Japan haunts the Big Three Central bankers fear a Tokyo-style deflationary spiral if the rate cuts go on
Larry Elliott and Heather Stewart Wednesday November 6, 2002 The Guardian Millions of American voters trooped to the polls yesterday to exercise their democratic rights and pass judgment on George Bush's first two years in the White House. Whether the president wins another term in 2004, however, may have more to do with the votes of just 12 men and women in Washington tonight. The 12 are the voting members of the Federal Reserve's open market committee, the group at the US central bank that sets interest rates for the world's largest economy. Today's decision will be seen, perhaps, as a pointer to how the 18 votes on the European Central Bank's governing council and the nine on the Bank of England's monetary policy committee will stack up tomorrow. What is certain is that a lot is riding on the deliberations of these 39 central bankers in Washington, Frankfurt and London. A year ago, the idea that late 2002 would see policy makers under pressure to give a boost to the global economy would have been seen as absurdly pessimistic. Stock markets were recovering quickly following the terrorist attacks on September 11 amid confidence that the aggressive rate cutting - particularly by the Fed and the Bank of England - would provide the stimulus for rapid recovery this year. Most of the analysts now demanding action from Alan Greenspan, Wim Duisenberg and Sir Eddie George were anticipating that by now rates would be going up not down. Things have, however, not gone according to plan. The US - the linchpin of the global economy - had a storming start to 2002, but gradually the impetus has petered out as the legacy of the bubble economy of the late 1990s - over-investment, weak profitability and an overhang of debt - has put the brake on growth. Unemployment is rising, the manufacturing sector is contracting and, despite its recent strong rally, the stock market has taken a fearful hammering. All that has kept the economy from a double-dip recession has been the consumers' willingness to rack up debt, but even here there have been signs in recent months that the shop-till-you-drop spirit has been on the wane. Figures out from the car industry last week showed falls of up to one third in sales last month as the boost from free credit deals wore off. The mood music coming out of the Fed recently suggests that Alan Greenspan is worried. "It is because the Fed seems uncertain whether growth will persist even at the disappointing rate seen so far this year that it appears to be contemplating further monetary ease", said Stephen Lewis of Monument Securities. The gloomier analysts say that today's expected cut will not the be the last and that by early next year interest rates could be down by one percentage point or more. This reflects the historic bias in US economic policy making, which ever since the terrible hardship of the Depression has given a higher priority to jobs and growth than to price stability. German obsession The same could not be said of the ECB, which has inherited the German obsession with inflation born out of the country's seminal economic event of the past century - the hyperinflation of 1923. A glance at the latest forecasts from the International Monetary Fund would indicate that Europe is in greater need of a rate cut than the US, with growth likely to be around 0.75% in 2002 and 2% next year compared with America's 2.2% and 2.6%. Almost every economic analyst, from the IMF and the OECD downwards, pinpoints Germany as the root cause of the eurozone's weakness. Europe's biggest economy has three interlocking problems; the legacy of unification, which saddled it with high labour costs; an uncompetitive exchange rate on joining the euro, and a policy inertia that prevents the government from embarking on serious structural reforms. "The eurozone is sliding down the slippery slope and Germany is a cat's whisker away from recession", said David Brown, chief European economist at Bear Stearns. "The problem with the ECB is that they always end up behind the curve. They always drag their feet." An added complication has been the fiasco of the stability and growth pact, with the ECB taking a robust line against governments which would like to turn a blind eye to the pact's strict deficit rules now that times are hard. And some analysts believe the ECB's determination to demonstrate its independence from eurozone politicians could prevent it following the Fed's lead when it meets this Thursday. "We expect the ECB to leave rates unchanged," said Paul Ashworth, from Capital Economics, "citing the deterioration in its two monetary pillars as reason and adding a petulant rider to the accompanying statement about the danger of national governments tinkering with its beloved stability and growth pact." Mr Ashworth added that failure to cut rates now would "only damage eurozone growth prospects further, and could con demn Germany to recession and deflation." Poised somewhere between the Fed and the ECB is the Bank of England. Later this month, the chancellor, Gordon Brown, will admit that growth for this year has fallen short of Treasury expectations, with manufacturing badly hit by the anaemic recovery in the global economy. On the face of it, the UK needs cheaper borrowing, as inflation has persistently undershot Mr Brown's 2.5% target. Three of the nine members of the MPC voted for a cut last month, citing the risks to the global economy, and arguing that a pre-emptive cut was justified by what was happening in Europe and the US. "The case for a cut is now overwhelming," said the TUC general secretary, John Monks, yesterday. "The Bank should recognise the very real dangers to growth and be brave."For Mr Monks to get his wish, however, at least two of the MPC members who last week voted against a cut need to be convinced that something has altered. But with consumers' appetite for borrowing and spending still apparently insatiable, the hawks look unlikely to change their minds. Whatever the respective strategies of the 39 monetary policy decision-makers this week, the markets now believe the question is when, not whether, rates will have to come down - on both sides of the Atlantic. With borrowing costs already at historic lows after the co-ordinated post-September 11 cuts of last year, the question which may secretly be niggling the central bankers is whether they should be keeping their powder dry. Nobody in Washington or Frankfurt wants to end up like policy makers in Japan, where there are no conventional tools left to drag the economy out of its deflationary spiral. Wishful thinking Ian Harwood, head of global economics at Dresdner Kleinwort Wasserstein, said he was convinced the Fed would move tonight but doubted whether even a 50-basis point reduction in US interest rates would stem the flow of disappointing data over the next few months. "I think it's wishful thinking to imagine that we're going to see both consumer spending and investment spending pick up." If Mr Harwood is right, this week could be only the start of a rate-cutting process that will see borrowing costs in 2003 plumb depths not seen for 50 years or more. That does not appear to be Wall Street's view. Share prices have just enjoyed their biggest one-month rise in 15 years, partly in anticipation of a rate cut from 1.75% to 1.5%. Sceptics say, however, that if 11 Fed rate cuts in 2001 failed to produce a sturdy and sustainable recovery, then why should anybody imagine that a 12th will do the trick?
