Stephen King: Two economies separated by a common policy

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The Independent Online

"England and America are two countries separated by a common language." Most people attribute these words to George Bernard Shaw although you'll find a remarkably similar formulation in Oscar Wilde's The Canterville Ghost. Winston Churchill used a comparable turn of phrase presumably because, as the son of Randolph and an American heiress, he could speak from personal experience. Here's a variation that can be used by economists: "England and America are two countries separated by a common monetary objective."

At least, that's the conclusion that we're likely to reach by tomorrow evening. Both the Bank of England and the Federal Reserve want to achieve price stability. Both banks are faced with high oil prices. Both banks have economies with relatively low unemployment rates. Both banks think inflation is, at the moment, a bit too high. Yet, whereas the Federal Reserve is likely to signal after tomorrow's policy meeting that US monetary tightening is over for now, the Bank of England last week raised interest rates and gave warning that more rate increases could be in the pipeline.

So why the difference of view? Based purely on recent inflation data, it would be reasonable to think that, of the two central banks, the Federal Reserve should be the one tightening monetary policy. US consumer price inflation stood at 4.3 per cent in June whereas UK inflation, on a similar basis, stood at 2.5 per cent. Wage growth in the US has also been picking up a bit in recent months whereas, in the UK, wage growth has been remarkably moderate.

Unless the Fed and the Bank of England have different views about how price stability is defined - and, philosophically, they almost certainly don't - their latest actions are presumably telling us that they don't place too much weight on the current inflation rate when they make their decisions on interest rates. Central banks should be forward-looking, deciding on the level of interest rates today in order to determine inflation outcomes at some point in the future. In doing so, they need to think about two broad issues. Cyclically, they need to make a judgement about the degree of spare capacity in the economy both now and in the months ahead. Structurally, they need to ensure their credibility is maintained: in other words, they mustn't allow inflationary expectations to get out of control.

For the Bank of England, the decision to raise interest rates came "against the background of firm growth, limited spare capacity [and] rapid growth of broad money and credit". Based on these observations, the MPC felt that "inflation [is] likely to remain above the target for some while". Recent comments from Federal Reserve governors have hinted at a different set of worries: interest rates have already risen a long way, some of the impact of these earlier increases is still in the pipeline waiting to pop out later this year, and there are already indications that growth is slowing down to a rate that might be consistent with ongoing price stability.

But for how long can these two central banking heavyweights dance to a different tune? The left-hand chart shows movements in base rates and Fed funds, the key policy rates on either side of the Atlantic, since 1997, the year in which the Bank of England was granted its independence. While there are some differences of timing and magnitude, the overall pattern on either side of the Atlantic is not so different. While both the Bank of England and the Federal Reserve may be independent from political interference, they seem to be singing, for the most part, from a remarkably similar hymn sheet. It's difficult to imagine a world where, persistently, the Bank of England raises interest rates when, at the same time, the Federal Reserve keeps rates unchanged or, as may be increasingly likely in the months and quarters ahead, actually contemplates cutting interest rates.

The Bank of England could argue, with some justification, that the Federal Reserve finds itself, this year, in a similar position to the Bank's in 2005. Back then, you may recall, the Bank began to fret about the effects of higher oil prices on business and consumer confidence. Last August's rate cut was like a shot in the arm, a confidence booster that seems to have done the trick. Whereas, last year, the risks to growth and inflation were all on the downside, the risks now appear, at least to the MPC, to be mostly on the upside.

Based on the Bank's experience, perhaps markets should regard any interest rate pause from the Federal Reserve as another shot in the arm, a neat monetary trick designed to give the US economy a second wind. Somehow, though, I doubt the Federal Reserve sees things this way. The Federal Reserve has raised interest rates a lot further than the Bank of England and some of its governors believe that monetary conditions are now restrictive. The US housing market is showing widespread signs of slowing down. The unemployment rate unexpectedly rose on Friday. And the pace of economic growth has faded fast, particularly after a post-Katrina bounce towards the end of last year.

And, most important of all, the US is a very large economy and the UK, despite being a major industrial nation, is rather small. Should the UK wilt in response to restrictive monetary conditions, the rest of the world is not likely to worry too much. Should the US slow down, we're all likely to be affected. In more ways than one, the UK can sometimes be regarded as America's poodle.

Domestic economic conditions in the UK have clearly improved over the last 12 months. The UK has also benefited from the eurozone's economic renaissance, a recovery that, like the UK's, has seen its reward in the guise of higher interest rates. But policymakers in both the UK and the eurozone will be casting nervous glances across the other side of the Atlantic, knowing through sometimes bitter experience that their own economic wellbeing still depends to a large degree on Uncle Sam's health.

What if Uncle Sam really is slowing down? What if the boom in the US housing market is drawing to a close? Or if US consumers are finally running out of steam?

For the UK, there are three broad concerns. First, a sizeable loss of US demand should lead to a narrowing of the US current account deficit: and that suggests fewer exports heading westwards from Britain. Second, an increase in cost-cutting pressure on American firms could lead to job losses not just in the US, but also in American affiliates elsewhere in the world, including those in the UK. Third, if US rates have peaked and eventually head lower, the dollar is likely to soften. Indeed, with sterling already above $1.90, a $2 pound can't be ruled out. Good news for British holidaymakers, no doubt, but the kind of exchange rate action that might, in time, lead the Bank of England to think again before raising interest rates another notch.

The Bank of England may be independent, but independence does not imply that Britain is in control of its own economic destiny.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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