Stephen King: It's time for the central banks to take a lesson in emerging market economics
Monday 07 July 2008
Despite all the talk of globalisation, mutual economic dependency and trade linkages, policymakers spend too much time focusing on the domestic minutiae and not enough on the really big international stories which determine our economic destinies. I know this because, like anyone else, I can log on to central bank websites and get a flavour of policymakers' concerns. The Federal Reserve and the Bank of England publish minutes of their regular policy pow-wows. Their discussions too often suggest the non-G7 world simply doesn't exist.
The latest published minutes available on the Federal Reserve's website refer to the meeting held in April. Of the 6,400 words that sum up the Fed's discussions, only 90 deal with the emerging world. Of the many lines included within the latest published minutes from the Monetary Policy Committee of the Bank of England, only a desultory two or three refer to the influence of countries like China. This, I think, is remarkable. The emerging economies, after all, are exerting an ever-larger gravitational pull on the rest of us.
The biggest single economic problem facing the developed world is the deteriorating trade-off between growth and inflation. This is happening primarily because of the impact of strong emerging economic expansion on global commodity prices. Only a few months ago, it seemed likely that central banks would have to cut interest rates again and again, egged on by falling house prices, banking paralysis and soggy labour markets. Yet, last week, the European Central Bank raised interest rates. Meanwhile, the appetite for cutting interest rates elsewhere has disappeared. Nothing has changed as far as the growth outlook is concerned. It still looks rotten. Inflation, though, has made an unwelcome return. Unlike the 1970s, though, higher inflation has nothing to do with wage pressures (at least, not yet). Instead, it's the result of higher oil, food and other commodity prices. The influence of these price increases is huge. It now looks as though inflation in the US, the UK and the eurozone will easily be above 4 per cent through the remainder of the year. There's even an unpleasant possibility, in the US and the UK, that the 5 per cent threshold might be breached. These numbers are remarkably high relative to the inflation objectives central banks are supposed to achieve.
Any yet many policymakers seem almost blasé in the light of these overshoots. The Fed minutes, for example, say: "In view of the projected slack in resource utilization in 2009 and flattening out of oil and other commodity prices, both core and headline PCE price inflation were projected to drop back from their 2008 levels, in line with the staff's previous forecasts." Why, though, should oil and other commodity prices necessarily flatten out? After all, they haven't done so up until now: in virtually every year during this decade, commodity prices have ended up higher than either central bankers or traders expected.
These errors are worrying. They reveal a huge lack of knowledge at the heart of the monetary and economic system. Put simply, if central banks can't accurately forecast the future level of commodity prices, they cannot accurately forecast the future rate of inflation. If they can't do that, they cannot easily judge where interest rates should be today.
It is for this reason that I find the absence of any serious discussion of emerging market economic developments so odd. We know that the emerging economies are playing a decisive role in driving commodity prices to ever higher levels. China has become the world's most important marginal consumer of energy in recent years. It now consumes more energy than the whole of the European Union and isn't too far behind the US. If China's economy overheats, it's no longer an internal Chinese prob-lem: through global commodity markets, China's overheating becomes a problem for the rest of us as well.
With the honourable exception of the European Central Bank (and, for that matter, the Swedish and Norwegian central banks), the threat posed from ever-higher commodity prices seems to be treated in a rather casual fashion. The Bank of England's Monetary Policy Committee has this to say on the subject: "Whatever the cause, it was not clear that the prevailing high price of oil could be sustained: there should be some reduction in demand, and possibly some increase in supply, if prices remained elevated. But the timing of any fall back was also uncertain and further price rises could not be ruled out in the coming months."
There are some obvious problems with this statement. If, for example, persistent increases in emerging market demand for oil lead to an ever-higher price, there is absolutely no reason why any reduction in demand coming from the UK, the US or elsewhere will lead to lower prices: our reduction in demand is a consequence of higher oil prices, not a cause of lower oil prices. And while a supply response might eventually be forthcoming, don't hold your breath.
The big question, then, is whether we are seeing a shift in the relative economic importance of different parts of the world big enough to overturn the assumptions policymakers have happily made about how the rest of the world affects their own economies. I think we are. This, in turn, makes life a lot less comfortable for policymakers. Earlier this year, Mervyn King, the Governor of the Bank of England, gave a speech in which he argued that the UK economy could do with a dose of rebalancing in order to wean ourselves off an ever-mounting debt dependency. What we needed, he suggested, was stronger exports and weaker imports. A fall in the exchange rate would "help to protect us from the worst effects blowing across the Atlantic". Admittedly, he warned of higher inflation as a consequence, but added that "inflation could start to fall back towards the end of the year".
He might still be right but inflation is now a lot higher than the Bank ever imagined. Arguably, then, the right prescription earlier this year would have been a higher, not a lower, exchange rate to protect the UK from the inflationary effects stemming from the emerging world. Then again, if your policy meetings include hardly any discussion of the emerging markets' gravitational pull, it's not surprising that this sort of prescription wasn't forthcoming.
The Bank of England has really struggled to get the balance right between domestic (and G7) economic weakness and emerging market economic strength. The struggle stems from an emotional attachment to a G7 economic world which can, to all intents and purposes, be confined to the annals of history. Our central banks would be better served if they focused on today's economic reality rather the nostalgia of all our yesterdays.
Stephen King is managing director of economics at HSBC
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