Central banks

A dangerous divergence

The world's central banks are worryingly far apart—especially when it comes to inflation and currencies

“SOME say the world will end in fire, Some say in ice.” Robert Frost is rarely quoted when central bankers gather. But wise heads nodded when Ken Rogoff, a Harvard professor and former chief economist of the IMF, recited the poet's apocalyptic lines at a recent meeting of monetary policymakers. The Federal Reserve, said Mr Rogoff, thinks the world will end in fire. The European Central Bank (ECB) fears ice.

The Fed is scrambling to douse financial crisis and recession. In recent days America's central bank has flooded credit markets with liquidity, creating new lending facilities apace. It has helped JPMorgan Chase rescue Bear Stearns, America's fifth-biggest investment bank. And on March 18th it cut the federal funds rate by three-quarters of a percentage point, the third big reduction in less than two months. At 2.25%, the Fed's policy rate is three points lower than at the start of the financial turmoil last August.

Other central banks have been doling out liquidity too—the Bank of England, the Bank of Japan and the ECB did so this week—but none has eased monetary policy with anything like the Fed's urgency. Whereas the Fed fears recession and financial collapse, most central banks elsewhere are more worried about inflation. Rates in Britain and Canada have been cut, but by much less than in America. Japanese rates are unchanged. The ECB's policy rate is still 4%, precisely where it was in August. Most other central banks have either kept rates unchanged or raised them. Indeed, central banks outside America, especially in Europe, worry that the Fed may be inviting a new bubble—and that the credibility that central banks painfully built over a quarter of a century is now at risk.

The gap between the Fed and the rest is having its plainest effects in the currency markets. The dollar has tumbled: against other leading currencies, the greenback is at its weakest since the era of floating exchange rates began in 1973. On March 13th it fell below ¥100 for the first time in 12 years. This week it sank to new lows against the euro and the Swiss franc before rallying after the Fed reduced rates (markets had thought a deeper cut possible). As the dollar has fallen, the prices of commodities priced in dollars have jumped: oil fetches well over $100 a barrel. Gold has soared above $1,000 an ounce.

The dollar's frailty is making policymakers outside America increasingly nervous. Speculation is rising that central banks may intervene to halt the dollar's slide, especially since Jean-Claude Trichet, the ECB's president, called recent moves “disorderly” and “undesirable”. Some worry that the Fed's easing will boost global liquidity and inflation. All told, the fear is that America's activism in fighting financial distress will create dangerous instability in the global monetary system.

The case for boldness

With inflation at 4% in the year to February, and the core rate (excluding food and fuel) at 2.3%, America's real short-term interest rates are now negative. In previous downturns, real rates turned negative only at or after the end of the recession. Further cuts are likely—to 1.75% by the end of next month, judging by the price of fed-funds futures. In the euro area, inflation is lower, but at 3.3% is the highest for 14 years and well above the ECB's 2% ceiling.

The Fed has been bolder than other central banks largely because America's economy is in trouble. It is almost certainly already in recession. But differences in central banks' official goals also play a role. The Fed is charged with promoting both growth and stable prices. Most other central banks in the rich world and a fair few in emerging economies are supposed to worry only about inflation. Many have explicit inflation targets.

History also counts. The Great Depression is seared into Americans' minds as the greatest economic catastrophe of the 20th century. In other countries (notably Germany, home of the ECB) the legacy of hyperinflation is every bit as strong.

But there is also an intellectual rift. The Fed has long argued that central bankers should not try to prick asset bubbles, but must mop up the mess promptly when they burst. Other central banks see a direct link between loose policy after the internet bubble popped and the housing bubble that preceded today's bust. The Fed has also set more store than others by monetary policy as an insurance mechanism. Concerns about the risk of deflation led Alan Greenspan, the Fed's chairman until 2006, to cut rates hard in 2001-03 and keep them low.

Ben Bernanke, Mr Greenspan's successor, holds these views even more strongly. As an academic, Mr Bernanke argued forcefully against targeting asset prices. The result, he said, would be unnecessary volatility. In 2003, as a Fed governor, he was one of the loudest advocates of using low interest rates to insure against the calamity of deflation.

The calamity being battled today is financial-market malfunction and the damage it can do to the economy. Mr Bernanke is an expert on the Great Depression and intellectual pioneer of the “financial accelerator”, through which banking distress worsens economic downturns. Lower interest rates, he argues, are an important weapon in stopping this negative spiral.

Once a bubble bursts, this means doing more than implied by standard rules of thumb, such as the Taylor rule, which links appropriate interest rates to the deviations of inflation from its target and output growth from its trend. As Frederic Mishkin, another intellectual heavyweight on the Fed's governing board, puts it: “The monetary policy that is appropriate during an episode of financial market disruption is likely to be quite different than in times of normal market functioning.”

