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Wed Sep 21 09:29:18 PDT 2005

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RELUCTANT PARTY-POOPERS
Sep 21st 2005  

Despite the economic impact of Katrina, which dealt a stiff blow to
America's oil markets, the Federal Reserve has once again raised
interest rates by a quarter of a percentage point. With high fuel
prices threatening to bring on both inflation and recession, being a
central banker is harder than it used to be

WILLIAM McCHESNEY MARTIN, a past chairman of America's Federal Reserve,
famously observed that the job of a central banker is to "take away the
punch bowl just when the party is getting started". Unsurprisingly,
this often generates quite a bit of hostility from the party-goers, who
would prefer a few more shots of low interest rates to really get
things going. This accounts for the tendency of many central bankers in
years past to err on the side of easy money, resulting all too often in
double-digit inflation.

Of course, if the party gets out of hand, and the house is wrecked, the
central banker can expect to come in for plenty of censure, even from
those who were previously begging him to give them just one more for
the road. After the excesses of the 1970s, and the hangover of the
early 1980s, it was thought that monetary authorities had learned their
lesson. Twenty years on, most developed countries seem to have built a
solid reputation for inflation-fighting; even lax Italy has been
brought under the discipline of the European Central Bank (ECB). And
developing countries, seeing the results, seem to be genuinely
interested in keeping inflation in check.

And yet this is a worrying time to be a central banker. Though global
economic growth is strong and inflation tame, powerful imbalances are
building beneath the surface, and they threaten to throw the world
economy off course. The fight against inflation is, it turns out, just
one battle in a wider war.

It is hard, of course, to feel too sorry for the Fed's Alan Greenspan,
who enjoyed rock-star-like levels of popularity in the late 1990s, when
America happily handed him the credit for its long economic boom.
Nonetheless, he now finds himself deep in uncharted waters. After
cutting short-term interest rates to just 1% to help ease the country
out of the 2001 recession, he has been raising them at a measured pace,
trying to keep the economy from overheating. The Fed's hawkish
credibility, along with cheap goods from China and other low-wage
countries, has helped to keep consumer-price inflation relatively tame
despite exceptionally loose monetary policy.

Asset-price inflation is another story. Though America's stockmarkets
are quiet compared with the go-go 1990s, its housing market looks
decidedly frothy. Consumers have tapped into home equity and cut back
saving to virtually nothing in order to finance their continued
spending. As a result, they are dangerously overstretched and
vulnerable to any change in interest rates. A sharp correction in the
housing market could give the economy convulsions. There are similar
worries in Britain, whose central bank cut interest rates in August as
the (so far) gentle deflation of the country's housing bubble
contributed to a sharp slowdown in consumer spending. The Bank of
England left rates unchanged this month, but with fears growing that
economic expansion will fall short of expectations, it may soon have to
choose between fighting inflation and staving off Britain's first
recession in over a decade.

The Fed may well face the same tough choice. Hurricane Katrina roared
into already tight oil markets, damaging much of America's oil-pumping
and -refining capacity, and another hurricane, Rita, threatened to
wreak more havoc along the Gulf coast this week. With the petrol price
hovering around $3 a gallon and America's consumers already living
beyond their means, another recession no longer seems impossible.
Nonetheless, the Fed continued to play the party-pooper this week,
raising rates by another quarter of a percentage point, to 3.75%, at
its meeting on Tuesday September 20th. Katrina's inflationary effects,
it concluded, were more worrying than its direct impact on GDP growth.

Nonetheless, both effects are causing concern, and this has led to
renewed talk of stagflation, a central banker's worst nightmare. With
its combination of slow growth and fast inflation, stagflation presents
the monetary authority with a dreadful dilemma: lower rates and let
inflation run away, or raise them and throw even more people out of
work. So far, there is little evidence of real danger. But given that
higher energy prices generally boost inflation and shrink demand, it is
not unreasonable to worry about the future.

Yet Mr Greenspan and Mervyn King, the Bank of England's governor, have
it easy compared with Jean-Claude Trichet, the head of the ECB,
monetary guardian of the euro area. Mr Trichet presides over a currency
zone more diverse than America's, but without the fiscal stabilisers
that help smooth over regional variations. In 2004, Portugal's economy
grew by 1%, Ireland's by almost 5%, but both had the same nominal
interest rate. This has the perverse effect of giving higher real
(inflation-adjusted) interest rates to slow-growing, low-inflation
countries, and lower real rates to booming economies with rapid
inflation--precisely the opposite of what a sound monetary authority
would prescribe. 

Moreover, the euro area as a whole has grown slowly: by just 2% in
2004, according to statistics from the Organisation for Economic
Co-operation and Development, compared with 3.1% in Britain and 4.2% in
America. For this, the central bank has taken a disproportionate share
of the blame. Critics say that the ECB, which has left interest rates
unchanged at 2% for more than two years, is paralysed, unable to look
beyond its inflation-fighting mandate to deal with Europe's economic
malaise. 

The reality is more complicated. The euro area's economic woes have
much more to do with tight fiscal policy and structural rigidities in
its markets, particularly those for labour, than with any bottlenecks
in the money supply. Real interest rates have actually been near zero
in the euro area for much of the past two years, making monetary policy
relatively loose. But because continental Europe's mortgage markets are
less sophisticated than those in Britain and America, changes in
interest rates do not filter through as easily to consumer demand,
limiting the effects of monetary loosening. And the ECB, like its
American and British counterparts, must contend with high oil prices
pushing up the inflation rate and hindering growth.

In Asia, too, central bankers are having to deal with the fallout of
higher oil prices. In Indonesia, rising prices for the country's oil
imports, paid for in dollars, recently sparked fears of a currency
crash. The central bank seems to have staved off the crisis, but only
by raising interest rates three times in the past month.

China's central bank faces a different set of problems. To keep the
yuan cheap enough to subsidise China's massive export industries, it
has had to buy billions of dollars and pour them into American bonds.
The longer this goes on, the more vulnerable the bank is to a fall in
the value of the dollar, which would in turn sharply decrease the value
of its bond stockpiles. But fears of the domestic political unrest that
might occur if the export sector faltered keep the bank from reducing
its exposure to the dollar. Moreover, the massive currency operations
create domestic inflationary pressure, which the bank struggles to
contain given the primitive state of China's financial markets. No
matter where you are, it seems, being the central banker is no party.

See this article with graphics and related items at http://www.economist.com/agenda/displaystory.cfm?story_id=4422583&fsrc=nwl

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