Jun 30th 2005 From The Economist print editionn
Even in a world of low inflation, central bankers cannot sleep soundly
THE desk of The Economist's economics editor is always piled high with reports on the global economy by official international institutions, central banks, think-tanks and investment banks. But in recent years one publication has towered above the others, thanks to its willingness to question the common complacency of policymakers: the annual report of the Bank for International Settlements (BIS), the so-called “central bankers' bank”. The latest edition, published on June 27th, points out several causes for concern.
Not least, perhaps, are the worrying similarities between the world economy now and that of the late 1960s and early 1970s, just before inflation surged. Like today, that was a period when both short- and long-term interest rates were low in real terms, while credit expanded rapidly. On June 30th—after The Economist had gone to press—America's Federal Reserve was widely expected to raise its federal funds rate by another quarter of a percentage point, to 3.25%. Yet that would still leave real rates at less than 0.5%, well below their usual level at this stage of an economic recovery (see the left-hand chart below) and below most estimates of the “natural” rate of interest consistent with non-inflationary growth. Moreover, the impact of higher short-term rates in America over the past year has been partly offset by a fall in bond yields, leaving overall monetary conditions very loose. Indeed, money looks unusually easy worldwide, with real interest rates close to zero in many countries.
A second parallel with the past, says the BIS, is that America's loose monetary policy is being exported to the rest of the world. In the late 1960s this occurred through the fixed exchange rates of the Bretton Woods system, which forced other countries to ease their policies to hold their currencies steady against a sickly dollar. Similarly, in the past couple of years the dollar's slide has caused China and other Asian countries to accumulate dollar reserves, and so run a looser monetary policy than they otherwise might, in order to prevent their currencies appreciating. As a result, global liquidity has been rising at its fastest pace since the 1970s. A third ominous similarity with 30-odd years ago is the jump in the prices of commodities and oil. Last but not least, governments' budget deficits have widened sharply in recent years, just as they did before the Great Inflation of the 1970s.
However, the BIS thinks it is unlikely that history is about to repeat itself with another burst of inflation. Prices took off in the 1970s largely because of errors in policy. Policymakers have since learned the hard way that rising inflation harms growth. Central banks have also been made independent of politicians and given the prime goal of price stability, which has helped to anchor inflationary expectations.
There are also some important differences between now and the late 1960s and early 1970s. Rich economies are now much less dependent on oil, and wage pressures have been muted as globalisation and the threat of outsourcing have curbed the bargaining power of workers. Deregulation, new technology and the integration of China into the global economy have also reduced the price of many goods, making it easier for central banks to keep inflation low. This has made inflation less sensitive to rising oil and commodity prices (see the right-hand chart below).
Although the BIS is not losing much sleep over a future surge in inflation, it worries about a different sort of risk: the rapid growth in debt and asset prices. Ironically, this is partly due to central banks' success in defeating inflation. Thanks to globalisation and technology, which have helped to hold down inflation, central banks have recently not needed to raise interest rates by as much as in past cycles. Well-anchored inflationary expectations also allowed rates to be cut more vigorously when economies stumbled in 2001 after the stockmarket crash. The cumulative effect of this is very low short-term interest rates.
Another change over the past three decades is that financial systems have been liberalised, making it even easier to borrow during a boom. This combination of cheap money and a liberalised financial system, suggests the BIS, explains why there have been more booms and busts in credit and asset prices in recent years. Top of the BIS's current list of worries are house prices, which it reckons are now “vulnerable to downward corrections”—likely to fall, in plain English—in several countries, and the vast amount of household debt. Sooner or later these could cause severe global economic and financial strains.
The BIS argues that America needs to raise interest rates further in order to restrain risk-taking in financial markets and borrowing by households. With debts and house prices already so high, this will hurt consumer spending, but it could help to avoid a more painful adjustment later.
Looking ahead, the BIS argues that policymakers need to modify their current policy frameworks in order to prevent the build-up of imbalances in future. Targeting inflation is not enough. Central banks also need to take more account of the increase in debt and exceptional rises in asset prices. Thus interest rates should be raised to curb excessive credit growth even if inflation remains tame. Regulatory policy could also be adjusted in a discretionary way over the cycle. Banks could be encouraged to build up more capital during booms, which would help to avoid excessive lending, and then be allowed to reduce their capital in bad times to cushion the economy from a credit crunch. During a rampant house-price boom lenders might be told to reduce the amount they can lend as a percentage of the purchase price of a home or to shorten repayment periods—the exact opposite of what tends to happen now.
The Federal Reserve has rejected the advice of the BIS for many years, insisting that the main job of a central bank is simply to control inflation. The risk is that in single-mindedly looking out for inflationary icebergs, a central bank will fail to spot the rocks that lie dead ahead.