 Central
banks have reduced interest rates to their lowest levels for
decades. But have they done enough to revive the sickly world
economy?
AMERICA'S Federal Reserve cut interest rates by
another half-point this week. The federal-funds rate is now
2.5%, down from 6.5% at the end of last year, and is at its
lowest in almost 40 years. After recent rate cuts around the
world, the average real interest rate in America, Japan and
the euro area (the G3) has fallen to its lowest level since
the 1970s.
This aggressive monetary easing, combined with a
large fiscal stimulus in prospect in America, has led some
economists to predict a future upsurge in inflation. Rising
long-term bond yields signal that investors are worried about
inflation, they claim. However, comparisons with American
index-linked bonds suggest that the main worry for investors
is not inflation but that the supply of bonds will soar as the
government borrows more.
That real interest rates in the big economies are at
their lowest for decades may appear to suggest that monetary
policy is exceptionally loose. A closer examination, however,
shows that this is somewhat misleading. Using headline consumer-price
inflation, American real interest rates are now close to zero.
But by the Fed's favoured measure of inflation, the core personal
consumption expenditure deflator (excluding food and energy), real
interest rates stand at almost 1%, well above the lows of previous
recessions. Moreover, inflation on all measures is expected to fall
again next year, which will push up real interest rates.
Average real interest rates across the G3 are historically low
because of the extraordinarily synchronised
global downturn. The last time American real interest rates
were this low, in the early 1990s recession, real rates in the
then booming euro area were 6.5%. Now the euro area and Japan
are also in trouble. Surveys this week confirmed that business
and consumer confidence have slumped sharply in Europe and Japan
as well as America. In The Economist's latest poll of forecasters,
GDP growth forecasts for the big economies have been cut dramatically
for next year (see article). CSFB now forecasts that global
growth in 2002 could fall to its lowest in half a century.
A better way to gauge the tightness of monetary policy is to compare
nominal interest rates with nominal GDP growth. An old rule
of thumb is that, when interest rates are higher than the rate
of growth in nominal GDP, monetary policy is restrictive; when
interest rates are lower, policy is expansionary. A crude way
to understand this is to see, say, America's nominal GDP growth
as, in effect, the average return from investing in America
Inc. If the average return as measured by nominal GDP is higher
than the cost of borrowing, investment will expand.
A recent analysis by UBS Warburg finds that by this yardstick monetary
policy is not particularly loose. In the year to the second
quarter, nominal GDP growth in the G3 was 2.7%, roughly the
same as the average interest rate. In the fourth quarter, as
economies contract and inflation falls, nominal GDP growth could
well slow to barely 1%, its lowest since the 1930s. If it does,
interest rates need to fall further.
 Japan
is largely responsible for the dangerously low rate of nominal
GDP growth: its nominal GDP has fallen by 2% over the past
year, yet nominal interest rates cannot go below zero. But
in America too, nominal GDP growth looks likely to fall towards
1% early next year as the economy shrinks. That is alarming.
As inflation and nominal GDP growth approach zero, central
banks' ability to loosen monetary policy becomes limited,
as the Bank of Japan has painfully discovered (see article).
Not only is monetary policy not yet sufficiently
loose; it is also possible that, in this downturn, interest
rates may be less powerful than usual in spurring demand. Massive
excess capacity and the heavy debt burdens of firms and households
may discourage new borrowing and spending. The unprecedented
nature of the terrorist attack and its impact on confidence
may also make consumers even less responsive to interest rates.
If so, rates may need to fall by more than in the past to generate
enough demand for a recovery.
Two-armed bandits
In recent years, it has become accepted wisdom that monetary policy is more appropriate
than fiscal policy for stabilising economies. Monetary policy
is much easier to reverse than spending increases or tax cuts,
a crucial point given many countries' worrying long-term budgetary
positions. This is why Alan Greenspan, the Fed's chairman, has
advised caution on a fiscal stimulus. If a big increase in government
borrowing pushes up bond yields, it will undermine cuts in short-term
rates.
Nevertheless, America is going to get a fiscal stimulus.
Fiscal easing from tax cuts equivalent to 0.6% of GDP was already
planned before September 11th. Now a further package with a
total of up to $130 billion (over 1% of GDP) may be added, tipping
America's budget from surplus to deficit. On top of extra defence
spending and emergency disaster relief already approved by Congress,
there is strong support for more spending and tax cuts.
Bigger tax incentives for investment and a rebate for low-income earners
seem likeliest, but there is no guarantee that either would
boost spending anytime soon. Firms with excess capacity might
not want to invest more and workers could simply save any tax
cut. A better idea has been suggested by Alan Blinder, an economist
at Princeton University. He proposes that Congress should reimburse
states for a temporary reduction in sales tax. This has the
advantage that, because it is temporary, it would encourage
people to buy now, not later, and it would not damage America's
long-term budget position.
At least America starts with a budget
surplus. Japan already has a vast deficit, thanks to years of
wasteful public-works projects funded in a vain attempt to revive
its sick economy. Japan now has little room for a further stimulus.
The euro area is also constrained by its needlessly restrictive
"stability pact", under which budget deficits can exceed 3%
of GDP only in exceptionally severe recessions.
This rules out
significant fiscal stimulus. Indeed, if governments were to
meet their intermediate targets for 2002, set in the framework
of the stability pact, fiscal policy would need to be tightened
in the euro area by an average of 1.5% of GDP next year. But
there are no penalties for exceeding these intermediate targets.
So, thankfully, Europe's governments have said that they will
set them aside and allow automatic fiscal stabilisers to work.
Germany's target for 2002 was to reduce its deficit to 1.0%
of GDP. Because of slower economic growth, it is now more likely
to reach 2.5% of GDP-uncomfortably close to the 3% ceiling.
Unless common sense kills the stability pact, Europe will have
to rely largely on further monetary easing.
The ECB and the Fed still have ample room to cut rates. Will they?
Central banks are by nature cautious. But with inflation relatively low and
falling, caution may now be more about ensuring that there is
not a depression. The price, if they overdo it, may indeed be
somewhat higher inflation in two years' time. But better that
than a deep global slump.
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