Though dominant, this view is not held by all America's central bankers. Several presidents of regional Federal Reserve Banks have worried openly about inflation. Tom Hoenig, head of the Kansas City Fed, argued recently that “we are placing too much burden on monetary policy in dealing with financial crises.” Two regional Fed presidents, Richard Fisher of Dallas and Charles Plosser of Philadelphia, dissented from the three-quarter-point cut this week. They had wanted a lesser reduction.

These worries are felt far more keenly outside America. But Mr Mishkin and others argue that the dangers are small. First, they say, the weakening economy will reduce inflationary pressure. Second, expectations of inflation remain contained. Third, once the risks of financial catastrophe have passed, rapid easing can be mirrored by equally rapid tightening.

Sadly, none of these arguments is clear-cut. Granted, more economic slack ought to reduce inflation. And core consumer prices were flat in February. But commodity prices and the dollar point to price pressures ahead. With global growth still robust, the link between domestic output and domestic inflation may be waning.

On expectations, some worrying signs are emerging. The Fed admitted as much in its statement on March 18th. Survey-based measures are nudging upwards. Market-based measures, such as the spread between inflation-linked and ordinary Treasury bonds, have risen since the turn of the year. The ten-year expected rate of inflation implied by yields on these two types of bonds has reached 2.5%. An alternative measure from the Cleveland Fed that adjusts for differences in liquidity and the premium for inflation risk in markets for the two has risen even more (see chart).

Finally, it is hard to be sure that swift cuts will be as swiftly reversed, as Mr Mishkin and others say. History suggests otherwise. John Taylor, the Stanford economist who invented the Taylor rule, points out that whenever the Fed has cut rates by more than his rule suggests, it has taken a long time to get interest rates back on track. And the danger posed by dysfunctional credit markets will not disappear overnight. Since rapid tightening may pose renewed financial risks, the Fed's own logic suggests rates will be raised gradually.

Moreover, higher inflation would reduce the real burden of mortgage debt, so alleviating the solvency problems posed by the housing bust. All in all, it is easy to believe that the Fed will tolerate higher inflation, and for longer, than it claims.

Knock-on effects

What does this mean for everyone else? In theory, not much. With floating exchange rates, countries can target whatever inflation rate they choose and currencies will adjust. But reality is more complicated.

For a start, currencies tend to swing around by far more than warranted by differences in interest rates: the euro's recent surge against the dollar is an example. Currency volatility can itself cause panic, especially when the dollar tumbles, given America's reliance on foreign capital (although the current-account deficit shrank in the fourth quarter, it was still 5.3% of GDP last year). And market movements can send exporters in countries with rising currencies screaming for help. These problems can be particularly acute in small, open economies: when Chile or New Zealand, say, raises interest rates to combat inflation, foreign capital pours in, particularly if America is easing policy.

More important, not all exchange rates float freely. The Gulf's oil exporters, for instance, tie their currencies to the dollar: the Saudi riyal is fixed firmly at 3.75 to the greenback. Countries with dollar pegs are in effect importing America's looser monetary policy and with it inflationary pressure. Saudi Arabia's inflation rate is at a 27-year high of 7%.

There are signs that the Fed's policy is prompting some countries to reconsider their links to the dollar. Speculation is rife, for instance, that Qatar and the United Arab Emirates are about to break their pegs. Many Asian countries have already allowed their currencies to rise substantially. China, which abandoned its dollar peg in 2005, has accelerated the pace of the yuan's appreciation. All this is sensible, but in the short term it will make the dollar more volatile as investors worry that emerging-market central banks will be less keen to hold large amounts of dollars.

If American interest rates remain disproportionately low, other emerging markets may resort to controls on capital inflows: last week Brazil's government imposed a 1.5% tax on foreign purchases of fixed-income securities denominated in reais, to assuage the currency's rise. Even so, it will be hard for small, open economies to hit their inflation targets if American policy remains so loose. Inflation targeting itself may be called into question.

Nor are big economies likely to ignore their currencies. The ECB, for all its bluster, may have to loosen sooner than it would wish to in order to stem the euro's rise. Mr Taylor's research suggests that the ECB's deviations from “optimal” policy have been closely correlated with America's short-term interest rates. A percentage-point reduction in the federal funds rate has been associated with a move of a fifth of a point away from the ECB's optimum. Worries about exchange rates, he argues, cause central banks to veer off course.

How worrying all this is depends on its scale. Modestly higher inflation or jumpier currencies seem a small price to pay for preventing the collapse of America's financial system. Alas, modest shifts cannot be taken for granted. The darkest scenario—that investors panic at the Fed's loose policy, sending the dollar into free-fall—is becoming worryingly plausible. A real dollar crash would force the Fed to raise rates, making America's predicament much worse and even sending the global economy into recession. The Fed would face ice as well as fire. And the rest of the world would have a far bigger problem.