What a dilemma. It seems the Fed made two mistakes. First, it let the rate of interest fall far too low earlier this decade fuelling a consumer borrowing boom and a bubble in asset prices. But, maybe more recently it was too slow to lower interest; as a result, the most recent cuts in rates seem to be having limited effect. A stitch in time saves nine, and it appears by lagging behind the curve, the Fed has left itself with lots of rapid stitching, in an apparently vain attempt to fix the threadbare fabric of the US economy.
But now, all eyes turn to the UK and Europe. Many argue that the Bank of England and European Central Bank need to embark both on rate cuts, and on pumping money into the economy now, and in the process avoid the apparent panic that has become endemic at the Fed.
But inflation in Europe is on the up.
Many think the rate of inflation in the UK could once again move by more than a full percentage point above its inflation target within the next few months, thus promoting another of those embarrassing letters from the Bank’s governor to the chancellor. In such an environment, how can the Bank of England start lowering rates?
Then this morning, news came in telling us that the CPI rate of inflation in the Eurozone is now 3.5 per cent, up from 3.3 per cent in February.
It now stands at the highest level since March 1992.
It’s a tough one.
If the global economy is set to slow dramatically, then that will presumably mean lower demand, and prices will then fall. Think ahead, say those itching for rate cuts, inflation is up simply because of one-off effects. When they ease out of the system, inflation will fall rapidly now is the time to allow for this.
But it appears a new school of thought is growing. This school says first of all that in future, central banks must take into account inflation of asset prices when setting rates.
Furthermore, goes the argument, the period of low inflation was not caused so much by low demand which usually requires cuts in interest rates, but was simply down to external factors – one-offs, for example, advances in productivity and cheap imports. It may be be a mistake to keep rates high now, because inflationary pressures are down to one-offs, but equally it was a mistake to let rates fall so low earlier this decade because low inflation was down to one-offs.
Maybe, then, monetary policy has got it completely wrong. Rates were cut when demand was already too high. Now rates are too high, when demand is falling off the edge of a cliff.
It’s all very well of course, but we are being wise after the event.
The conclusion: we now need to stitch this idea into economic thinking going forward, but it may not be that relevant to solving the crisis we are in right now.
© Investment & Business News 2013