Stephen King: The Fed cuts rates while the ECB frets over inflation. Which one has it right?
Monday 04 February 2008
Are we staring into a recessionary abyss? Or are we facing an inflationary blow off? Returning from Norway last week, I grabbed a copy of the European edition of the Financial Times. The main headline made for disturbing reading: "Eurozone inflation soars to 14-year high". Now, call me old-fashioned, but I think of soaring inflation as something rather unpleasant. In my childhood, UK inflation was, for a while, running at over 20 per cent per year. Could the eurozone be suffering a similar fate?
Fortunately, inflation within the eurozone is not, yet, in that league. In fact, the inflationary surge in January was, by past standards, rather small. With perhaps an overdose of hyperbole, the FT was referring to an increase of eurozone inflation to 3.2 per cent in January from 3.1 per cent in December. Sitting in the frozen tundra that provides the setting for Oslo's airport, it was difficult to see this rise as an indication of serious economic overheating.
However, for the European Central Bank (ECB) this is an inflation rate a good percentage point too high. The ECB's self-proclaimed inflation target is "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 per cent. Price stability is to be defined over the medium term." For some ECB members, notably those of a Germanic temperament, the latest inflation news is enough to bring on a dose of the vapours: left to their own devices, some members of the ECB would probably shove interest rates up a notch or two.
This, though, is surely not the right approach. The explicit reference to "the medium term" suggests that the European Central Bank, like other central banks, can afford to be flexible on inflation.
The ECB would doubtless argue that, with the forthcoming wage round in Germany, it would be wrong to be too relaxed in the light of an inflation rate which has strayed a little too far from target. The last thing the ECB wants is to underwrite wage demands which might, in time, lead to higher inflation. But how big a threat are the wage increases? First, they relate mostly to Germany, which may be the biggest economy in the eurozone but certainly doesn't account for the majority of the eurozone economy. Second, even if wage increases did come through, higher inflation need not follow. The eurozone economy is slowing down. Higher wages would, in these circumstances, trigger higher unemployment, not higher inflation. And, the last time I looked, the ECB didn't have an unemployment target.
While the ECB refuses to cut interest rates, the Federal Reserve has been slashing rates with gay abandon despite an inflation rate of over 4 per cent. Presumably, in the Financial Times' hyperbolic lexicon, this would be described as "hyperinflation." On the face of it, then, the Federal Reserve and the ECB have very different views about monetary policy. One central bank has members itching to raise interest rates with inflation a touch over 3 per cent. The other is full of members providing some of the biggest rate cuts ever seen despite inflation of over 4 per cent.
Imagine a cocktail party hosted by Messrs Trichet and Bernanke. Might it be that, with a few drinks inside them, members of the two central banks would engage in verbal (and possibly physical) fisticuffs as they berated each other for reaching the wrong policy decisions? And what if members of the Bank of England's Monetary Policy Committee were invited along? Would they, in turn, be split asunder, with some sidling up to members of the Federal Open Market Committee, others choosing to mix with the Bundesbank boys, with the remainder standing in the middle of the room, unsure of their avian preferences?
I am, of course, being a little unfair. The US housing market has been in a state of collapse for a couple of years now. On Friday, we discovered that employment had fallen by 17,000 in January, the first drop in four and a half years. In the eurozone, the signs of weakness are nothing like as worrying and, even in the UK, the property market has only recently hit a brick wall. Cyclically, then, there are plenty of reasons for the ECB and the Bank of England to exercise more caution than the Fed. Moreover, the ECB and Bank of England could argue, with plenty of justification, that the Federal Reserve has, for too long, made a habit of taking its eye off the inflationary ball. The Fed spent most of its time in the middle years of this decade looking at so-called "core" inflation, which excludes the supposedly volatile bits like food and energy. For the most part, this measure behaved reasonably well. However, far from being volatile, food and energy prices rose year-in, year-out, a reflection of persistently higher demand for raw materials from rapidly industrialising countries such as China and India. The inclusion of these items suggests that that Fed's recent record on inflation has been, at best, patchy (see charts).
Indeed, earlier overly loose US monetary policy may have contributed not just to higher inflation but also to the housing bubble which has now left the world in a sub-prime mess. If this is true, why criticise the ECB or the Bank of England for being slow off the mark?
For me, all three central banks need to think carefully about three key issues. First, they have to consider their economies' vulnerability to the sub-prime crisis. Although the knee-jerk reaction is to see this as purely an American phenomenon, the crisis has, in my view, spread out on both sides of the Atlantic. There are plenty of sub-prime borrowers in the UK and Spain. Meanwhile, many of the investors in asset-backed securities (the pieces of paper which provided the fuel for the housing fire) who, now, are losing money, are based in Europe. And it's not only in New York that banks are under pressure. We are seeing the beginnings of a transatlantic credit crunch.
Second, they need to think about the second-round effects stemming from the sub-prime crisis. It's easy enough to argue that Germany, for example, has little direct exposure (not withstanding the problems faced by IKB and Sachsen LB last year). However, this ignores Germany's trade vulnerabilities. Germany, after all, is an economy which does well when everybody else is doing well, but tends to be hit for six when other economies suffer.
Third, the central banks need to consider inflation in a medium term context. Yes, inflation is a little too high at the moment. But to worry too much about current inflation and, as a result, to stand idly by while the financial system is in danger of imploding would be a huge error. It is, after all, what the Japanese did at the beginning of the 1990s, before their economy tumbled into deflation. The defence of inflation credibility can, sometimes, be taken too far. In my view, then, both the ECB and the Bank of England should cut rates this week. Only the Bank, though, is likely to oblige.
Stephen King is managing director of economics at HSBC email@example.com
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