Stephen King: The mounting dangers of central banks' high-wire act

A few months ago, economic life was both complicated and, yet, so simple. The US housing market was collapsing. The UK housing market seemed to be heading the same way. Banks on either side of the Atlantic were seeing profits haemorrhaging and capital disappearing. The cloying smell of recession was in the air. For central banks, then, the answer was really rather easy. Cut interest rates and hope that, in time, housing would stabilise, banks would recover and recession would be avoided.

Now, though, central bankers seem in an altogether different mood. Their earlier enthusiasm for monetary stimulus has fallen by the wayside as inflationary pressures have made an unwelcome return. Earlier last week, Ben Bernanke, the chairman of the Federal Reserve, hinted that America's central bank was no longer happy with the dollar's persistent weakness, an indication, perhaps, that the Fed wouldn't be cutting interest rates any further.

For a central bank which, traditionally, has taken a laissez-faire approach to the value of its currency on the foreign exchange markets, this was a remarkable message. It's not difficult to see why. In a world of rising commodity prices, a weak dollar leaves Americans more exposed to inflationary pressures than others. With gasoline prices up to $4 a gallon (never mind that American drivers still pay only half the amount British drivers shell out at the pump), inflation is now a hot issue.

For a fleeting moment, the currency markets rejoiced in Mr Bernanke's new-found enthusiasm for the dollar. If the earlier policy of benign neglect was coming to an end, this surely meant that the dollar had room to strengthen against other currencies. And strengthen it did until Thursday.

There is, of course, an obvious problem with Mr Bernanke's comments. While it's true that a stronger dollar will, other things equal, limit US inflation via cheaper imports, a stronger dollar implies weaker currencies elsewhere. On its own, this is no more than a zero-sum game: the US ends up with a little bit less inflation but others end up with a bit more inflation. A stronger dollar merely redistributes inflationary pressures around the world. It doesn't tackle the source of those inflationary pressures head on.

Jean-Claude Trichet, the President of the European Central Bank, is no fool. His comments in Thursday's policy meeting press conference – always eagerly awaited by semantic pedants – contained a veritable barrage of hawkish language. The governing council "would act in a firm and timely manner" and was in a state of "heightened alertness" (as if central bankers are members of some strange paramilitary force). Was M. Trichet deliberately responding to Mr Bernanke's earlier comments by threatening to raise eurozone interest rates? Mr Bernanke may want a stronger dollar, but M. Trichet won't be letting the euro's value slip quite so easily.

Messrs Bernanke and Trichet have a shared problem. For both central bank-ers, inflation is not only too high, but it's too high against a background of sluggish growth or, worse still, recession. In a relative sense, though, the problem is currently more acute for the US. Friday's US labour market release was a true shocker. The rise in the unemployment rate to 5.5 per cent looks like one of those once-in-a-cycle moments which marks a shift in perceptions from slowdown to recession. That, in turn, makes America's inflation problem more worrying than Europe's. How can the Federal Reserve deal with inflation when the political pressure to keep interest rates low while unemployment is rising and house prices are falling is only going to intensify?

Underneath all of this is a particularly awkward issue. Inflation may be elevated but, in the US, monetary conditions seem rather tight. That, after all, is what a credit crunch implies. Banks aren't lending and households can't borrow. Why, then, is inflation so high?

The obvious culprit is commodity prices – oil, food and the rest. This, though, doesn't get us very far. Historically, one of the most reliable drivers of commodity prices has been the performance of the US economy. When the US was strong, commodity prices were high and, when it was weak, commodity prices were depressed. No longer does this relationship hold. Commodity prices have risen rapidly in recent years with no help whatsoever from the US economy. Even before the move into recession, US economic growth was insipid, at best.

In my view, higher commodity prices reflect the growing influence of the emerging economies. Part of this is a structural story – countries such as China are quickly making up for hundreds of years of atrophied economic development – but part also relates to overly loose monetary conditions. Many of these countries link their monetary policies to those of the Federal Reserve yet, at the moment, aren't suffering from sub-prime, credit crunch or housing crises. Their monetary conditions are, as a result, too loose and their inflation rates are rising. Higher commodity prices are merely a consequence of this effect.

Rising commodity prices are, though, seriously hampering the rescue efforts launched earlier this year to deal with housing and credit crunch problems. Will housing recover if people begin to believe that central banks are no longer able to cut interest rates? Will banks lend more freely if they believe monetary accommodation will be taken away? Will counterparty risk in the banking sector rise once again as banks begin to question each others' business models in the light of a persistent absence of economic recovery?

We've seen these kinds of difficulties before. At the beginning of the 1990s, even when equity prices were already falling rapidly, Japanese policymakers became ever more fearful of inflation. Japanese bond investors were equally worried, selling bonds in anticipation of rising price pressures. At one point, the yield on Japanese government bonds had jumped from around 5 per cent to over 8 per cent.

Yet these fears ultimately proved unfounded. The earlier period of excess liquidity had doubtless contributed to rising inflationary pressures in the short-term. An earlier oil price spike which stemmed from the effects of Iraq's invasion of Kuwait in 1990 also hadn't helped.

Admittedly, the rise in oil prices on that occasion was short-lived. There was, however, a more general failure to recognise the ultimate impact on seemingly elev-ated domestic inflation of persistent falls in asset prices even though, nowadays, it's almost laughable that neither policymakers nor investors managed to spot the imminent arrival in Japan of deflation.

Japan's experience reveals an obvious problem for policymakers. There is often no a priori "right" answer when it comes to setting interest rates. Hawks will doubtless point to the persistence of commodity price increases and argue that interest rate defences must be bolstered. Doves will argue that falling asset prices will, in time, swamp the effects of rising commodity prices. At this stage, either view might, in time, prove correct. We can laugh at Japanese policymakers with the benefit of hindsight, but only in hindsight is the correct policy decision revealed. In the meantime, all we know is that the chances of getting policy wrong have risen dramatically.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com