - the things that central banks can obviously control - and their ultimate effect on the economy at large, either in terms of growth or inflation. Like broadband, sometimes these connections work extremely rapidly, delivering the desired effect. Sometimes, though, they work too slowly or not at all, leaving our policymakers scratching their heads in puzzled bewilderment.
The connections between changes in monetary policy and the economy at large all fall under the general heading of the "transmission mechanism" of monetary policy. This sounds like a useful scientific term, suggesting there are neatly engineered mechanical linkages between changes in interest rates and economic activity. Transmission mechanism is, though, something of a misnomer. If you purchased a mechanical device that had the reliability of the transmission mechanism, you'd quickly return to the shop and ask for your money back. The transmission mechanism is, in truth, one of the murkier areas in economics.
Yet we need to say something about it. The Bank of England may still be sitting on the fence, but the US Federal Reserve, European Central Bank and Bank of Japan are all tightening monetary policy and presumably have some sort of goal in sight. They know what they want to achieve - price stability and, hopefully, a bit of growth as well - but the lack of precision associated with the transmission mechanism suggests they could easily make mistakes along the way. A bit like driving a car with a faulty gearbox, the danger lies with central bankers who want to make progress but, by accident, throw the economy into reverse.
Of all the central banks, the Fed has, to date, been the most aggressive in slamming on the monetary brakes. Fed funds have risen to 4.75 per cent per cent from just 1 per cent three years ago. Alan Greenspan finished his monetary reign overseeing the biggest monetary tightening of his era and Ben Bernanke has carried on the tradition. Yet the US economy still appears to be growing at a robust pace. Does this mean monetary policy no longer works? Or that it works only with unpredictable lags? Or that Fed funds will have to rise a lot further before policy begins to have "traction"?
There's not a central bank in the world that could easily answer these questions. As with my broadband connection, the answer depends on a series of "trial and error" experiments. Unfortunately, when central banks are conducting these experiments, it's the economy at large that's the guinea pig.
For central banks, the problems lie with lack of knowledge about economic relationships and the near-certainty that these relationships are constantly changing. Think back to 1999 and 2000. Then, only modest increases in Fed funds led to a monstrous decline in stock prices and paved the way for the 2001 recession. Now, much more substantial increases in interest rates have led to scarcely a dent in the US's - and the rest of the world's - economic progress.
These variances should not really be so surprising when you think about the diverse ways in which monetary policy feeds through to an economy. Changes in interest rates affect asset prices, bank lending and exchange rates. They affect people's wage and price expectations. And, in each case, the effects are uncertain, because they depend on how people's expectations change. Monetary policy is, if you like, at the mercy of Keynes' animal spirits.
One mechanism that doesn't seem to be working to the advantage of the US these days is the emerging markets channel. During the 1990s, higher US interest rates often signalled disaster for emerging markets. Whether it was the 1994 Mexican crisis, the 1997 Thai crisis or the 2000 Argentinian crisis, US interest rates were heading upwards. Emerging markets back then were acutely vulnerable to the effects of tighter US monetary policy. When US interest rates were low, emerging markets attracted excessive capital inflows that typically led to domestic overheating, asset price inflation and big current-account deficits. Once US interest rates started to rise, however, the process went into reverse: capital headed for the exit, current account deficits could no longer be funded, and emerging market economies collapsed.
Oddly enough, this was all rather good news for the US economy. Rising US interest rates placed a lid on US inflation not so much because US growth slowed down but because the US, indirectly, benefited from the deflationary forces unleashed within emerging markets. Collapsing economies elsewhere in the world led to lower commodity prices and a strong dollar, at a stroke making US imports a lot cheaper. The US had, inadvertently, found a mechanism by which domestic inflation could be lowered without the need for domestic output losses.
This mechanism no longer works. Emerging markets have deliberately avoided running current-account deficits. Indeed, the offset to the ever-widening US current-account deficit has been an ever-growing emerging market current-account surplus. Partly a deliberate act of policy - China has no intention of going the same way as Thailand or Mexico in the 1990s - it's also a reflection of rising commodity prices, which have provided higher export revenues for the likes of Russia, the Middle East and some countries in South America. They, in turn, have benefited from the continuation of strong growth in China, India and other fast-developing areas of the world economy.
Unlike the 1990s, therefore, US monetary policy isn't having much of an effect elsewhere in the world. Commodity prices are still rising and, as a result, US inflation isn't behaving itself.
Perhaps this means that US monetary policy now has to hit home to achieve the right results. And maybe - just maybe - there are the first tell-tale signs that the US economy may slow later this year. With short rates and, more recently, long rates having risen, the US housing market could prove vulnerable.
Meanwhile, although markets are still worrying about higher inflation, any rise in either wages or import prices might eventually lead to lower profits, not higher prices. After all, globalisation tends to reduce company pricing power, so any cyclical upward pressure on costs is more likely, in my view, to suppress profits than to boost inflation, pointing to a weaker environment for investment. The avoidance of an emerging-market crisis in the light of tighter US monetary policy is, undoubtedly, a very good thing but it may mean that the US will eventually have to do more of its own adjusting to a world of higher interest rates. If only I could work out what needs to be adjusted to get my broadband connection working again ...
Stephen King is managing director of economics at HSBC
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