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Wednesday, September 21, 2005

The Economist: Central Banking is Hard

With growing global imbalances, natural disasters, currency areas, public disapproval of rate hikes, asset price inflation, stagflation worries, uncooperative fiscal policy, exchange rate adjustments, growing downside risk to policy, and maybe even underwear that’s too tight, it’s a tough time to be a central banker. Former Fed Governor Lawrence Meyer explains, "Each member appreciates the heavy responsibility the Committee has for the economic well-being of the country and the importance of their personal participation in this process. ... Serving on the FOMC is, without question, the most important responsibility I could have..."  The Economist discusses worries and difficulties faced by central banks around the world in their attempt to live up to this responsibility:

Reluctant party-poopers, The Economist: 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 ... This accounts for the tendency of many central bankers ... 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, ... Twenty years on, most developed countries seem to have built a solid reputation for inflation-fighting... 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.

…the Fed’s Alan Greenspan … 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. … America’s … housing market looks decidedly frothy. Consumers … 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 … 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. … this has led to renewed talk of stagflation, a central banker’s worst nightmare. ... 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... 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 ... 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 ... 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 ... Real interest rates have actually been near zero in the euro area for much of the past two years, making monetary policy relatively loose. ... 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. ... 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, ... 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.

By getting its fiscal house in order and coming up with a credible plan to reduce the deficit, the U.S. could do a lot to ease global economic uncertainty.

    Posted by on Wednesday, September 21, 2005 at 10:52 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (1)


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