Stephen King: The policymakers are all agreed. But are they right?

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The Independent Online

When there's an overwhelming consensus, it's often wise to think about the alternatives. There was an overwhelming consensus that Brazil would win this year's World Cup but, like England, they were booted out in the quarter-finals.

There was an overwhelming consensus that Neil Kinnock's Labour Party would win the 1992 General Election but, confounding all expectations, John Major and his soap box prevailed.

And, today, there is an overwhelming consensus among central banks that inflation is a problem and that monetary policy isn't yet tight enough.

In its latest policy statement, released after the 29 June Federal Open Markets Committee (FOMC) meeting, the US Federal Reserve asserted that "the high levels of resource utilisation and of the prices of energy and other commodities have the potential to sustain inflation pressures".

Last week, the European Central Bank was also warning about inflation. Following its latest policy meeting, Jean-Claude Trichet, the ECB's president, said: "We will exercise strong vigilance so as to ensure that risks to price stability over the medium term do not materialise."

And, at the end of this week, the Bank of Japan may raise interest rates for the first time in aeons as Japanese deflation heads off into the sunset.

So inflation is a risk and monetary policy needs to be tightened a bit more. All perfectly reasonable, you might think.

Think again. Here's another example of central bank pontification: "The utilisation of the pool of available workers remains at an unusually high level, and the increase in energy prices, though having limited effect on core measures of prices to date, still harbours the possibility of raising inflation expectations. The Committee, accordingly, continues to see a risk of heightened inflation pressures."

You'd be forgiven for thinking that this message is a fairly recent one. On a cosmic timescale, you'd be right, but on a financial market timescale, you'd be wrong. The words come from the Federal Reserve policy statement following the FOMC meeting on 15 November 2000.

To its credit, the Fed had recognised that demand was beginning to slow a bit, but "the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future". In other words, the Fed was indicating that interest rates were likely to be going up further.

Six weeks later, the Fed cut its key policy rate by 0.5 per cent, marking the beginning of a plunge in Fed funds from a peak of 6.5 per cent to a trough of just 1 per cent. Meanwhile, the US growth rate collapsed.

We all tend to believe that central banks are omniscient, seemingly able to spot trends in economic data that mere mortals can't comprehend.

The evidence for this omniscience, though, is hardly convincing. Like the rest of us, central banks get things wrong.

Back in 2000, the Federal Reserve and other central banks were not alone. According to the data collected by Consensus Forecasts, economists were remarkably slow in spotting what was happening to the US economy.

Many were happy to buy into the wonders of the so-called new paradigm, extrapolating the rapid growth rates of the late 1990s into the distant future.

How wrong they were. According to Consensus Forecasts, optimism over US economic growth peaked in September 2000, when economists on average predicted gains in GDP of 5.2 per cent in 2000 and an additional 3.7 per cent in 2001.

Their confidence in ongoing expansion was so great that they were happy to shrug off the falls in the Nasdaq share price index which had begun six months earlier.

Embarrassingly for these optimists, latest official estimates - admittedly affected by subsequent data revisions - suggest that growth was only 3.7 per cent in 2000 and a pathetically feeble 0.8 per cent in 2001.

Why was the outcome so different from expectations? Part of the problem was an absence of early warning indicators from the traditional gauges of economic progress. Unemployment was low, the labour market was tight, wages were rising and companies were supposedly profitable (as it turned out, their "profits" were often more fiction than fact).

Financial indicators, however, offered a different perspective. Short-term interest rates had risen far enough to provide an inverted yield curve - a traditional sign of impending downswing. Equity prices had been falling. Banks had been tightening their lending standards to companies. And the profit share within GDP had been falling for a good two years.

For the most part, economists chose to ignore these signs. The yield curve was inverted largely because of low long-term rates, supposedly distorted downwards because of the government's Treasury buyback programme.

Although the Nasdaq had fallen a long way, other stock market indices - notably the S&P 500 and the Dow Jones Industrial Average - were still within shouting distance of their earlier highs.

Meanwhile, economists were mostly happy to dismiss the news on profits as measured by government statisticians. Stock market profits were, apparently, much more reliable. That they were signed off by company boards awash with stock options was apparently of no great importance.

I wouldn't like to suggest that we're about to see a re-run of the 2000 episode all over again. The important lesson from that period, though, is that an overwhelming consensus can sometimes get things badly wrong. It is, if you like, the "madness of crowds".

Staying with the pack is always the easiest position to adopt. It's why so few people questioned Brazil's right to progress all the way to the World Cup final. Most of us were happy to extrapolate Brazil's past performance rather than focus on the incredible bulk that, once upon a time, was known as Ronaldo.

In these situations, the consensus not only gets things wrong, but also refuses to recognise the evidence that might suggest an alternative viewpoint.

Is the madness of crowds preventing us from seeing the real risks facing the global economy? Once again, the US yield curve is inverted and, once again, the consensus is happy to find excuses for the low level of long-term bond yields (these days it's the Chinese, rather than the American government, buying Treasuries).

Once again, there have been signs of unease in financial markets (perhaps the second quarter was just a wobble, but how many dismissed the initial falls in the Nasdaq back in 2000 as no more than a wobble?).

Once again, we've been through a period of sustained monetary tightening.

The good news is that the corporate sector looks much healthier than it did back in 2000. Corporate debt is no longer a problem and corporate profits, even on the GDP measures, are buoyant.

Does this mean that the US economy, the engine of global growth in recent years, is now better placed to withstand a few financial jitters?

Maybe, but focusing on the corporate sector ignores the one area of the US economy which is under pressure. Households may have carried on spending but, just like companies at the end of the 1990s, their income gains have been pitiful.

Adjusted for inflation, US personal disposable income has been unchanged since the end of last year. Back in 2004, real income gains were up 3.4 per cent.

This loss of income momentum has not yet shown up in the spending data. But it's only a matter of time. With employment growth slowing down, with the housing market losing momentum and the lagged effect of earlier monetary restraint still to be seen, maybe it's households which, this time around, will prove to be the US economy's Achilles' heel.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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