Central bankers had it easy over the past decade. Now they are going to have to earn their money. Inflation is rising rapidly, and growth rates are falling. But unfortunately, as I first noted back in March, they still seem to have differing ideas about what policies will best counter these twin challenges.
The US Federal Reserve has been firmly in the ‘sustain growth’ camp. It cut rates dramatically, and supported Congress’ plans for last month’s tax rebate. But neither seems to have done much to solve the core US issue – the financial black hole caused by falling house prices. What they have done is to weaken the US$.
Initially, this was a net positive for the US chemical industry, as it allowed exports to substitute for declining domestic demand. But more recently, it has caused oil prices to soar in US$ terms, putting pressure on feedstock costs. It has also caused inflation to jump. Now the Fed is finally having to admit that higher food and energy prices can hike overall inflation.
The Bank of England initially followed the US lead, cutting rates to support the UK housing market. And like other Western central banks, it has supplied plenty of liquidity to the banking sector. Its rescue of Northern Rock also set a precedent for the Fed’s ‘rescue’ of Bear Stearns. But more recently it has begun to worry about inflation, as the unions use rising food and energy prices as a justification for higher wage claims.
The European Central Bank (ECB) has consistently taken the opposite line to the Fed, and refused to cut interest rates. In this it has been helped by the fact that Germany and the euro-bloc is more a ‘late-cycle’ economy. Its boom comes later than the more consumer-oriented Anglo-Saxon economies (although countries such as Spain and Ireland are clearly exceptions).
So the ECB has not yet come under the same political pressure to sustain growth. German exports of engineering and other late-cycle products are, however, now starting to slow. Which road will the ECB take, when this happens? Raising rates would eventually help to reduce inflation, but at a cost of slowing demand and deepening the current downturn. Reducing them would temporarily increase demand, but boost inflation.
Meanwhile Asian central banks have also pursued differing policies. China and India have both raised rates, and reduced liquidity by increasing deposit levels for the banking sector. Their focus on inflation as the greater evil is understandable, given that food and energy account for more than 40% of average incomes, compared to around 20% in the wealthier Western countries.
Japan’s central bank, of course, has been trying to create inflation after more than a decade of deflation. Its wish is now being granted, but Japan’s export-oriented growth risks seeing slower growth anyway, due to the rising value of the yen against the US$.
My blogging colleague, Barbara Ortner, quoted Robert Frost’s famous poem last week about difficult choices. Frost’s line ‘two roads diverged’ provides a suitable summary of the choice now facing central bankers. Will they set interest rates to favour lower growth, or higher inflation? The road they choose is certain to have a major impact, especially as chemical companies start to think about 2009 Budgets.